If you are thinking about selling your business in the near future, it’s a good time to consider the tax-planning strategies that may be available to help minimize the capital gains tax that will be payable on the sale. In a share sale, one of the most common strategies involves structuring the transaction so that the vendor can rely on the $800,000 lifetime capital gains exemption.
The lifetime capital gains exemption is only available if the shares being sold are shares of a qualified small business corporation (“QSBC shares”).
The rules relating to the exemption are complex, but in general terms, in order to qualify as QSBC shares, the shares must pass three separate tests:
- The small business corporation test: The first test involves determining if the company is a small business corporation (“SBC”) at the time of the sale. In order to be a SBC, the company must be a Canadian-controlled private corporation of which at least 90% of its assets (based on fair market value) are assets used principally in an active business carried on in Canada, share or debt of other “connected” small business corporations, or both.
- The holding period ownership test: The second test focuses on who held the shares prior to their sale, and requires that the shares must not have been owned by anyone other than the individual claiming the exemption, or by a related person, throughout the 24 months preceding the sale (the “holding period”).
- The holding period asset test: The third test deals with the value of the company’s active business assets during the holding period. In cases where the shares are held directly, this test requires that more than 50% of the fair market value of the company’s assets at all times during the holding period to have been attributable to assets used in an active business, certain shares or debt of connected corporations, or both. However, where the assets making up the 50% include shares or debt of connected corporations, an additional set of rules must be considered and the asset composition of the connected corporations must be reviewed.
Many tax planning strategies involve removing non-qualifying assets (such as cash or investments) from a company in order to ensure that the company’s asset mix meets the first and third tests described above. In some cases, the strategy will be simple and will just require that the cash or investments be distributed to shareholders or employees, or used to pay down debt or purchase additional business assets. In other cases, the appropriate tax planning strategy may be more complex and require a corporate reorganization in order to move the non-qualifying assets into another entity, preferably on a tax-deferred rollover basis.
Since there are a number of rules in the Income Tax Act that can limit the availability of the capital gains exemption, it’s helpful to do some tax planning in advance to ensure that the exemption will be available when the times comes to sell.