If you are a small business owner, you may be eligible to claim capital gains exemption on when you sell the shares of your Canadian corporation. This exemption is known as Lifetime Capital Gains Exemption and is an annually indexed amount. For the year 2019, for example, the limit was $866,912. This means that you may be able to extract this amount from your business on a tax-free basis, if the transactions is structured properly and all required conditions are met.

Capital gains exemption is covered in section 110.6 of the Act. Subsection 110.6(2.1) provides that an individual resident of Canada can claim the capital gains deduction on disposition of qualified small business corporation shares. Qualified small business corporation share (QSBC share) is defined in subsection 110.6(1). A QSBC Share, at any time (the “determination time”) is a share of the capital stock of a corporation that meets following three tests.

1) Small Business Corporation Test (SBC test)

This test requires that the at the time of disposition, the share in questions is a share of the capital stock of a Small Business Corporation (SBC). In addition, the share must be owned by the individual, the individual’s spouse or common-law partner, or a partnership related to the individual.

Analysis of the SBC test as well as a discussion of strategies to meet the test is provided in the following pages.

2) Holding Period Test

During the 24 months immediately before the date of disposition, the share should not be owned by anyone other than the individual concerned, or person or partnership related to the individual.

3) Fair Market Value Asset Test (Holding Period Asset Test)

During the 24 months immediately before the disposition of the share, the corporation must be a CCPC and more than 50% of the fair market value of its assets must be attributable to assets used principally in an active business carried on primarily in Canada.

Small business Corporation is defined in subsection 248(1). An SBC is a corporation that is a Canadian-controlled private corporation (CCPC) all or substantially all of the fair market value of the assets of which at that time is attributable to assets that are used principally in an active business carried on primarily in Canada by the corporation or by a corporation related to it.

CCPC is defined in subsection 125(7) and means a corporation that is not controlled by non-residents or a public corporation.  If you are a resident of Canada for tax purpose, the corporation you own will likely be regarded as a CCPC.

The most important question to answer is whether “all or substantially all of the fair market value of the assets of corporation is attributable to assets that are used principally in an active business”. Th term “all or substantially all” is not defined in the Act. CRA has maintained an administrative position that, for income tax purposes, the term all or substantially all is understood to mean at least 90%.  While trade receivables, inventory and fixed assets are considered as being used in active business, excess cash is generally not regarded as an asset required for active business.

If assets used in active business represent less than 90% of total assets of the corporation, the corporation would not meet the QSBC test and capital gain exemption cannot be availed without further planning. The 90% test can be met however if non-qualifying assets are removed from the corporation.

The strategies to meet the QSBC test and other requirements will be discussed in future blog posts.

Mudassar Bajwa CPA, CA