The Capital Gains Exemption - Forgotten But Not Gone

Twenty years ago, the Income Tax Act provided everyone with a $100,000 capital gains exemption.  The exemption lasted until 1994 when the government cancelled it.  However all was not lost in 1994.  A capital gains exemption is still available for small business owners, and it is surprising how many such people have overlooked this fact.

WHAT IT IS 
Up to $500,000 of capital gains on small business shares can be exempt from tax.  As it only applies to shares, businesses must be incorporated in order to qualify.  The phrase “small business” simply means that it cannot be a public company.  There is no size test; however, the business must be carried on in Canada.  If you have used any portion of your $100,000 capital gains exemption, you must deduct the used portion from the $500,000.  The exemption is available for life or until the government changes the rules, whichever comes first.

HOW TO USE IT
There are three ways to use the exemption.  The first, and most obvious, way is when you sell the shares of your small business.  The second way is on death.  If, on death, the small business shares have a value higher than their tax cost, the excess value is considered a capital gain, taxable at that time. (There are exceptions for shares left to a spouse.) 

The third way to use the exemption is by adding it to the tax cost of your shares, provided that the increased cost does not exceed the value of the shares.  Thus, you lock in the benefit of the exemption for future use, even if the law should change.  This technique is commonly called crystallization.  A word of warning, you should not attempt a crystallization without the assistance of a professional tax advisor.

WHEN TO USE IT
Usually if you realize a gain on the sale of small business shares, you will want to use the exemption.  The question is whether to wait for the event or to crystallize the exemption now.

The primary argument in favour of crystallization is concern about whether the shares will qualify for the exemption in the future.  (See the comments below regarding the qualifying tests.)  You may wish to crystallize the exemption when you know the tests can be met, rather than constantly being concerned about keeping the company in a qualifying state.
 
WHO CAN USE IT
Only individuals can use the exemption.  It is not available to companies.  Therefore, if you own shares in a holding company that owns a business company, you may want to sell the holding company, rather than have it sell the business company.

However, there are a number of tests to be met before the shares qualify for the exemption.  Some of the more significant ones are as follows:

• There is an ownership test.  You or a related person must own the shares for the 24 months immediately preceding use of the exemption.

• There is a type of share test.  While common shares qualify, other shares may not.  This depends on such things as the circumstances of their issue and the past dividend policies of the company.

• There are two business asset tests.  First, the shares of a small business company will only qualify for the exemption if more than 50 per cent of the company’s assets are business assets, rather than investments.  There are special rules for investments in related companies.  Therefore, you might own shares in a family holding company which in turn owns the shares of a business company, and few other assets.  If the business company meets the proper tests, then the shares of the holding company qualify for the exemption.  This 50% test must be met throughout the 24 months immediately before the use of the exemption.  The second test applies only at the time you use the exemption.  It requires 90 per cent of the company’s assets to be as described above immediately before use of the exemption.  (There are ways to remove non-qualifying assets tax free.)

The important point in all of this is to be sure you are aware of the exemption, and know how and when to use it.  Advance planning and consultations with a professional tax advisor are imperative.  However, proper planning could save you thousands of tax dollars.

If you want to learn more about reducing the tax you pay, please join us on October 19, 2004 for “5 Strategies to Reduce the Tax You Pay” with Linda Lutsche, Integrated Services Solutions, Tax Services Manager, of PricewaterhouseCoopers.
Register On-line at httpwww.greaterkwchamber.com/EventList.asp://

This article submitted by:
PricewaterhouseCoopers
900-55 King St W, Kitchener, ON  N2G 4W1
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