Understanding the Lifetime Capital Gain Exemption Limit in Canada

Introduction:

In Canada, individuals are subject to taxes on their capital gains, which are the profits made from the sale of assets such as stocks, real estate, or businesses. However, to encourage entrepreneurship and investment, the Canadian government provides a tax break known as the Lifetime Capital Gain Exemption (LCGE). This allows Canadian residents, when disposing of shares of qualified small business corporations (“QSBC”), to exclude a portion of their capital gains from being taxed up to a specified limit called LCGE.

In this article, we will delve into the details of the LCGE and explore its significance for taxpayers.

LCGE for 2023 is $971,190. It is indexed to inflation and is adjusted annually. Accordingly, if an individual sells qualifying shares in 2023, that individual can claim an exemption of up to $971,190 of capital gains. LCGE limit is only for qualified small business corporations (or qualified farm or fishing properties), so let’s discuss what it is then. 

What are Qualified Small Business Corporation Shares?

For shares to qualify as “QSBC” all of the following conditions must be met:

1. The corporation is a “Canadian Controlled Private Corporation” (CCPC).
2. At the time of sale, more than 90% of the assets of the corporation (computed on a fair market value basis) are used principally in active business operations carried on primarily in Canada by the corporation or a related corporation or are shares or debt of a connected corporation that meets the 90% test.
3. In a 24-month period preceding a sale, 50% of the fair market value of the assets of the corporation are used principally in active business operations carried on primarily in Canada by the corporation or a related corporation or are shares or debt of a connected corporation that meets the 90% test above.
4. Throughout the 24 months immediately before the determination time, the shares were not owned by anyone other than the individual or a person or partnership related to the individual.

Multiplying the Capital Gains Exemption 

Families can potentially multiply the LCGE limit if other family members own shares of the “QSBC”. However, tax on split income (TOSI) rules introduced in 2018 may impact the ability to multiply the capital gains exemption where minor children are involved and the disposition of the shares was to a non-arms length party.

What if the Above Conditions are not Met?

If you are the owner of a corporation planning to sell shares of your corporation and the above conditions are not met currently, there are “purification techniques” that might help you qualify for claiming the exemption.  

Purification Strategies to Take Advantage of The “Lifetime Capital Gains Exemption”

When a corporation does not meet the test for QSBC, the shareholders need to consider “purifying” i.e., moving out redundant cash and investment out of the corporation. Purification techniques are further grouped into two main categories.

Taxable Purification Strategies

Taxable strategies would trigger tax either at the corporation or the shareholder level. Examples of such strategies include:- 

1. Dispose of or sell passive assets and utilize cash generated by such dispositions as working capital in an active business.
2. Paying out salaries, bonuses, or dividends to get rid of the extra cash and reducing the size of assets not engaged in active business. 
3. Distribute the passive assets as dividends in-kind to the shareholders. The dividends are included in the shareholder’s individual tax returns and gains or profit at a corporate level under paragraph 69(1)(b) of ITA. 

In the case of sizeable investment income or capital gain (from disposable assets), one needs to be aware of the impact of higher corporate taxes on investment income and small business deductions. 

Non-Taxable Purification Strategies

Non-taxable purification strategies do not have any tax implications for the corporation or the shareholder. Examples of non-taxable purification strategies include:-

1. Pay off loans obtained from shareholders or related parties. 
2. Paying capital dividends, provided there is a balance in the capital dividend account. Capital dividends are tax-free for the shareholders. 
3. A corporation can repay its paid-up Capital, tax-free if it helps achieve the right asset mix.
4. Investing in business assets that are used for the generation of business income (unlike passive investment income)

Crystallization of “QSBC” Exemption

Although the LCGE can be very beneficial, its application comes with stringent rules. A business might meet conditions now, but it might be difficult to meet these conditions in the future. Essentially reverse situation when we use purification.

For example, the condition of a minimum of 50% of assets engaged in active business income must be met for the last 24 months. A business might have the condition now, but it may not meet this in the future. Or another shareholder who owns more than 50% of the shareholding might sell his share to a non-Canadian resident and the corporation will not be a Canadian-controlled private corporation or “QSBC” then.

Therefore, an individual shareholder may not be sure that in the future, the company will meet the requirements when he decides to sell his shares. If you have determined that the business qualifies for “QSBC”, you can “crystallize” the gains. What this means is that you “trigger” a capital gain without actually disposing of shares.

There are different methods to crystallize the exemption, but essentially all methods boil down to triggering a capital gain on the QSBC shares through a transaction or election. A common method of crystallization, through a corporate reorganization in which an individual would:

1. exchange his shares in the corporation for a new class of shares of the existing corporation; or
2. transfer his shares to a new holding corporation in exchange for his existing shares pursuant to subsection 85(1) of the Act and elect an amount that triggers the desired gain for the lifetime capital gains exemption.

However, this can only be done to the extent that there is sufficient fair market value in the common shares at the time of the freeze since Section 85 of the Act precludes an election above fair market value.

Benefits and drawbacks of crystallization

1. Crystallization locks in the benefits of capital gain exemption without the need to worry if the corporation will qualify for LCGE in the future when shares are actually sold. 
2. On the other hand, crystallization also “locks” the exemption with a particular company. And you might not find a buyer for the company in the future. 
3. Often section 85(1) rollovers are subject to review of the CRA. Poorly planned transactions are challenged by the CRA and result in heavy and unanticipated tax consequences. 
4. A positive Cumulative Net Investment Loss (CNIL) reduces an individual’s LCGE. CNIL balance is an excess of investment expenses of the current and preceding tax year over the investment income of the current and preceding tax year after 1987. 
5. Tax benefits and credits are dependent on the income of an individual (and of the family). Crystallization of LCGE triggers the income for the taxpayer and affects benefits such as old age security, HST/GST credit, and Ontario Trillium benefits. etc.

Alternative Minimum Tax (AMT) 

A very important implication of crystallization is the Alternate Minimum Tax (AMT), an alternate method to calculate income tax in Canada. This tax is often applicable when a taxpayer has claimed a preferential tax deduction like LCGE or has preferential tax rates due to credits, such as dividend tax credits. AMT can be viewed as a prepayment of future tax and over the next 7 years you can recover this amount. If an individual does not expect to have income in the future years (subsequent 7 years), this AMT might not be recovered. The future dividends do not help recover AMT. 

Conclusion:

The Lifetime Capital Gain Exemption serves as a valuable tax incentive for individuals who own qualified small business shares, qualified farm property, or qualified fishing property. By allowing taxpayers to exclude a portion of their capital gains from taxation, the government aims to foster entrepreneurship and investment in these sectors. 

However, the rules surrounding LCGE are complicated, and an ill-planned claim of exemption may result in a huge surprise tax bill from the CRA. It is highly recommended to seek professional advice if you want to take advantage of it. 

Seek assistance from tax experts who can help you make the most of the Capital Dividend Account (CDA), holding corporation, corporate tax planning, and other estate planning tools, ensuring that you don’t end up paying a significant portion of your income in taxes. Source Accounting Professional Corporation (CPA) is a full-service accounting firm in Mississauga. We specialize in assisting business and corporation owners with their business plans and tax-saving strategies. Call us at 647-930-8130.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice, nor can it or should it be relied upon. Please contact/consult a qualified tax professional specific to your case.