Profit and Policy: Navigating the Lifetime Capital Gains Exemption

All references to a spouse include common-law partners. All references to the ‘Act’ or the 'ITA' mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised. Please contact us to discuss the contents of the article herein.

Good morning Toronto! For many small business owners in Canada, the Lifetime Capital Gains Exemption (LCGE) is a powerful tax benefit that can significantly reduce the amount of capital gains tax owed on the sale of qualifying property. In today’s article, we will discuss how the LCGE works and the requirements to claim it.

The Lifetime Capital Gains Exemption (LCGE) is an exemption on the sale of Qualifying Farm/Fishing Property (QFFP) and Qualified Small Business Corporation Shares (QSBCS). It allows individuals to shelter from tax, up to a certain lifetime amount. Currently, this amount is set as $1.25m. In practice, as capital gains are included as income at a rate of 50%, the LCGE takes the form of an up to $625k deduction. For many owner-managers, their business is their largest asset. Selling the business often triggers significant capital gains liability. By sheltering a portion of the mentioned capital gain from taxation, the LCGE allows entrepreneurs to support their retirement, transfer wealth to the next generation, or even reinvest proceeds into another venture.

The LCGE is claimed when filing the T1 Personal return for the tax year in which the disposition occured. The sale is reported on Schedule 3: Capital Gains or Losses of the T1 return. The LCGE is then applied by completed Form T657: Calculation of Capital Gains Deduction - it is not an automatic deduction. The CRA often requests proof after filing the return to ensure that the deduction meets all eligibility criteria (discussed below).

QFFP is defined in ITA §110.6(1) as property owned by the individual, their spouse, or a partnership where an interest in the partnership is an interest in a farm/fishing operation of the taxpayer or their spouse. Eligible farm/fishing property is defined as land, buildings, quotas, an interest in a farm/fishing partnership, or a share of the capital stock of a family farm/fishing corporation. In addition, the property must have:

• Been owned by the individual, their spouse, or the partnership for at least 24 months before deposition; AND
• More than 50% of the FMV of the property was used in the course of carrying the concerned farming/fishing business.

More relevant in today’s article, QSBCS are defined in ITA §110.6(1) to be shares of a Small Business Corporation (SBC) that meet certain conditions and tests at the time of disposition (sale). Specifically, immediately before disposition:

• The shares must have been owned by the individual or a related person (See ITA §251(2) for definition) for at least 24 months; AND
• During the 24 months preceding the sale, the corporation must have always been a CCPC; AND
• During the 24 months preceding the sale, at least 50% of the FMV of the CCPC's assets were active business assets (the 50% test); AND
• Immediately before disposition, at least 90% of the FMV of the CCPC's assets were active business assets (the 90% test).

Shares that are issued within 24 months of the acquisition may not automatically meet the 24-month holding period requirement. ITA §110.6(14)(f) deems such shares to be owned by an unrelated person before the issuance of the shares. However, if the shares were issued as consideration for other shares (such as in a share-for-share exchange, estate freeze transaction, corporate reorganization, amalgamation, etc) or as dividends, then the newly issued shares will be deemed to have been for the same period as the original shares. In the event the 24-month test is not met, the LCGE will be denied with respect to the ineligible shares that failed the test. All other shares that meet the 24-month holding period will continue to remain eligible for the LCGE, contingent on meeting all other eligibility requirements.

Furthermore, to satisfy the 50% and 90% tests, at least 50% and 90% of the CCPC’s assets must be active business assets during the 24 months before, and immediately before, the disposition, respectively. Active business assets are defined as assets used principally¹ in generating income from active operations of the business. Typical examples of active assets include inventory, equipment, goodwill, and property used in daily operations. Conversely, assets like excess cash, investment portfolios, and real estate (for rental) are considered non-active (passive) assets because they are not directly tied to the company’s line of business.

¹For the purposes of the Act, ‘principally’ means that the asset was used at least 50% of the time/value in the active business.

In the event the corporation has too many passive assets, it will negatively impact the owner's ability to claim the LCGE. Typically, to meet these tests, corporations often undergo 'purification', a process that aims to remove and reduce passive assets before the sale. This can be done by:

• Paying out excess each as dividends/salaries/bonuses
• Transferring passive assets to a holding company (HolCo)²
• Reinvesting idle funds in active operations

²The HolCo must not be a related corporation (controlled by the same shareholder) to the owner, as the assets of all related corporations are included for the calculations of the 50% and 90% test.

The definition of an active business asset has been tested repeatedly in the courts. In Ensite Ltd. v. The Queen, the Supreme Court of Canada was tasked with considering whether cash can be treated as an active business asset. This case eventually produced the 'Ensite test', which deems that an asset is only considered active if the withdrawal of the property would have 'have a decidedly destabilizing effect on the corporate operations themselves.'

In all cases, Ensite and related rulings have repeatedly emphasized the importance of maintaining comprehensive and well-documented records that justify the classification of assets as active business assets. Cases that lack this documentation tend to be looked on unfavourably by the courts.

In Gervais v. Canada (originally argued in French at the Federal Court of Appeals), the taxpayer attempted to split the capital gain from the sale of shares between himself and his spouse to multiply the LCGE. The court found that the transaction was primarily structured to avoid taxes. As a result, General Anti-Avoidance Rules were applied to reverse and deny the tax benefit. In all, owners should take care to ensure that all transactions undertaken for purification purposes are genuine, well-documented, and have a clear business rationale.

Finally, it should be noted that since the LCGE is an exemption, a taxpayer can claim a portion of it today and, if they start a new qualifying venture in the future, claim the remaining portion of the LCGE again, subject to the overall lifetime limit at that point in time.

In all, the LCGE is a powerful tax planning tool for owners of qualifying small business corporations and/or farm/fishing properties. Successfully claiming the LCGE requires careful attention to meeting the tests and maintaining proper documentation. With careful planning, taxpayers can easily maximize the LCGE while remaining compliant with the Act and Regulations.

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