Frankie Fenton CMA

The Capital Gains Exemption

It’s the most sought-after word in tax planning  – “exemption”.  It’s better than reducing, or deferring tax.  It means eliminating tax.  But eligibility for the capital gains exemption is a seed that must be nurtured and monitored.

The government began taxing capital gains in 1972.  The percentage of gains taxed (often referred to as the “inclusion rate”) has varied, beginning at 50%, at some periods going as high as 75%.  However currently only 50% of net capital gains realized are included in taxable income.  This inclusion rate applies to all taxpayers – individuals, corporations, partners and trusts alike.

Between 1985 and 1994 there was a $100,000 lifetime exemption on capital gains earned by individuals.  This is no longer available at all.

Currently, only the more restrictive capital gains exemptions remain available to individuals and trusts (except trusts that are not personal trusts) – such as the $750,000 exemption on the sale of qualified small business corporation (“QSBC”) shares or the sale of qualified farm property(“QFP”).  However there are a number of conditions that apply to these exemptions, and in the case of the QSBC exemption, just because you qualify today, does not guarantee that you will qualify tomorrow or thereafter.

QSBC Exemption

The capital gains exemption applies to the sale of QSBC shares and is available for the first $750,000 of net capital gains realized. Since only 50% of capital gains are included in taxable income, the exemption itself is for the first $375,000 of taxable capital gains.  However in order to qualify, the individual or related person must have held the shares throughout the 24 month period prior to disposition and have been resident in Canada throughout the year.  In plain english, you or a relative held the shares for at least 2 years and you live here.

What is a QSBC?  It’s not as simple as being a small business.    It must be one where:

  • 90% or more of the fair market value (not book value) of the assets have been principally (50% or more) used in an active business carried on primarily in Canada at the time of sale (there are a lot of proportions built in here!);
  • throughout the 24 month holding period, more than 50% of the value of assets were used in an active business carried on primarily in Canada.

Again – in plain english?  It can get a little complicated.  “Active business” generally refers to the generation of income other than investment income or income from property (like rent).  So if your business holds significant investments or rental property it may not qualify. Furthermore,  assets held by a business can include shares of another corporation.  There are special “look through” rules for determining whether shares in a subsidiary qualify as assets used in active business.  Note that there is an asset test for time of sale and a separate one related to a 2 year holding period.  Note also that you are using fair market value, not book value of assets.  Fair market value can sometimes fluctuate.

Bottom line?  If you think you may be selling your small business in the next few years, it pays to determine now whether you qualify for the QSBC exemption and make yourself aware of the steps you need to take to ensure you will still qualify upon sale.  There are planning measures that can sometimes be taken to ensure eligibility.

QFP Exemption

If the QSBC exemption left you shaking your eyeballs into readjustment, the QFP exemption could render you mute so I will try to keep it simple.

The exemption on the sale of QFP is available for the first $750,000 of net capital gains realized. Again, since only 50% of capital gains are included in taxable income, the exemption itself is for the first $375,000 of taxable capital gains.  In order to qualify, the individual or related person must have been resident in Canada throughout the year.  When you acquired the property is key. There may be a 2 year holding test (similar to the QSBC exemption) if the property was acquired after June 17, 1987.   Regardless of when the property was acquired, there are some tests pertaining to the level of farming activity but they differ depending on whether the property was acquired before or after June 17, 1987.

A QFP isn’t limited to just farmland.  It can include shares in a family farm corporation, interest in a family farm partnership, or eligible capital property used for farming purposes (such as a dairy quota).  Farm assets must generally have been “principally used” in a farming business.   This is interpreted in different ways if you acquired the property before, or after, June 17, 1987.    Where the farm was acquired after this date, there is generally a 2 year holding period, and a requirement for at least 2 years that the farm was continuously active and was the principal source of income for the individual.  If the farm was acquired before June 1987 this test must generally be met in the year of disposition or in at least 5 prior years.

Once again, bottom line?  Don’t wait until you are about to sell your farm before investigating whether you qualify for the QFP exemption.  It could cost you dearly.

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