Capital Gains Exemption: Use It or Lose It

Most business owners are aware that up to $750,000 of capital gains on the sale of the shares of their company are eligible for a capital gains exemption. Fewer people will be aware of the many restrictions and requirements that will prevent a taxpayer from taking advantage of the exemption which include asset tests, holding period tests and restrictions on sale to related parties.

If a company holds investment assets or other business assets to be excluded from a sale, removing these assets from the mix can be costly. Getting all the vendors onside can be problematic. If a vendor has already used his/her capital gains exemption, has it available on other shares or is prevented from taking advantage of it because of business investment losses or cumulative net investment losses, he/she will not be motivated to sell shares. In addition, generally you require a willing buyer. Buyers can be reluctant to purchase shares instead of the assets of the business. A buyer could inherit unknown liabilities (the skeletons in the closet), they lose the tax shield that the purchase of depreciable assets offer and they risk double taxation since the a subsequent asset sale will be subject to tax as the vendor’s lower cost base of assets is inherited.

Finally certain structures and industries do not lend themselves to a share sale. An example would be professional partnerships. As a result, it is easy for business owners to assume that the difficulties passing the many tests and restrictions are too onerous or that a sale of shares is so unlikely, that the capital gain exemption is meaningless to them.

In tax planning you often have to look beyond the obvious.

First of all, with adequate time, there are many ways to meet the asset and holding period tests in a tax efficient manner. A company can be “purified” of offside assets, assets extraneous to the sale can be removed and the disparate tax situations of each of the vendors can be managed. Often when a share sale looks impossible, corporate restructuring can make it a viable option, for example through a hybrid share/asset sale. Finally, even if it is clear that a sale of shares to an arm’s length party simply will not take place, a vendor’s capital gains exemption can still be triggered or “crystallized” and the adjusted cost base (”ACB”) of the shares increased. This increased ACB can save significant tax if the shares can be sold at a later date even if the company no longer meets capital gains exemption tests. So for example the company may hold investment assets such as real estate. With the right motivation an interested buyer may purchase shares. There may be other situations that arise to allow you to reap the benefits of this increased ACB during your lifetime, and ultimately it should at least save significant tax on death.

The capital gains exemption represents tax savings of $150,000 to $290,000 depending on the province and the individual’s tax rate. If you own a business, you owe it to yourself to explore the opportunities to take advantage of the capital gains exemption.