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The benefit of having an individual’s shares qualify for the capital gains exemption is that the first $750,000 of capital gain can be sheltered from tax resulting in a tax savings of approximately $172,000 depending on the province of residence.
The capital gains exemption is only available on the disposition of shares of a qualified small business corporation (QSBC) and qualified farm/fishing property. Shares of a QSBC must meet the following requirements in order for the shares to qualify for the capital gains exemption.
To meet the SBC test, the corporation has to be a Canadian-controlled private corporation and all or substantially all of the fair market value of the corporate assets have to be used more than 50% in an “active” business carried on in Canada. The other 2 tests relate to the asset mix in the company at the time of a disposition of shares and the 24-month period preceding the disposition of shares.
For example, if a company has assets worth $1 million dollars including cash/investments of $300,000 not being used in the active operations of the company, i.e., used for investment purposes, the shares of this company would not qualify for the capital gains exemption since greater than 10% of the assets (cash/investments) are not used actively in the business. On the disposition of these shares, the capital gains exemption would not be available. Non qualifying assets can also include other assets redundant to the operations of the company.
In order to have the shares of a company qualify for the capital gains exemption, the assets tainting the QSBC status need to be removed thereby “purifying” the company. The purification of a company will fix the asset mix so that the shares of the individual will meet the QSBC criteria and allow the individual to use their capital gains exemption on the disposition of their shares.
There are several ways to purify a company including straightforward techniques such as paying down debt and other financial obligation, paying dividends to the shareholders or more complex maneuvers that move the non qualifying assets into another company.
The removal of the excess cash/investments preserves the eligibility for the capital gains exemption and may provide a level of asset protection if the excess cash/investments (redundant assets) are moved into another corporation away from the risks that may be encountered in the operating company.
Other considerations should also be addressed before the disposition of shares occurs to ensure shareholders can use the capital gains exemption. Previously deducted capital losses or allowable business investment losses can restrict the amount of capital gains exemption that can be claimed against a capital gain. In addition, if the shareholder has a cumulative net investment loss (CNIL) balance whereby his/her investment expense exceeded investment income, the amount of capital gains exemption available will be reduced.
For situations where a shareholder of a company dies, there is relief for not meeting the QSBC requirements at the time of death provided the company qualified as a QSBC in the previous 12 months prior to the shareholder’s death.
Determining if shares of a small business qualify for the capital gains exemption can be complicated therefore professional advice should be sought in order to ensure taxes are minimized upon the disposition of those shares. For more information, please contact your local MNP Tax advisor.
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