The lifetime capital gains exemption has helped many people save tax since it was introduced in 1986.
In short, it allows people to shelter a certain amount of capital gains income under certain conditions (see “History of the capital gains exemption”). This article will examine what those conditions are, and how they work.
How to qualify
The capital gains exemption (CGE) is available to individuals only, not corporations, and forms a deduction (worth 50% of the exemption, since 50% of capital gains are taxed) from net income. Benefits that use net income, such as the age credit and OAS clawback, will be calculated before the deduction is reflected.
To qualify for the exemption, three tests must be met at the time of disposition.
- Small business corporation (SBC) test: All, or substantially all, of the company’s assets must be used in an active business carried on primarily in Canada. “All or substantially all” is generally considered to mean at least 90%, using fair market value. Only the company’s assets are considered in the criteria; debt and other liabilities have no impact. Assets not listed on the balance sheet are also included, such as goodwill and internally generated patents. The reference to “primarily in Canada” generally means at least 50%.
- Holding period test: The disposed share must have been owned by the shareholder or a related person throughout the 24-month period prior to the disposition. This is an attempt to limit the CGE to longer-term investments rather than rewarding quick flips.
- Basic asset test: Throughout the 24 months prior to the disposition, the corporation had to have been a Canadian-controlled private corporation and more than 50% of the company’s assets had to have been used in an active business carried on primarily in Canada.
Common planning strategies
A series of tactics are commonly used to help qualify for or optimize CGE.
When assets do not meet the 90% percent threshold for the SBC test, shareholders can attempt to purify their assets—i.e., employ them in earning active business income. To adjust the mix of active and passive assets, a company could use passive assets to pay down liabilities, buy active business assets or pay a dividend to the shareholder. By recharacterizing or removing passive assets, the mix of assets is re-proportioned to meet the 90/10 ratio of active to passive.
Crystallization refers to claiming the CGE on qualifying shares that the shareholder continues to own. When CGE is crystallized, the CGE claimed is embedded in the adjusted cost base (ACB) of the shares held by the shareholder, increasing the ACB by the amount of the CGE claimed.
Say, for instance, a shareholder has $800,000 in CGE left and her shares have an ACB of $1,000 and a fair market value of $850,000. If she crystallizes her CGE, the ACB of the shares will increase to $801,000 instead of $1,000.
The CGE claim cannot be immediately converted to cash without triggering negative tax consequences. By embedding the amount claimed in the ACB, it reduces the capital gain when the shareholder eventually sells the shares. Crystallizing ensures a shareholder benefits from this tax advantage without having to meet qualifying criteria at the time of sale.
Multiplication involves using the available CGE of other family members. If several family members can claim their CGE at the time a business is sold, the overall income tax liability can be reduced across the family unit.
Pitfalls to watch for
When using these planning strategies, watch for anti-avoidance measures and other tax implications, such as the following, to minimize any unanticipated consequences.
- As mentioned, Section 84.1 of the Income Tax Act blocks shareholders from using crystallization strategies to convert CGE into cash.
- The alternative minimum tax (AMT) can cause an unexpected tax liability in the year CGE is claimed. Generally, this can occur when a taxpayer crystallizes in a year of otherwise low income. While AMT is refundable, a refund is generated only when AMT is less than* the regular tax calculation in the subsequent seven years.
- A balance in a taxpayer’s cumulative net investment loss (CNIL) account can restrict access to the CGE. As the name implies, this is a cumulative calculation that considers all of an individual’s investment income and investment expenses incurred after 1987. If the calculation results in a net loss, the CNIL could impact a CGE claim.
- An allowable business investment loss (ABIL) could impact a CGE claim. If an ABIL is realized in the year, whether or not it is claimed on the tax return, it is used in the CGE calculation.
- The CGE could be denied if it is reasonable to conclude that a significant portion of the capital gain realized on the disposition of the shares is attributable to a lack of dividends having been paid on the shares.
- The capital gain from a disposition and capital gain deduction must be reported and claimed in the year of disposition. Failure to include the deduction in the return cannot be corrected later.
- If the capital gain is realized in a trust and the trust allocates the capital gain among several family members, these amounts are payable to the family members. Using a family member’s CGE entitles that person to a payment.
July 18, 2017 federal proposals
The federal government’s recent proposals aimed at curbing income splitting by business owners will directly impact common CGE strategies, beginning in 2018. A general overview of the changes include:
- capital gains accrued in a trust and allocated to a beneficiary will no longer qualify for the CGE;
- capital gains accrued to individuals while under the age of 18 will no longer qualify for CGE, eliminating crystallization strategies involving minors;
- CGE will not be available if the capital gain is subject to an expanded set of kiddie tax rules. Under the proposals, the current kiddie tax regime is extended to capital gains realized by specified individuals who haven’t contributed capital or services to the company.
(Update on Nov. 14, 2017: In October, the government rescinded its tax reforms for the lifetime capital gains exemption; however, income sprinkling measures stand.)
The proposals contain transitional rules and elective options for transitioning to the new regime.
While CGE appears to be a simple concept, a claim can easily be derailed by the intricacies. Working with a tax professional can minimize unexpected consequences.
*A previous version of this story incorrectly stated that a refund is generated only when AMT is greater than the regular tax calculation in the subsequent seven years. A refund is generated when AMT is less than the regular tax calculation. Return to the corrected sentence.
History of the capital gains exemption
Introduced in 1986, the capital gains exemption (CGE) initially applied across any type of capital property. It was curtailed in 1994 when it was restricted to shares of a qualified small business corporation and/or qualified agricultural capital property. That same year, individuals could file an election to crystallize unused amounts up to $100,000 under the original rules (any capital property). All CGE utilized during the original regime integrates with an individual’s overall limit of $835,716 in 2017 (indexed annually to inflation).
by James W. Kraft, CPA, CA, MTax, CFP, TEP, and Deborah Kraft, MTax, LLM, TEP, CFP. Deborah is faculty and director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo. James is vice-president, Head of Business Advisory & Succession, BMO Nesbitt Burns.