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Don't Lose the Capital Gains Exemption
In: Business Tax - Canada

     

   Two Critical Tests

 

The lifetime capital gains exemption on small business corporation shares is one of the most important advantages of running a business as a corporation rather than as a proprietorship. But it's easy to lose the tax benefit if you don't closely follow the rules that determine whether a company is a small business corporation.

 

In order for the shares to qualify, the company must meet the 90 per cent rule under which the business must:

Active Business

  
Under the law, an active business generally means any business carried on by the corporation other than a "personal services business" or a "specified investment business", and includes a venture or concern in the nature of trade.
   A personal services business is one carried on by a corporation where an employee of the corporation performs services for another entity and who, in the absence of the corporation, would reasonably be regarded as an employee or officer of the entity for which the services are provided. A corporation does not carry on a personal services business if it has more than five full-time employees throughout the year or renders its services to an associated corporation. 
    A specified investment business is one whose principal purpose is to derive income from property (including interest, rents, dividends, and royalties). A specified investment business does not include the business of: a credit union, property leasing other than real property, or a corporation that employs more than five full-time employees throughout the year.
   Also excluded from the definition of specified investment business is the business of a corporation that receives managerial or similar services from an associated corporation and that would otherwise reasonably require more than five full-time employees. This exclusion only applies to situations where the associated corporation provides the services in the course of carrying on an active business itself.
1. Be a Canadian controlled private corporation that
2. Uses 90 per cent or more of the fair market value (FMV) of its assets
3. More than 50 per cent of the time and
4. Be in an active business (See right-hand box)
5. Carried on 50 per cent or more in Canada
6. By the corporation or a company related to it.

In addition, throughout the 24 months preceding the sale the company, the second requirement drops to 50 per cent or more of the assets' FMV. This is called the "50 per cent rule."

 

It is usually feasible to address the 90 per cent rule by "purifying" the corporation through the removal of excess assets immediately before the sale.

 

The 50 per cent rule can actually be a more serious problem, because the corporation must meet that rule at all times during the 24 months before the sale.

 

There can be problems associated with the company's assets, which makes it critical to consider each individual asset when determining if your corporation meets the 50 per cent or 90 per cent tests. For example:

 

  • Investments, rental property and leasing property, as well as excess cash balances, do not qualify as active business assets.
  • If an asset is used less than 50 per cent for business, it is considered entirely non-active.  There is no "percentage of use" of each asset applied to the 90 per cent and 50 per cent tests.  An asset either qualifies or it doesn't.

     

  • Incidental use of assets, such as the rental of land and building, rental of equipment, or personal use of corporate assets by employees or shareholders, can cause an asset to be counted as a non-business asset if the non-business use is 50 per cent or more.

     

  • If your corporation rents out a portion of a building it does not use for business, you will have difficulty meeting the 90 per cent test unless the rented portion is less than 10 per cent of the FMV of the building. In looking into this, Canada Revenue Agency (CRA) auditors factor in not only the square feet rented, but will also determine a relative value for the rented space by examining factors such as whether the space is ground floor or second story, whether parking space is included, and whether the frontage is on the main street or access is only through an alley.

     

  • Assets such as vehicles that employees and shareholders use will also count for the 90 per cent and 50 per cent test. If there is substantial amount of personal use, the vehicle may not qualify as an active business asset, unless it can be proved by a mileage log that the personal use is less than 50 per cent.

     

  • Assets that are leased, or rented on a regular basis, are not active business assets, unless they are rented to an associated small business corporation. The occasional rental of business assets such as equipment and vehicles is not a problem, however, as long as the assets are regularly used in the business.

     

 

Using a holding company can solve some of these problems. The holding company can then own the non-active assets and rent them to the operating company. Because the operating company doesn't own the assets, they do not "taint" the operating company and create a situation where the shares do not qualify for the lifetime capital gains exemption.

 

If you think you may want to sell your shares in the future, and want to make sure they qualify for the lifetime capital gains exemption, consult with your accountant. And remember that the corporation must qualify during the entire 24 months before the sale, not just at the date of the sale.

In Issue: July 21st, 2010 RLB LLP