The Lifetime Capital Gains Exemption (LCGE) is an incredibly valuable tax exemption. Every individual is entitled to this exemption and it currently (for 2023) can exempt a gain of up to $971,190 (the amount is indexed to inflation each year).
In Ontario for example, the tax savings from the LCGE can be worth up to about $260,000 in 2023.
However, sadly, the LCGE is not available in respect of all capital gains. It is generally only allowed on the sale of private company shares, and certain farming and fishing property. In particular, it applies to shares which meet the definition of “qualified small business corporation shares” (QSBC).
Often, business owners wrongly assume that because they own their own business, they are automatically entitled to the LCGE when that business is sold. This is not the case! The LCGE will be available only if certain tests are met in relation to the shares.
24-month holding test
First, the shares of the business must be sold. Often business sales are structured as asset sales by the corporation, which business purchasers tend to prefer for a number of tax and legal reasons (including being able to claim capital cost allowance on depreciable assets). However, for the seller of a business, it is usually preferable to sell the shares of the business (and therefore to sell the company and all of its associated rights and obligations).
The decision as to whether a business sale is achieved by way of a share sale or an asset sale (a combination of both is also possible) will normally be the subject of commercial negotiation prior to sale. However, for a seller, a share sale (at least in part) is essential in order to claim the LCGE.
Another requirement for the shares is that the seller (or a person related to them) must be the only person to have held the shares in the 24-month period leading up to the sale. If any unrelated person has held the shares at any point during this period, the shares will not qualify for the LCGE.
An important point to note in this regard is that shares issued directly from the corporation are deemed to have been held by an unrelated person in the period before issue. So, if new shares have been received directly from the company, and they have been held for less than 24 months, these shares will also not qualify for the LCGE.
50% asset use test
A second test that must be met relates to the assets of the business. In the 24 months before the sale, more than 50% of the fair market value of the assets of the business must be used principally in the active business of the corporation (or the active business of a related corporation).
If the corporation holds shares or debt of a “connected” corporation, these may also count towards the 50% threshold, provided the connected corporation meets this 50% test itself, and provided the 24-month holding period test is met for the shares or debt.
The determination of whether corporations are “connected” is subject to another set of complex rules. However, corporations will normally be connected if one controls the other, or holds at least 10% of the voting shares and 10% of the value of the other.
The 50% test is easily met in some cases, but in other cases it can be the most onerous requirement to qualify for the LCGE. Note that the test must be met for the entirety 24‑month period leading up to a sale. Therefore, any momentary breach would disqualify the shares from LCGE treatment.
This is a particularly important provision where a corporation holds non-business assets, such as portfolio investments or excess cash. In this scenario, the value of these assets must be constantly monitored to ensure that the combined value of all non‑business assets never reaches 50% of the value of all assets held by the corporation.
A corporation is allowed to hold certain cash reserves and have this counted as an active business asset, but there is a limit. The CRA’s view on whether cash is necessary for the business, or whether it is instead excess cash, is that the cash should be considered an active business asset if its removal from the business would destabilize the business as a whole. Therefore, there is no fixed amount that is allowed. Instead, one must assess the cash requirements of the business.
Where a corporation does have non-business assets, to the extent that the value of these is a concern for LCGE purposes, certain planning steps can be taken. For example, excess cash could be used to pay down debt or to buy active business assets.
Alternatively, it is possible to reorganize the corporation to allow for excess, non-active, assets to be transferred to a different corporation (this is commonly known as a “purification”). By doing so, the company being sold can be kept “pure”, i.e. can continue to meet this 50% test, despite the build up of non-active assets.
Small business corporation test
A final test that must be met is that, at the time of the sale, the corporation must be a “small business corporation”. This term does not mean what it seems to; it is a defined term with a very specific definition..
Firstly, the corporation must be a “Canadian-Controlled private corporation” − a corporation resident in Canada whose shares are not traded on a public stock exchange, and which is not controlled by non-residents or by a public company. This is usually the case for most small businesses, but the definition is complex and needs to be reviewed carefully.
Secondly, at the time of sale, “all or substantially all” of the value of the corporation’s assets must be used principally in the corporation’s active business (or the business of a related corporation), or must be shares or debt of a connected corporation.
The CRA generally interpreted “substantially all” as meaning 90% or more of the value of the corporation’s assets.
As this is a point-in-time test (i.e., it needs to be met only at the time of sale, in contrast to the 50%-holding test), it easier to plan to ensure that this test is met at the relevant time, even though it is more restrictive than the 50% test in terms of non-active asset value.
For example, all non-active assets can be moved out of the corporation immediately before the sale to ensure compliance, even if the “all or substantially all” test has never been met by the corporation in the past.
Planning to maximize the LCGE available
Although these QSBC tests can be quite demanding to comply with, the benefits are obvious. Ensuring compliance can mean tax savings of around $260,000 depending upon the province, and higher amounts in future years as the LCGE increases over time. Of course, since this is a “lifetime” exemption, if you have already used part of it in past years, your ability to use it now is reduced by your past claims.
If a sale is anticipated far enough in advance, with proper planning and professional advice, it is possible to increase these savings further.
For example, it may be possible to reorganize the business well in advance to include other persons as shareholders, thereby increasing the possibility that additional LCGE amounts can be claimed on a sale.
This is often done by way of an estate freeze, which we’ll discuss in next month’s Tax Letter. As part of a freeze of the corporation, for example, a spouse or child can be brought in to hold shares and take advantage of their LCGE on a subsequent sale.
Alternatively, or additionally, it is possible for a family trust to become a shareholder. The major benefit of this is that the LCGE amounts of several beneficiaries may become available, as the trust can allocate any gain on its shares to one or more beneficiaries.
Any attempt to benefit from the introduction of additional shareholders for this purpose usually must be done well in advance of a sale, as the new shareholders will only benefit from the growth in value of the company after the freeze. In other words, the company must grow enough after a freeze for the new shareholders to realize a gain against which they can use their LCGE.
To fully use a second LCGE, for example, the corporation would have to grow by over $1 million following the freeze.
For most business owners, the LCGE is a crucial tax exemption which should be available. However, its availability should not be taken for granted. Given the requirement to meet various conditions for 24 months before that sale, professional advisors should be consulted at the earliest opportunity for long-term planning for the exemption.