When you work with a business broker to buy or sell a business, they must tell you there are two types of transaction - asset sale or share sell. In most case, buyer prefer purchase asset and seller prefer to sale shares. What make this difference? Cumulative Lifetime Capital Gains Deduction is one of reasons.
What is Lifetime capital gains deductions?
It is a deduction under Division C of the Income Tax. It was $800,000 in 2014 and increases every year base on indexed of inflation. Effective 2020, it will be $883,384. Any Canadian resident individual, who dispose Qualified small business corporation shares (QSBC shares) and qualified farm or fishing property is entitled to a cumulative capital gains deductions. In other words, by meeting certain criteria, the seller will not need to pay tax for the capital gain from the business disposition.
The #1 criteria: only dispose qualified small business corporation share, qualified farm and fishing property is entitled to claim this deduction. Dispose any other unqualified assets will not be entitled to utilize this cumulative lifetime capital gain deduction.
The #2 criteria: only individual Canadian resident who are eligible to claim this deduction, it is not for non-resident, not for corporation or trust. If the individual is part-year residents of Canada, certain special rules will apply.
What is qualified small business corporation(QSBC) share?
S110.6(1) a share of a corporation is considered to be QSBC if it passed three specific tests:
1st- Small business corporation 248(1) test:
at the time of disposition, the business to be sold must be a CCPC
the owner of share must be individual, individual's spouse or individual business partner
90% FMV of its asset are used in active business, and this active business must be more 50% are in Canada. CRA consider the location of the assets, 50% FMV of assets are located in Canada.
OR 90% FMV of its asset are shares or debt of one or more small business corporations (meet above 3 criterias) that are connected to it (owns more 10% issued share capital).
OR combine 90% FMV of its asset are used in active business in Canada and its connected small business corporations.
2nd - Holding period test:
no one unrelated to the seller has owned the shares in the previous 2 years before disposition.
If the shares that seller wants to sell were purchased from other unrealed parties, and didn't hold them for over 2 years, the seller will not pass this test because the previous owner had owned the shares within this 2 years period.
As per ITA 110.6(14)(f), it also apply to newly issued treasury shares. Even a seller wants to sell the newly issued shares that has never been hold by unrelated person, the seller still need to hold share for 2 years before they are eligible to pass the holding period test.
3rd - Fair market value asset test:
throughout the 24 months before the time of disposition, more than 50% of the FMV of the assets of the corporation must have been used principally in an active business, carried on primarily in Canada
Special Case: If the owner of share dies, which triggered a deemed disposition of the shares, it could be QSBC share if the corporation met above 3 test in any time passed 12 months.
How could A tax planer help client to be pass above 3 tests?
Pass Test 1 - Small business corporation test:
The business seller only need to meet this criteria at the point of before dispose the shares. Purify passive assets by using the passive assets to pay down liabilities, buy active business assets or pay dividend to shareholders.
Pass Test 2 - Holding Period Test
IF the business has incorporated already, the seller has to hold shares for 24 months in order to be entitled to lifetime capital gain deductions. However, if the business is operating as proprietorship or partnership, the seller could incorporate a new company and rollover assets to newly incorporated company and then sell the shares, holding period test is bypassed in this satiation as per 110.6(14)(f)(ii).
Pass Test 3 - Fair Market Value Asset Test
Test 1 looks at the company's status at the point of disposition, and test 3 looks at the company's status in a 24-month period prior to the disposition. They are looking at how does the company use its asset. It must be at 50% FMV of assets that are used in active business in Canada for 2 years before disposition. Purify is still the best solution to it.
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