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Cash - A Business Asset?

12/10/2011


Selling the shares of your company? If you are, I’m sure that the $750,000 lifetime capital gains exemption (the “exemption”) is on your mind. The question you should be asking yourself is “does my company qualify?”. There are a number of conditions that must be met before an individual can claim the exemption. One condition, which is fundamental to claiming the exemption, is that the company must be considered a “small business corporation” as defined in the Income Tax Act at the time of sale. Generally speaking, a “small business corporation” is a Canadian-controlled private corporation where all or substantially all of the fair market value of its assets are used in an active business carried on primarily in Canada. Canada Revenue Agency (CRA) accepts that “substantially all” means greater than 90%. Therefore, the company can hold a minor amount of investment assets (no more than 10% of the fair market value of the company’s total assets) such as cash and still be considered a “small business corporation”. CRA recognizes that companies require some amount of cash to run its business. Cash required for this purpose would be considered an “asset used in an active business”, and not an investment asset. Cash not used in an active business would be considered an investment asset or commonly referred to as “excess cash”. Holding excess cash, at the time of sale, could jeopardize the company’s status as a “small business corporation” and consequently, your ability to claim the exemption.

The next logical question is “how much of the company’s cash balance can be considered “used in the business?”. In most cases, we, as advisors, have a difficult time answering this question, but, fortunately, CRA has provided some general guidelines on this question:

  1. The question of whether a particular asset is an "asset used…in an active business" is one of fact which must be determined based on all the relevant facts and circumstances of each case. The relevant circumstances include the actual use to which the cash or near cash properties are put in the course of the business, the nature of the business and the practice in the particular business.
  2. Cash or near cash property is considered to be used principally in the business if its withdrawal would destabilize the business.
  3. Cash which is temporarily surplus to the needs of the business and is invested in short-term income producing investments could be considered to be used in the business.
  4. Cash balances which accumulate and are then depleted in accordance with the annual seasonal fluctuations of an ongoing business will generally be considered to be used in the business but a permanent balance in excess of the company's reasonable working capital needs will generally not be considered to be so used.
  5. The accumulation of funds in anticipation of the replacement or purchase of capital assets or the repayment of a long-term debt will not generally in itself qualify the funds as being used in the business.
  6. Cash or near cash property is considered to be used principally in the business if its retention fulfills a requirement which had to be met in order to do business, such as certificates of deposits required to be maintained by a supplier.
  7. The Department recognizes that prudent financial management requires businesses to maintain current assets (including inventories and accounts receivables, as well as cash and near cash properties) in excess of current liabilities and will consider this requirement in assessing whether cash or near cash assets are used principally in a business. In the Department's view, cash and near cash assets held to offset the non- current portion of long term liabilities will not generally be considered to be used in the business.1

It’s without saying that the above points should be used as a guide only since CRA specifically states that the points are of a general nature2. However, it does provide some insight on what CRA considers relevant.

Of particular interest is point 4 where it implies CRA will review historical financial information and focus particularly on the company’s ongoing cash balance. It’s fairly clear that a permanent cash balance, over and above what CRA considers a reasonable working capital amount, will not be considered an “asset used in an active business”.

If your company looks like it will have “excess cash” at the time of its sale, there are various options available that can be undertaken to ensure the company will be a “small business corporation” so that you will be able to claim the exemption.

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References

1. CRA Document 9605165, June 13, 1996
2. CRA Document 9605165, June 13,1996