My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, September 22, 2014

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme

One of the biggest misconceptions small business owners have is that they have automatic access to the $800,000 capital gains exemption (“CGE”) upon the sale of the shares of their corporations (Note: beginning in 2015, the $800,000 will be indexed for inflation). Nothing can be further from the truth. There are three complex tests that must be met in order to qualify for the exemption and something as innocuous as imposing a holding company (with significant cash and investment assets) between you and your operating company may disqualify the shares.

Warning!!! Before I move forward, please note that I am “dumbing down this post”. You may think it complex, but I am leaving out significant issues, definitions and details to make it somewhat readable. Do not rely upon this blog for your capital gains planning, use it only to gain an understanding of the issues and please contact your tax advisor before undertaking any planning discussed in this post. In fact, to emphasize the complexity of this issue and how intricate and fact related the planning is, I will not answer questions and respond to comments on this post. Sorry about that.

The Capital Gains Exemption


In order to access the CGE, the shares you sell must meet the definition of a "qualified small business corporation share” (“QSBC shares”). Sounds simple, but this provision and the related provisions often prove to be a tax quagmire for many practitioners.

The shares must meet three tests to be considered QSBC shares and become eligible for the CGE.

Small Business Corporation Test


At the time you sell your shares, they must be shares of a Small Business Corporation (“SBC”). A SBC, amongst other criteria, must be a Canadian-controlled private corporation whereby all or substantially all (meaning 90% or greater) of the fair market value (“FMV”) of the assets of which at that time is attributable to assets that are used principally in an active business carried on primarily in Canada.

In plain English: at the time of the sale, the company must be using a minimum of 90% of its assets in carrying on an active business in Canada. In other words, if you have more than 10% of the FMV of your corporation in passive assets such as cash, stocks, rental real estate, you may be offside the rule.

It is important to note that the Goodwill (which is often the largest asset) of a business will count as an asset used in an active business. However, generally cash, portfolio investments and intercompany loans will not qualify as active assets.

Holding Period Ownership Test


This test requires that the shares cannot have been owned by anyone other than the individual or a person or partnership related to the individual, throughout the 24 months immediately preceding the disposition time. The two year test is very confusing. It is a rule that at its core is intended to prevent anyone not related to you from holding the shares within the last two years. However, on one hand the 24 month rule provides for exceptions such as if you transfer a proprietorship or partnership to a corporation, yet if you incorporate a new company and hold the shares less than 24 months, you will be disqualified.

In plain English: in most cases you will be required to have held the shares two years prior to the sale.

Holding Period Asset Test


If you thought the above rules were complicated, this test makes the other rules seem simple.

This test requires that throughout the 24 months immediately preceding the sale, more than 50% of the FMV of the corporation's assets must have been attributable to assets used in an active business. For this purpose, assets considered to be used in an active business consist of:

1) Assets used principally in an active business carried on primarily in Canada by the corporation or a related corporation;

2) Certain shares or debt of connected corporations; and

3) A combination of active business assets or certain shares or debt of connected corporations

In plain English: at least 50% of the company’s assets must have been used in an active business throughout the two-year period prior to sale.

Where you have a holding company ("Holdco") or stacked companies (Holdcos owning Holdcos) ultimately owning the shares of an operating company, the threshold percentage for meeting the Holding Period Asset Test may become 90% instead of 50%. These rules are far too complicated to discuss, suffice to say, if you have a chain of companies, at least one of the companies in the chain must meet the 90% threshold percentage over the two-year period.

As you can see, the CGE is no gimme. You need to ensure you hold the shares 24 months, at the time of sale 90% of the assets are used in an active business and over the prior 24 months, 50% (in some case 90%) of the FMV of the assets were used in an active business.

Traps and Obstacles


Holding Companies


Many small business owners utilize a Holdco for creditor proofing, which is often recommended. However, over years the Holdco may end up owning substantial investment assets. These assets may be problematic for the following reasons:

1. Since Holdco owns your operating company ("Opco"), you have to sell your holding company shares to a buyer to qualify for the CGE and if you have substantial assets, you need to remove them prior to a sale. This may trigger a substantial tax liability and/or cause the shares to fall offside the QSBC rules.

2. Many people use their Holdco to hold the shares of other corporations. This is very problematic when you want to sell your shares of Company A, but your Holdco not only owns Company A, but also owns shares of Company B and Company C. How do you get the shares of Company B and C out of your Holdco prior to the sale? The answer is - not easily.

As I have written in prior blogs, I often suggest rather than automatically interposing a Holdco between you and your Opco, you may wish to consider using a family trust with a corporate beneficiary (a Holdco typically owned by you). Thus, instead of the cash being plugged up in your Holdco and potentially putting you offside the QSBC rules, your Opco pays a dividend of the excess cash to your family trust which in turn allocates a tax-free dividend (in most cases) to the holding company beneficiary of the family trust.

This is a very subtle point, but now instead of having the dual problem of your Holdco company potentially having too many investment assets and/or you needing to sell your Holdco shares to access the capital gains exemption, you can now just sell the Opco shares, as the operating company is owned by the trust. The Holdco company even if it has accumulated substantial assets, is not part of the three CGE tests as it has no direct interest in the company being sold.

Safe Income


I have no desire to get into this complicated issue. However, where a Holdco or Opco has other assets such as excess cash, shares in other corporations or real estate that a purchaser does not require, it is often necessary to transfer these assets out of Opco or Holdco (known as purification). This is often done by cross share redemptions that result in dividends. All you need to know for purposes of this post is that if an operating company pays a dividend to another corporation in contemplation of a sale and the dividend exceeds the recipient’s proportionate share of safe income (in very simple terms, retained earnings of the dividend payer) the excess portion becomes a taxable capital gain. This can be very problematic when you are trying to purify your corporation of excess assets prior to the sale to qualify for the CGE and you definitely require your tax advisor's assistance.

Cumulative Net Investment Loss


The Cumulative Net Investment Loss (“CNIL”) account tracks an individual’s net historical investment income. Essentially it is the sum of your investment income, such as interest and dividends, less investment expenses such as interest expense, carrying charges, losses from limited partnerships and resource deductions from flow-through shares. If the cumulative balance is negative, this balance restricts access to the CGE. The negative balance can in many circumstances be eliminated by having your company pay you a dividend prior to any sale, subject to the safe income rules noted above.

Allowable Business Investment Losses


An Allowable Business Investment Loss (“ABIL”) typically results from capital losses on shares and debt in private Canadian corporations. If an individual has realized an ABIL in a prior year, it will reduce his or her CGE available to claim. Thus, you need to confirm if you have ever made such a claim prior to utilizing your CGE.

Insufficient Dividends


This issue is way beyond the scope of this article, however, where it is reasonable to conclude that a significant portion of the gain is attributable to the fact that a minimum amount of dividends has not been paid annually on any class of shares in the corporation, other than classes of "prescribed shares”, the CGE can also be restricted. Ask your accountant if this is an issue for you.

Planning


Prudent planning would suggest that you and your advisor consider these rules far in advance of any potential sale, so you can monitor whether your corporation is onside the rules. Where the corporation falls offside you can “purify” the corporation of any offending assets. Purification should be ongoing, because if you have to purify at the last minute, there is a good chance you will not meet the various criteria to qualify for the exemption.

If you are still with me, I am sure you will agree that you should never assume your corporation’s shares will qualify for the CGE. The morass of rules requires you and your advisors to carefully navigate the rules to ensure your shares will qualify when you decide to sell your corporation.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

23 comments:

  1. One thing we've done incidentally, is that my wife and I are 50% owners of our business. It's my understanding that if we sell, we each get capital gains exemption. Since our personal funds are combined, that effectively gives us twice the exemption room on a business sale. This is pretending that I'd sell our business for an amount large enough to matter :).

    ReplyDelete
    Replies
    1. Hey Glenn:

      I am not really answering questions or commenting on specifics on this post, but since you post is general I will comment. Any capital gains planning undertaken with your advisors should consider how best to maximize the capital gains exemption, such that is multiplied with your spouse and/or children. But again, very fact specific to each situation and whether maximizing the exemption is practical or possible.

      Delete
  2. Hi Mark,
    Would it be possible to add a link for each of your blog....so that it can be saved in Word of PDF format.

    Thanks

    ReplyDelete
  3. Hi Mark,

    Here is a situation and perhaps you can help me:
    I have held my shares of my holdco (operates as a small active company)for over 10 years. My holdco has also owned 1/3 of an Opco and have held those opco shares for 7 years. My holdco recently bought (Jan 2015) the other 2/3 shares of Opco (unrelated to me) so now we hold 100% of Opco. If I happen to get a good deal for someone to buy my holdco shares this summer will I be entitled to the capital gain exemption?

    Someone tells me my holdco had to have owned the other 2/3 Opco shares for at least 2 years. I'm not sure if this is correct.

    Nick

    ReplyDelete
    Replies
    1. Hi Nick

      Sorry, I do not provide personal tax planning advice on this blog. There are complicated look through rules for Holdco's, you should speak to your accountant.

      Delete
  4. 110.6(14)(f)(ii) what happens if a taxpayer wants to roll only part of his customer list (say 33%) from a sole proprietorship to a corporation under s85 and sell the corporation and use the CGE . Does this section disqualify the shares because 90% of his list is not transferred?

    ReplyDelete
    Replies
    1. Hi David

      Sorry, but I don't answer technical questions on this blog. Ask your own accountant or engage one for questions such as this.

      Delete
  5. Hi Mark,
    I have purchased my residential house on Holdco. now I want to sell my house but my Accountant shocked me that large tax is payable by Holdco because the house price is appreciated. If I cannot use my LGE?

    ReplyDelete
    Replies
    1. Hi Anon

      Your accountant is correct, you cannot use your capital gains exemption on passive investments such as real estate. I always steer my clients away from owing their home in a corp for many reasons, including the fact once you put it in a corp, it is no longer tax free because you lose the principal residence exemption and cannot claim the capital gains exemption, let alone the taxable benefits you incur having ur home in a corp.

      Delete
    2. Thanks Mark for your reply. I search on internet and came to know about "replacement property rules" and wondering if it is possible that I purchase my new home again on the holdco and declare sale as replacement property. In this way I may defer the immediate capital gain.

      Delete
    3. Off the top of my head, it would not qualify for a replacement property, but I have not researched it. Speak to your accountant, I don't do other accountants planning on this blog

      Delete
  6. Hello Mark,
    You are good.
    You should publish a book:
    "QSBC Purification and Such"
    a plain English version of our murky ITA

    If I had paid $2500 for such a book, it would still have been way cheaper that what it cost me to understand up to just what you explain in the above article.
    Thank you for publishing.

    ReplyDelete
  7. Hi Mark,

    I have a OpCo right now for a year in SK, with myself owning 100 Class A common voting and my wife owning 100 Class B common non-voting. There is a bit of retained earnings after year one.

    If I were to introduce a HoldCo, could I get the HoldCo to own Class C common shares and then issue a class specific dividend back up to HoldCo for creditor proofing?

    ReplyDelete
    Replies
    1. Hi Gabe:

      There is probably some value in the company at this point, so you cannot just issue new Class C shares at nominal value and trying to override the dividend rights of the common shares are problematic. You need to speak to your accountant or engage one to determine the best course of action as there are many other factors to consider.

      Delete
  8. Hi Mark,
    I heard something about a rule regarding a stress test of how many employees the company has in order to qualify. Have you heard of that?

    ReplyDelete
    Replies
    1. Hi Anon

      There is no such rule, you may be thinking of the more than 5 employee rule for specified investment income, but that is just a deeming rule for claiming the small biz deduction, it has nothing to do with the QSBC status for the capital gains exemption.

      Delete
  9. Hi Mark,
    Is there any rule (in AB maybe?) where there is a minimum number of shares a Holdco MUST purchase of an Opco to actually exist? Someone's told me that you MUST own at least 10.1% of the Opco's shares to open a Holdco. Love the blog, by the way...

    ReplyDelete
    Replies
    1. Hi Anon

      There is no minimum. You are mixing up concepts. The 10.1% is so the Holdco is connected and can receive intercorporate dividends tax free

      Delete
  10. Hi Mark,
    Are there any timing requirements as to when the purification of a SBC is done prior to a freeze and introduction of a family trust?

    ReplyDelete
    Replies
    1. Anon as noted above this area is super complex. The timing may or may not matter depending upon what you are trying to accomplish. Speak to your accountant

      Delete