New Limitations on the Lifetime Capital Gains Exemption

This is the second in a series of posts arising out of the Liberal Government’s paper “Tax Planning Using Private Corporations.”

The Income Tax Act currently provides business owners with a lifetime capital gains exemption (the “LCGE”) that exempts from tax 835,716 (in 2017) of capital gains arising on the sale of qualified small business corporation shares and $1,000,000 of capital gains arising on the sale of qualified farm and fishing property. The government’s policy paper titled “Tax Planning Using Private Corporations” (the “Paper”), which was discussed generally in our previous post, proposes a number of significant changes to the LCGE that will severely limit its availability.

The government’s concern with the current LCGE rules is that the rules can be used to “multiply” the LCGE so that it is not only available to a person who is active in the business but also to their family members who are not involved in the business. For example, under the current rules, where shares of a private company are issued to a family trust, and the family trust sells the shares, the trust can allocate the capital gains that are realized on the sale to one or more beneficiaries of the trust. The beneficiaries of the trust (including minor beneficiaries) can then claim their LCGE, if all of the requirements of the Income Tax Act are met. The government is of the view that this type of tax planning is unfair because it permits individuals to claim the LCGE even though they may not have invested their own capital in the business, or otherwise contributed to the business being sold.

To deal with this perceived abuse, the Paper proposes three different changes to the LCGE tax rules:

1. No LCGE for Minors

The LCGE will no longer be available to an individual with respect to capital gains that are realized or that accrue before the year in which he or she attains the age of 18. This would be the case regardless of whether the child is involved in the business. If an individual acquires shares of a private company while they are a minor, but disposes of them when they are an adult, the increase in the value of the shares during the time the individual was a minor is not eligible for the LCGE. Accordingly, if shares are issued to minors, it may be necessary to have a valuation of the shares completed at the beginning of the taxation year in which the individual turns 18.

2. Limits for Adult Family Members (Reasonableness Test)

No capital gains exemption will be available on private company shares held by an adult family member that gave rise to the Tax on Split Income (TOSI). The changes relating to TOSI will be discussed in more detail in the next post. In general terms, this measure will introduce a reasonableness test in determining whether the LCGE applies in respect of a capital gain realized by an adult family member of a “connected individual” who exercises a level of influence over the corporation. Unless the gain was reasonably ‘earned’ by the related shareholder, the LCGE may be denied.

3. Limits for Trusts

Individuals will no longer be permitted to claim the LCGE in respect of capital gains that accrue during the period in which a trust holds the shares. This means that if a trust allocates a capital gain to a beneficiary of the trust, the beneficiary will not be able to claim the LCGE in respect of that gain. This will also apply where the trust distributes the shares to the beneficiary (so that the beneficiary can dispose of the shares and claim the LCGE) because the proposed changes provide that where a trust distributes shares to a beneficiary on a rollover basis, the beneficiary will also be unable to claim the LCGE.

An exception to this rule will be available where the trust qualifies as a spousal or common-law partner trust or alter ego trust, where the individual claiming the LCGE is the principal beneficiary of the trust. There is no concern with these types of trusts claiming the LCGE because there are limitations on who can benefit from the property of the trust during the lifetime of the principal beneficiary. Another exception will apply for certain employee share ownership trusts where the beneficiary entitled to the LCGE is an arm’s length employee of the employer sponsor of the arrangement.

The proposed changes are to come into effect in 2018. The Paper refers to special transitional rules that would give individuals and trusts the option to trigger capital gains and offset the gains with their unused LCGE in 2018. The election would be available for property owned by the individual continuously from the end of 2017 until the day the capital gain is triggered. In order for the shares to qualify for the election, the holding period that applies (being the period of time that the shares must be held prior to the sale and during which more than 50% of the fair market value of the company’s assets must be attributable to assets used in an active business) is 12 months instead of 24. Accordingly, if business owners are considering crystallizing their unused LCGE in 2018, they may need to take steps to purify the company (by removing excess assets) before the end of this year.

It is clear that the proposed changes will limit the availability of the LCGE to family members that are not actively involved in the business. However, the proposed changes appear to go much further than this. For example, where a family trust holds shares of a private company, the LCGE will be unavailable even in cases where the gain is allocated to a beneficiary who is involved in the business, or the shares are distributed to a beneficiary who is involved in the business prior to the sale.

The next post will deal with the balance of the income splitting measures announced in the Paper.