Capital Gains Deduction Eligibility for Proprietors
The Capital Gains Deduction is a powerful tool for business people available under Canadian income tax law. Where it is available, it allows business-people to avoid paying income tax on a certain amount of capital gains ($883,384 in 2020) throughout their lifetime. However, if a businessperson (as opposed to someone earning farming or fishing income) wishes to claim this exemption, they must sell “Qualified Small Business Corporation” shares (among other requirements). This would exclude sole proprietors or people operating through other vehicles from taking advantage of these provisions. Fortunately, several income tax provisions work in concert to allow sole proprietors to take advantage of this provision, provided they plan the transactions carefully.
Basically, before the proprietor takes advantage of the LCGE, they need to “get their business into” a corporation. The first step is for proprietors to incorporate a company and subscribe for shares from the treasury. However, if they were to give their business assets over to the company, they would be deemed to have sold the property for proceeds equal to the fair market value, which would largely defeat the purpose. However, Section 85 of the Income Tax Act provides a “rollover” provision, allowing the proprietor and the company to choose a price at which the transaction will be deemed to have taken place, provided that they receive shares as consideration. The proprietor provides his interest in the business to the corporation in exchange for newly issued shares, and they elect for the transaction to take place at the proprietor’s cost base of his business assets, which means that the corporation now owns the business and the proprietor did not realize any capital gains.
Now, the proprietor holds valuable shares in the company that he could sell to a third party. To claim the Capital Gains Deduction, however, they must meet the “holding period test,” requiring the relevant shares to be owned only by the proprietor or a related party for 24 months prior to the sale. Unfortunately, the default rule set out in 110.16(4)(f) provides that treasury shares are deemed to have been owned by an unrelated party, and so absent an exception, the shares cannot meet the holding period test.
However, subparagraph 110.6(14)(f) provides for such an exception. Where the proprietor received these shares as part of a transaction or series of transactions that included their disposing “all or substantially all” of the assets used in an active business, the default rule applying to newly-issued shares does not apply, allowing proprietors to meet the holding period test and claim the capital gains deduction.
Lastly, taxpayers who acquire assets with the intention to sell them hold it as “inventory.” This means that when they dispose their assets, they will realize income from a business, not capital gains. Since Taxpayers can only claim the Capital Gains Deduction against capital gains—not against business income, how will these taxpayers claim the capital gains deduction? The answer lies in section 54.2, which is addressed specifically to this issue; shares that have been obtained in exchange for substantially all of the assets of a business are deemed to be capital property, notwithstanding that the proprietor had intended to sell them the whole time.
The result of these and related provisions is that operating a business as a proprietor does not necessarily prevent you from claiming the Capital Gains Deduction, as “rolling the business into” a newly incorporated company can allow them to sell the business in the form of shares.
We would note that planning transactions to take advantage of the Capital Gains Deduction can be complex and involves a number of additional criteria, so we encourage you to work with a tax professional. We would be happy to discuss the details of your situation with you.
There are several additional requirements, most notably that for the shares to be QSBC shares, there are restrictions on the value of the assets that must have been used in an active business. It is often necessary to obtain an independent valuation of the assets to make sure that you meet these requirements.
The value of the Capital Gains Deduction depends on the year in which it is claimed. For 2020, individuals have a “Lifetime Capital Gains Exemption” of $883,384, but this figure increases each year. Claiming the Capital Gains Deduction, or some other tax benefits, in prior years will “draw down” this exemption and reduce the amount available going forward. The lifetime capital gains exemption effectively allows individuals to shield that amount of capital gains from taxation. Individuals draw on this exemption to claim a deduction that offsets taxable capital gains at the capital gains inclusion rate. As the capital gains inclusion rate is currently 50%, the maximum deduction that would be available would be $441,692 (effectively shielding a capital gain of $883,384 from tax).
The amount that can be claimed in any given year is also limited by the “cumulative gains limit” and the “annual gains limit”, both of which are constrained by the use of other tax benefits, such as loss carryovers and business investment losses.
The same set of provisions allows business partners access to the Capital Gains Deduction regime, provided that they structure their transactions similarly to those described above.
-James Alvarez, Tax Counsel
© Kalfa Law 2020
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.