The July 18, 2017 proposed income tax provisions targeting tax planning using private corporations. It included measures to “constrain multiplication of claims to the lifetime capital gains exemption” (LCGE). The LCGE is available to individuals who realize capital gains arising on the disposition of qualifying shares of Canadian controlled private corporations and on farming and fishing properties. The discussion below focuses on shares.
What is the lifetime capital gains exemption?
Where capital gains are realized on shares of a qualified small-business-corporation (QSBC), the LCGE allows for a cumulative lifetime deduction of roughly $836,000 (indexed to inflation). To qualify as a QSBC share, generally the share must be of a Canadian controlled private corporation (CCPC) that carries on an active business primarily in Canada and at the time of sale, all or substantially all (90%) of the fair market value of the corporation’s assets must be attributable to assets that are used in that active business. For 24 months prior to the date of sale, more than 50% of the fair market value of the corporation’s assets must be attributable to assets that are used in that active business. In addition, shares of a company that own assets that are leased to a related QSBC can qualify. Shares in a holding company that owns shares and debt of other QSBC’s can also qualify if they meet certain ownership tests either directly or within a related group.
Half of the amount of capital gains is subject to income tax. Tax savings from accessing the full $836,000 capital gains deduction capital gains exemption could be as much as $224,000 (rounded) at the highest 2017 Ontario personal income tax rates for each vendor of QSBC shares. To take advantage of this generous tax provision, many owners of private Canadian active corporations have adopted corporate structures that allow multiple family members to access the LCGE on a third-party sale, either as beneficiaries of a family trust that owned the corporate shares, or by family members owning such shares directly.
How do the proposed rules change the application of the lifetime capital gains exemption?
The Liberal government has determined that the LCGE was not intended to benefit minors or family shareholders who have not “contributed” (labour, investment, risk etc.) to the family business.
- a special one-time 2018 election available to adults only, described further below and,
- an exception for an actual third party 2018 disposition in favour of a minor,
the following changes are proposed to limit the use of the LCGE for post 2017 dispositions:
- Any capital gains that are realized or accrue before the taxation year in which a person turns 18 will no longer be eligible for the LCGE.
- For example:
- At the time of disposition, a 30-year-old, owns shares in a private company controlled by his father with a cost of $1 and a fair market value of $500,000;
- The corporate assets consisted of qualifying active business assets of a business carried on in Canada (and otherwise met the 50% qualification test over 24 months preceding the sale and 90% immediately before the sale).
- The individual has been very active in the business for years;
- The shares had a fair market value of $300,000 when he turned 18.
- The gain that accrued from the time the individual turned 18 is $200,000 ($500,000- $300,000).
- Of the total gain in the amount of $499,999, the amount eligible for capital gains exemption is only $200,000.
- The Tax on Split Income rules (TOSI) rules will be tied to the LCGE regime. To the extent that the TOSI rules would apply to a notional dividend paid equal to the capital gain on the share disposed of, the LCGE on the gain will be denied. As described in detail in our previous post on TOSI, a dividend would be subject to TOSI to the extent that is unreasonable. (The recipient’s contribution to the business through labour, investment, or assumption of risk is compared to what a similar business would pay.)
- For most trusts, capital gains that arise from a disposition of shares held in a trust will no longer be eligible for the LCGE when allocated to beneficiaries.
- Capital gains will no longer be eligible for the LCGE where the gain accrued while a trust held shares that were subsequently distributed to a beneficiary. Only gains accruing after the distribution may qualify for LCGE.
- An exception will continue to permit LCGE of spousal/common-law partner trusts, alter ego trusts or certain employee share ownership trusts.
Special one-time 2018 election
The proposed new rules limiting access to the LCGE do not come into effect until 2018. However, an adult individual or trust can elect (at any time in 2018) a deemed disposition and reacquisition of QSBC shares owned. The election filing due date is the due date of the tax return that includes the elective disposition date. The resulting capital gain could be offset using the shareholder’s available unused LCGE, allowing a step up in the cost base of the shares.
The election may be amended or revoked prior to 2021. The election may be late filed before 2021, with penalties.
The increased cost base will reduce capital gains on subsequent third-party sales (or otherwise on the deemed disposition arising on death).
As mentioned above, to qualify for the LCGE, there are certain active asset-holding requirements that must be met over a 24-month period prior to claiming the LCGE. For purposes of this special 2018 election, the requirements must only be met during the 12-month period prior to the elected disposition time. The 90% active asset test referred to above must still be met at the elected disposition time.
What are the implications of this change?
For families that have included the LCGE as part of their existing tax planning structures, the implication of these changes could be significant.
- If qualifying shares are owned by a family trust, a decision will be required to either cause the trust to elect on the accrued capital gain, or accept that it cannot ever be claimed with respect to the gain that accrued while the shares were held by the trust. This is the case even if the property is subsequently distributed by a trust.
- A decision to crystallize is likely easier where there is an investment in only one family business that is either to be sold, or to be held in the family, for the foreseeable future. However, for taxpayers owning multiple businesses, the decision might be more complicated. Which one will most likely be sold?
- Electing to trigger a capital gain on a particular share may prove to be regrettable. For example:
- A decision is made to elect the LCGE on the qualifying shares of a corporation, held by a family trust, that are expected to be retained for the long term. If not for the 2018 election, under the proposed new rules, the gains accrued while owned by the trust will not be eligible in the future for LCGE. If the shares are distributed from the family trust, there remains a concern that the shares may not sufficiently increase in value, to apply the LCGE on future growth.
- A child who elected to trigger the LCGE in 2018 as a beneficiary of the trust subsequently invests in a qualifying business that is ultimately sold.
- The result is not ideal – a realized gain for which a LCGE may not be accessible because it has already been utilized as part of a previous election on another property; the elected shares have a stepped-up cost base that may result in a reduced gain upon death, presumably many years in the future.
- Therefore, factors to consider in deciding upon triggering the election include weighing the likelihood of other eligible future investments, timing and likelihood of sale, expected future growth of currently owned shares if distribution from a trust is an option to consider, and the possibility that the LCGE may at some point be repealed.
- Similar reasoning would apply to an individual that owns shares with accrued gains on shares that would be considered as subject to TOSI. Other than this 2018 election, such gains will not qualify for LCGE under the new regime.
- Another consideration is the impact of Alternative Minimum tax, a temporary tax that may arise in the year of the election. It typically would be refundable in the following year or two, but should be evaluated.
- Where shares are held on behalf of beneficiaries of a recently established trust, a tax professional should be consulted to determine if a transfer of at least some of the shares to the beneficiaries would be suitable, sufficient to accumulate future growth to utilize the LCGE. Professional advice should be sought to review implications of family law and shareholder agreement requirements.
The proposed changes have broader implications than the issue the Department of Finance is purportedly trying to solve – preventing multiplication of LCGE to minors or family members that are not involved in the business. Why could they not have achieved this objective within the structure of shares owned by trusts? It is not clear. The result is an attack on trusts as if they exist solely for LCGE multiplication.
Trust planning allows for flexibility in transferring future growth of the company to heirs without transferring ownership to a particular beneficiary today, while maintaining control over trust property. There are, and will continue to be, legitimate estate, matrimonial and creditor concerns that make holding assets through trusts prudent financial planning.
Shareholders of corporations carrying on active businesses in Canada should contact their advisors to discuss a review of their corporate structure. They should consider the viability of an election to crystallize the LCGE. To ensure that they meet the 50% active business test on a 12-month look back basis, such taxpayers have a small window of time to qualify for the 2018 election. It is hoped that the Department of Finance will extend the election period to provide more time. If that does not happen, the 50% active business test must be met by January 1, 2018.