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MEMO TO CLIENTS - Lifetime Capital Gains Exemption (LCGE)

Charles Rotenberg

A Lifetime Capital Gains Exemption (LCGE) exists for “qualified small business corporation shares” (QSBC Shares) and for farming and fishing businesses.  The exemption is currently $1,250,000.00 gains realized after June 24, 2024.For those who own their own companies, this can mean tens of thousands of dollars in tax savings.


The effect of the LCGE is that upon a sale of the shares of the corporation, either an arm’s length sale, or a transfer to the next generation, the first $1,250,000 of capital gain per shareholder will be free of tax.  Even if one has no thought of selling the shares of the corporation, there are situations where the Income Tax Act will treat assets as having been sold for proceeds equal to the fair market value (referred to as a “deemed disposition”).  Foremost among these situations are non-arm’s length gifts, and death. 


If shares of a qualified corporation, are owned by a family trust, the gain on the disposition can be allocated among all of the capital beneficiaries of the trust. 


At 2025 tax rates, the tax saving in respect of $1,250,000 of capital gains would be as much as $334,800 per individual.


There are many technical rules to determine whether shares of any particular corporation qualify for the Exemption.In order for the shares of a corporation to qualify for the enhanced capital gains exemption the shares must first meet the criteria for Qualified Small Business Corporation ("QSBC") shares.


The primary tests are as follows:


Holding Period Test


In order to qualify for the LCGE, during the 24 month period immediately preceding any disposition of shares, the shares must not have been owned by any person other than the current shareholders or by a person related to the current shareholder.


Active Business Assets Test


As set out above, all or substantially all (defined by Canada Revenue Agency to mean at least 90%) of the fair market value of the assets of the corporation must be assets used principally in an active business carried on in Canada.  As well, at least 50% of the fair market value of the assets of the corporation must be used in the active business over the 24 month period leading up to the sale or other disposition.  An accumulation of cash or other “non-active” investments can throw the mix of assets offside, and the result is that the shares might not qualify for the capital gains exemption.  In such a situation, cash and other investment assets may need to be transferred to a holding company. On an ongoing basis, it may be necessary to strip excess cash and investment assets out of a corporation in order that the shares always qualify for the capital gains exemption.


Need for Ongoing “purification”


It may seem pointless to engage in a series of transactions to strip excess cash assets out of an operating company if there is not thought of selling the company.  However, a number of events, the most notable of which is death, will trigger a deemed sale at fair market value. Since none of us can know when such an event will occur, it only makes sense to ensure that the shares of our companies qualify for the capital gains exemption at all times, in order to meet the tests set out above.  It would be a shame for our families to be saddled with a tax bill of as much as Two Hundred Forty-Five Thousand Dollars ($245,000) being the top marginal tax cost in Ontario in respect of a capital gain on shares that, with some advance planning, would have qualified for the exemption.


Shareholder Entitlement to LCGE


Assuming that the shares of a company qualify for the capital gains exemption using the criteria set out above, there is still a requirement that each individual shareholder is entitled to claim the capital gains exemption. 


The first requirement is that the shareholder must be an individual.  This will include a family trust, but not another corporation.


The capital gains exemption is not $800,000 per company, but $800,000 in aggregate.  Accordingly, if a shareholder claimed $400,000 on the disposition of shares of a company in the past, he or she would only have $400,000 available to be claimed.  If there is any question as to a shareholder’s entitlement, the Canada Revenue Agency will, upon request, confirm the amount of capital gains exemption previously claimed by any individual.


In addition to determining whether a shareholder has previously claimed any amount of the capital gains exemption, it is important to determine if he or she has any accumulated investment losses (referred to as a Cumulative Net Investment Loss or CNIL account).  To the extent that a shareholder has a balance in his or her CNIL account, that balance will reduce the amount of the capital gains exemption that he or she can claim.  In planning for the sale of a QSBC, it is important to plan for the reduction of any CNIL account balances for any of the shareholders.


If shares are owned by a family trust, the gain on the disposition can be allocated among the capital beneficiaries of the trust.  If the shares qualify for the LCGE, each beneficiary of the trust could, potentially, recognize a tax free capital gain.  As discussed below, this is one of the changes initially proposed by Morneau, but in respect of which he has backed down, so each beneficiary will still be entitled to claim the LCGE if the shares qualify.


Proposed Tax Changes


Finance Minister Morneau has launched an all-out attack on small business corporations and their shareholders.  In the largest overhaul of the tax system in 45 years, he has proposed dramatically increasing taxes on investment income earned in a private corporation (where it is already approximately double what a public company pays), and has proposed extending the Tax on Split Income (TOSI) rules to all non-active family shareholders.


Morneau announced that he would not be proceeding with changes to the LCGE. Initially, he proposed that a “non-active” shareholder would not be entitled to claim the LCGE in respect of the shares of a CCPS. 


However, the TOSI rules will tax the non-exempt capital gain for a non-active shareholder as a dividend, taxable at top personal rates.  So, if the shares of a CCPC do not qualify for the LCGE, a non-active shareholder who is a minor, instead of being taxed on the basis of a capital gain (top rate in Ontario is 26.76%), he or she will be taxed on the basis of an ordinary dividend at top personal rates (47.47%). A non-active shareholder over the age of 18 will be taxed on the basis of a capital gain but at top personal rates rather than graduated tax rates.


I cannot stress this enough – it is important to keep the company onside in terms of its non-active business assets.  It is relatively easy to get onside for the 90% test at any time.  It is impossible to go back 24 months in time to get onside for the 50% test.


I would be happy to work with you and your advisors to ensure that the shares of your company always qualify for the LCGE.

--Chuck

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