The Capital Gains Deduction Minefield
David Christianson, CFP, R.F.P., TEP“Dollars and Sense”
Elmer and Mary Neufeld built up a very successful implement business over 30 years, then sold the assets of the business for almost $1 million. After taxes on the gain, they were left with about $700,000.
Meanwhile, Robert and Roberta Roberts started in 1972 with a great idea, which eventually grew into a successful business that they were able to systematize and duplicate in other locations. They set it up from the start with a plan for an eventual sale. When they sold the shares of their corporation recently to a competitor for a $1 million, they got to keep the entire $1 million after taxes.
The Neufeld’s sale did not qualify, because they sold assets of the business, and not shares of the corporation. While the buyer was happier, with a higher cost base to depreciate in the future, the Neufeld’s could have enjoyed the same tax result as the Roberts, if they had planned a little better.
Properly structured, the Roberts’ sale qualified them for the capital gains exemption on the sale of shares of a qualified small business corporation. If they had sold the business assets instead of shares, they would have paid tax on the difference between the adjusted cost base of the assets and the sale price.
Let's look at the rules that may allow the sale of shares in an active business, farm corporation or active farm to qualify for a capital gains deduction. We will also look at a recent Federal Court of Appeal case that adds one more hurdle to overcome.
There is no universal capital gains deduction anymore. However, in special circumstances, capital gains may be earned without tax.
As you know, a capital gain arises when property (a "capital asset") like corporate shares, business interests, real estate or similar assets are sold at a profit, or when a "deemed" disposition takes place.
A deemed disposition can be triggered (with proceeds considered to have been received equal to fair market value) by an event such as death, gifting a property to a non-arms’ length person, or by changing the use of a rental property from rental to personal use.
The capital gain on your principal residence is usually considered tax free, but each couple (or individual) only gets one exemption. (This was changed in 1982 from allowing two properties per couple.) You can choose which dwelling to use, if you own more than one, but generally each year the exemption had to apply to only one. (The exception can be if you sell two properties in one year, where a partial exemption may apply to each if you do it right.)
For owners of “qualified small business corporation shares” or shares of a qualifying active farming corporation or proprietorship, a capital gains deduction of $750,000 per lifetime exists. This is obviously a tremendous benefit for people who spent their lives building up value in a business or farm, like the Neufelds and the Roberts.
If the ownership is set up correctly (preferably from the start), the capital gains deduction can be multiplied by the number of family members who own shares, either directly or through a family trust. This is why it is important to get good professional advice, and review the situation every few years.
This exemption opportunity means that a better tax result is almost always obtained for the seller when shares are sold instead of assets.
However, to qualify for this exemption, there are several criteria, all of which must be met. It must be an active business, so an investment holding company does not qualify, nor does a corporation that no longer carries on its former active business.
As well, the shares must have been owned by the current owner (or a person related to the individual) for the previous 24 months prior to disposition. The shares must also be shares of a small business corporation, which is a Canadian-controlled private corporation where all or substantially all of the fair market value of the assets are principally used in an active business carried on in Canada.
Meeting all through these rules means forward planning and a lot of work for those few tax specialists who focus on helping owners "purify" their corporations to qualify, prior to a sale becoming imminent.
The Federal Court of Appeal recently added another criterion, according to the July/August 2008 issue of the CLU Institute Comment newsletter. In a case called La Survivance v. The Queen, a small business was deemed to not qualify for this exemption when its shares were sold to a public corporation. Subsection 256(9) of the Income Tax Act states that when there is a change of control in the corporation, the change of control is deemed to happen at the beginning of the day - 12:01 a.m.
When this deal closed at 5:00 pm that same day, the company was no longer a Canadian-controlled private corporation, but a publicly-controlled Canadian corporation and no longer qualified for the exemption.
An election can be filed to opt out of this deeming provision, but it requires agreement of both sides (which might not be in the best interests of both parties), and must be done before the deal closes.
That court decision is a pretty scary outcome from such an arcane provision, and one more reminder that the best specialized professional advice is usually a bargain.
(c) 2008 Dollars and Sense, Used by Permission