Since its inception in 1986, the lifetime capital gains exemption (“LCGE”) has been viewed as a bright spot in Canadian Taxation by business owners. In essence, the LCGE affords entrepreneurs who spend years building a business an exemption from taxes upon their business's sale. To minimize abuse, Canadian tax legislation imposes stringent conditions on its application. The article below will focus on the sale of shares in a business.
There are only three types of property eligible for the LCGE when sold:
The first type of property is Qualified Small Business Corporation Shares (“QSBCS”). These shares represent ownership of a privately held Canadian company. Consequently, publicly listed companies will not meet the criterion. To qualify as QSBCS, three tests that must be met at the time of the sale:
1. At least 90% of the company's assets' fair market value must be used in an active business carried
on primarily in Canada. For this test, the term “primarily in Canada” is considered to mean at least
50%. The term “active business” negates the possibility of applying the LCGE to corporations whose
purpose is to act as a holding company for investment properties generating passive income.
2. The shares that are sold must have been owned by either the shareholder or a related party for a
period of 24 months before their sale.
3. For 24 months before the sale, the Business had to have been a Canadian controlled private
corporation (“CCPC”), and more than 50% of the company's assets must have been used in an active
business carried primarily in Canada. This means the business must have been controlled by Canadian
residents and not, directly or indirectly, controlled by public corporations or non-residents.
The second type of property is Qualified Farm Property. Qualified farm property is understood to include buildings, land and milk, and egg quotas used in a farming enterprise.
Lastly, there is Qualified Fishing Property. Like Qualified Farm property, this property type is meant to include property used in a specific enterprise. The types of property that may be considered for this category are fishing vessels, fishing licenses and real estate.
It is important to note that the exemption may only be claimed by individuals. Additionally, benefits that use net income, such as the age credit and OAS clawback, will be calculated before the deduction is reflected.
The 2020 LCGE amount is $883,384 and is indexed annually to account for inflation. The LCGE forms a deduction from net income. In other words, because only 50% of realized capital gains are taxable, the amount of money that can be saved by using the LCGE is $441,692.
Consider the following example illustrating this principle:
John is the founder and owner of 100 class A shares of a manufacturing business that qualifies as QSBCS. His shares are worth $900,000. John decides to sell his shares and retire. Without using the LCGE, John would make $900,000 of capital gains. As mentioned above, only 50% of realized capital gains are taxable; thus, john would have to pay tax on $450,000.
In the case John would use the LCGE, he would be eligible to subtract $883,384 from the profits resulting from the sale of his shares. As a result, John is left with $16,616 ($900,000 - $883, 384) in capital gains. However, only 50% of capital gains are taxable. Thus, he would only pay tax on $8,308 ($16,616 x 50%). Consequently, LCGE allowed John to pay taxes on a significantly lower amount and reap him major tax saving.
To summarize, in either case, John would not have had to pay tax on an amount of $450,000. However, the LCGE allowed him to deduct an additional amount of money on what otherwise would have been considered taxable capital gains.
Furthermore, LCGE is a cumulative limit. This means that it can be applied multiple times until it reaches the $883,384 threshold.
Robert is the founder and owner of two construction companies (Company A and Company B). He holds 50 shares of company each that qualify as QSBCS. Both companies are valued at $400,000. If John decided to sell his shares in Company A, he would be eligible to apply for LCGE. Thus, he would not pay any tax on the sale. However, because the LCGE is a cumulative limit, when he decides to sell his shares in Company B, he will be eligible to apply the remainder of the LCGE.
How to Claim the Exemption
To claim the LCGE, the T675 form must be filled out. To fill out the form, certain information is required:
I. Proceeds of disposition: The price you sold your shares at plus the fees associated.
II. Adjusted Cost Base: the price you paid for the shares + any accrued value.
Other information may be required, such as any exemption amounts you have applied to previous qualifying property sales.
The LCGE can provide immense tax-saving benefits for business owners. The above article is meant to showcase these benefits and outline the conditions for its application. It is important to remember that they must be considered with individual facts like all tax-saving strategies and benefits. Multiple tax traps eliminate the possibility of claiming the LCGE. Intending to claim the LCGE should always be carefully considered and planned.