You’re likely aware of the tax advantages of donating public company shares to a qualified charity: the donor does not have to pay taxes on any capital gains and also receives a donation credit. This year’s federal budget proposed similar treatment—with important caveats—for donations involving private company shares and real estate situated in Canada.
On July 31, the Department of Finance released draft legislation that would implement the new rules (subject to any possible modifications that may result from the comment period ending on September 30). It confirms the exemption can apply to donations made during a taxpayer’s life or after he or she dies.
To qualify for the exemption, the private company shares or real estate must be sold and cash proceeds gifted to a qualifying charity within 30 days. The sale must be to an arm’s length, non-affiliated person or partnership, and the taxpayer must be a resident of Canada at the end of the year of disposition. The draft says the new rules would take effect in 2017.
The donor will get a charitable gift receipt for the cash proceeds donated to the charity, as well as a tax exemption for some or all of the capital gain triggered by the sale of the shares or real estate. If the gift is made by a corporation, a capital dividend account (CDA) credit for the non-taxable portion of the capital gain would also result.
So, it is possible that:
- the entire capital gain is sheltered from tax;
- the donation could be used to shelter other income; and
- in the case of a corporate donation, the credit to the CDA could be distributed as a tax-free capital dividend to shareholders of the corporation.
This possibility is equivalent to what happens with gifts of publicly-traded securities.
The draft has plenty of sticky spots, so don’t get your hopes up.
There’s a formula to calculate the amount of the exemption that can be claimed. It pro-rates the amount of the capital gain that can be exempted. The capital gain is multiplied by the lesser of:
- the amount of money gifted, and
- the amount of money received as proceeds on the disposition prior to the gift (less any advantage received in respect of the gift)
The resulting amount is then divided by the entire proceeds of disposition.
This only allows the amount received as monetary proceeds to be sheltered, even if more is actually given in cash as a gift. Because the capital gain is multiplied by the lesser number, if the shares or real estate have a material adjusted cost base (ACB), it limits the amount of the exemption even when the entire amount of the proceeds is received in cash and given to the charity.
The largest exemption under this formula would arise where there is a nominal ACB and the cash donation equals the entire proceeds of disposition. If the capital gain from the disposition exceeds the amount under the formula, the excess amount is taxed as a capital gain.
The rule can apply to gifts made by the graduated rate estate (GRE) of a deceased taxpayer. Say your client’s private company shares have no ACB. On death they’re deemed disposed for $1 million. The resulting $1 million capital gain on the terminal return can essentially be eliminated if the shares are sold for cash to an arm’s length party by the GRE and the cash is donated to charity within 30 days of the sale.
Since the formula for estate dispositions limits the amount that can be exempted to the capital gain deemed to occur on death, any appreciation in value of the shares between the time of death and the time the shares are disposed (and the cash donated) will not be exempted.
On death, where there is a spousal rollover of shares or real estate, and a subsequent disposition, it would have to be the spouse or testamentary spousal trust that makes the gift and claims any exemption.
A sale of private company shares can be made by an estate funded by life insurance proceeds in arm’s length buy-sell arrangements. It is possible that the sale of private company shares funded with life insurance proceeds may qualify for preferential tax treatment under the new rule. But it’s not as easy as it may sound.
For example, the traditional promissory note buy-sell method using corporate-owned insurance would not provide the vendor (the deceased taxpayer’s estate) with cash proceeds, even though the life insurance proceeds may be received by the estate in repayment of the promissory note and gifted to charity within the 30-day period. That’s because the promissory note is debt, not cash.
Since the deceased taxpayer must be at arm’s length with the purchaser(s), buy-sell arrangements between family members involving family businesses would not appear to qualify. Corporate redemptions involving businesses where the deceased holds a majority of the shares, even if the surviving shareholders are at arm’s length with the deceased vendor, also may not be able to access the benefits of the new rule.
The draft also contains an anti-avoidance provision that taxes a capital gain that was previously exempted if, directly or indirectly, the property, substituted property or property that derives its monetary value from the property, finds its way into the hands of the taxpayer or non-arm’s length parties in the following 60 months after the initial disposition.
Triggering this provision would result in tax on the initially exempted capital gain. Interest would be owed on outstanding taxes from the time of the original disposition.