CAPITAL GAINS EXEMPTION AND PROPOSED CHANGES
The capital gains exemption allows Canadian resident individuals to earn tax-free capital gains when they sell qualified small business corporation (“QSBC”) shares. The lifetime exemption limit as of 2017 is $835,716 of capital gains. Since one-half of capital gains are included as taxable capital gains, the limit is actually $417,858 of taxable capital gains. The limit is indexed each year to account for inflation.
In addition to describing the current exemption, this section of the letter discusses some proposed changes to the exemption, scheduled to take effect in 2018.
Various conditions must be met in order for the share to qualify for the exemption. Two of the main conditions are as follows.
First, at the time of the sale of the share, the corporation must be a "small business corporation". In general terms, this is a Canadian-controlled private corporation (“CCPC”), where 90% or more of the assets of the corporation (based on fair market value) are assets used principally in an active business carried on primarily in Canada, shares or debt invested in other small business corporations, or a combination of such assets.
A CCPC is basically a Canadian resident private corporation that is not controlled by non-residents or public corporations.
Second, there is a 24-month hold period. Basically, throughout the 24 months before the sale, the share must not have been owned by anyone but you or a person related to you. Also, during those 24 months, more than 50% of the assets of the corporation must be assets used principally in an active business carried on primarily in Canada, shares or debt invested in other CCPCs, or a combination of such assets (other more specific criteria also apply).
Effects of ABILs and CNILs
The taxable capital gains that qualify for the exemption in a particular year are reduced by two amounts: your allowable business investment losses (“ABILs”) for the year or previous years, and your cumulative net investment loss (“CNIL”) at the end of the year.
An ABIL is one-half of a “business investment loss”, which is a capital loss that is incurred on the disposition of shares or debt in certain types of small business corporations (ABILs are deductible against all sources of income and not just taxable capital gains).
In 2016, you claimed a $40,000 ABIL. In 2017, you realize $120,000 of capital gains ($60,000 of taxable capital gains) on the disposition of QSBC shares. Only $20,000 of the taxable capital gains will qualify for the exemption.
Suppose that in 2018 you had a further taxable capital gain of $100,000 from a disposition of QSBC shares. The amount that would qualify for the exemption would not be reduced by the 2016 ABIL, since the latter already reduced the amount you could claim in 2017.
Generally, your CNIL account includes your net investment losses for the year and previous years going back to 1988. Your net investment losses are basically your investment expenses in excess of your investment income.
Qualified farm or fishing property
There is also an exemption for capital gains realized on the sale of qualified farm or fishing property. The current exemption covers $1 million of capital gains ($500,000 of taxable capital gains). The $1 million amount will be indexed for inflation once the indexation of the QSBC exemption amount reaches $1 million.
In general terms, qualified farm or fishing property includes property that is used in the course of carrying on a farming or fishing business in Canada, a share of a family farm or fishing corporation, and an interest in a family farm or fishing partnership. Various conditions must be met, including a general 24-month hold period test and a business activity test.
Proposed changes for 2018
As discussed in last month’s Tax Letter, on July 18, 2017, the Federal government released draft legislation that, if enacted, will affect the taxation of small businesses and CCPCs in particular. The draft legislation proposes to make some significant changes to the capital gains exemption. The proposals are scheduled to take effect on January 1, 2018. However, there has been significant pushback from the business community and it is possible the government will amend or abandon some of the proposed changes.
The proposed changes include the following:
Gains for children from dispositions before the year in which they turn 18 will no longer qualify for the exemption.
Gains that accrued on the property up to the beginning of the year in which the child turns 18 will not qualify for the exemption.
Gains that accrued while the property was owned by a trust and subsequently distributed to a beneficiary on a tax-free basis will generally not qualify for the exemption, except in the case of an “eligible lifetime capital gains exemption (LCGE) trust” (see below).
The only trusts that will be able to flow out the capital gains exemption in respect of taxable capital gains to beneficiaries will be LCGE trusts. These trusts include qualifying spousal and joint spousal trusts, alter ego trusts, and certain trusts that hold securities that are subject to an employee stock option agreement. All of these trusts are quite limited in how they can be used.
There are some transitional rules that will allow individuals to trigger gains on qualifying property in 2018 to take advantage of the current rules that apply before 2018.
As noted above, it remains to be seen whether these proposals are enacted in their current form.