Capital Gains Exemption

 
 
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Who is eligible | What is the current maximum amount available | Which assets are eligible for capital gains deduction |Qualified Small Business Corporation Share | Qualified Farm or Fishing Property | Crystallizing the $1,000,000 Capital Gains Exemption | Sale to Spouse | Sale to Children |Sale to a Corporation | Sale to a Partnership | Sale to a Trust | Tips and Traps | Did a $100,000 capital gains election taint property for the purposes of the $1,000,000 capital gains election? | Can land be transferred to a company to crystallize the exemption followed by immediate transfer back out to the individual who owned the land originally?
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Lifetime Capital Gains Exemption


This topic briefly discusses the rules contained in section 110.6 of the Income Tax Act (the “Act”) concerning the lifetime capital gains exemption (LCGE).

LCGE has been enacted on February 13, 1986 and has seen many changes since then.

Note that the material presented here is merely a summary of the rules, and consultation of the Income Tax Act and a subject specialist should be consulted in all cases.

Any amount of Capital Gains Exemption that has been utilized in previous years, will have an impact on the current amount available.

Who is eligible?
The exemption is available to individual taxpayers while resident in Canada.

The exemption is not available to offset capital gains realized by a corporation. Nor is it available to offset capital gains retained by a trust, i.e., capital gains that are not paid or payable in the year to a beneficiary.

Finally, the capital gains exemption is not available to non-resident individuals throughout the year (subsections 110.6(2) and (13) of the Act). However, a part-time resident may qualify for the exemption if the individual was resident in Canada throughout the particular year and the immediately preceding or immediately following taxation year (subsection 110.6(5) of the Act).

What is the current maximum amount available?
The maximum amount for LCGE currently available for small business corporation shares, farm property, and fishing property is expressed in the following table.

Small Business Corporation SharesFarming / Fishing PropertyAllowable Capital Gain Deduction
$824,177
$1,000,000
50%

The maximum amount LCGE for Small Business Corporation Shares (SBCS) is $824,177 which is based on $800,000 as determined in 2014 and indexed to inflation with 2014 at 100 (2014 is $800,000). Capital gain on SBCS is available on capital gain as the result of the sales of qualified small business corporation shares.

A maximum of $1,000,000 is available in case capital gain results from the sale of qualified farm and fishing property.

50% of the LCGE is the maximum amount you are allowed to claim as capital gains deduction against your taxable income as a result of the disposition of certain capital properties.

Example:

In 2015, Mario sold 400 shares of XYZ Public Corporation of Canada for $6,500. Her received the full proceeds at the time of the sale and paid a commission of $60. The adjusted cost base of the shares is $4,000. We can now calculate his capital gain, and capital gain deduction, as follows:

Proceeds of capital sale
$6,500
Adjusted cost base of assets$4,000
Cost on sale$ 60
$4,060 -/-$4,060
Capital Gain
$2,440

Because only 50% of the capital gain is taxable, Mario reports $1,220 as his taxable capital gain on his income tax and benefit return.

Which assets are eligible for capital gains deduction
You may be able to claim the capital gains deduction on taxable capital gains you have from:

1. The disposition of Qualified Small Business Corporation Share (QSBCS); and

2. The disposition of Qualified Farm or Fishing Property (QFFP).

Qualified Small Business Corporation Share
For shares to qualify as QSBC shares the following tests must be met:

1. No one, other than the shareholder (or a related person or partnership), must own the shares for two years prior to the disposition.

2. During this period 50% or more of the fair market value of the assets was share of a Canadian-controlled private corporation that was used in an active business carried on primarily in Canada or by a corporation related to it.

Qualified Farm or Fishing Property
QFFP is defined as real property, shares of a family farm corporation, an interest in a family farm partnership, an eligible capital property owned by an individual or spouse or an interest of the individual or spouse in a family farm partnership. QFFP includes:

Real property, such as land, buildings and fishing vessels;

A share of the capital stock of a family-farm or fishing corporation that you or your spouse or common-law partner owns;

An interest in a family-farm or fishing corporation that you or your spouse or common-law partner owns; and

Eligible capital property, such as milk and egg quotas or fishing licenses.

To qualify the following tests must be met:

1. The property must have been held for two years or more prior to the disposition by one of the permitted users described above; and

2. the property must have been “used in the course of carrying on the business of farming in Canada” by the individual, his spouse, any of his children or parents, by a family farm corporation or partnership in which he, his spouse or any of his children or parents has a share or interest or a personal trust of which any of them is a beneficiary which is determined by:

a. Either the gross income from the farming business is larger than the person’s income from all other sources in the year;

Or

b. The individual, his spouse, any of his children or parents must have been actively engaged on a regular and ongoing basis in the farming business.

Crystallizing the $1,000,000 Capital Gains Exemption
Any owner of QFFP or QSBS can choose to crystallize their capital gain exemption by entering a future sale or deemed disposition on death, now rather than waiting for when the actual disposition is to occur.

Several techniques can be used in a non-arm’s length relationship, to crystallize the gain without losing family control of the land, including:

Sale to Spouse or Common-Law Partner;

Sale to Children;

Sale to a Corporation;

Sale to a Partnership; and

Sale to a Trust.

Sale to Spouse or Common-Law Partner
A QFFP (i.e. farmland) can be sold or gifted to a spouse or common-law partner (spouse), for any value between the adjusted cost base and fair market value.

An election under 73(1) must be made on the seller’s tax return for the year of the sale to elect the capital gain that results from the transfer.

The transfer can be structured as a non-interesting bearing note payable, say, in 30 days after demand in exchange for the property. This approach is chosen since the spouse usually does not have the resources to pay for the purchase or does not wish to do so. This offers an advantage over a gift in the use of a capital gains reserve to control alternative minimum tax and also leaves some control with the vendor spouse. (Alternative minimum tax limits the tax advantage you can receive in a tax year from certain incentives. If the adjusted taxable income calculated on Form T691, Alternative Minimum Tax, exceeds the basic exemption of $40,000, you may have to pay the minimum tax.)

The impact of attribution rules must be considered. If the property is leased, any net rental income could attribute back to the initial owner. This would occur unless the purchasing spouse actually pays full fair market value at the time of the sale (disposition) or if any remaining debt bears interest at commercial rates, and interest is paid in full each year (during the year or within 30 days after the end of the year). There is no attribution, however, if the recipient spouse uses the property to earn income from a business.

Any capital gain on a future sale by the purchasing spouse will also attribute back to the vendor spouse unless the conditions are met to avoid attribution of property income.

Sale to Children
A QFFP (i.e. farmland) can be transferred to a child.

If the QFFP is being rolled-over under 73(3.1) for qualifying farmland or buildings or 73(4.1) for shares of a family farm corporation or partnership, the sale must occur for actual proceeds (cash or debt consideration).

If the property were simply gifted, a capital gain would not result as the property would automatically rollover at its cost base pursuant to those sections.

The amount of proceeds can be any value between cost and fair market value so that a gain less than the full possible amount may be triggered.

The sale may be structured as a promissory note that a parent may require payments on. The balance of the note owing on a parent’s death could be forgiven under the will without tax consequences. However, forgiveness of the indebtedness other than through a will can cause adverse tax consequences.

There is a need to consider the impact of attribution. If the property is leased, any net rental income could attribute back to the parent. This situation would occur unless the purchasing child actually pays fair market value at the time of sale or any remaining debt bearing interest at commercial rates, and interest is paid in full each year (during the years or within 30 days after the end of the year).

Any capital gain on a future sale by the purchasing child will not attribute back to the vendor parent if the child owns the property for more than three years. (Watch subsection 69(11) of the Act).

Income attribution will not occur if the purchasing child uses the property in his or her business – even if the above conditions are not met. The attribution rules do not apply to business income.

By structuring the transfer as a sale at fair market value, with the child giving debt consideration such as a non-interest bearing note payable due, say, 30 days after demand, a capital gain reserve may be available to mitigate the effect of the alternative minimum tax (AMT) or a clawback of Old Age Security (OAS). The debt on the land gives the parent some control over the sale or pledging the land for security would require repayment of the debt or a preferred creditor’s position.

Note that on a sale of farmland to a child, the reserve can be spread over a period of up to ten years (as opposed to the normal rule of five years).

Sale to a Corporation
In many cases, incorporation may make sense for a farmer, or the farmer may already have a corporation in place but still own land personally.

A transfer of qualifying property to a corporation will result in a sale at fair market value and will, therefore, trigger any capital gain that exists.

A Section 85 election is often used on the transfer of property to a corporation. This option allows the amount of gain triggered to be controlled by use of the appropriate elected amount on the election form. This can be particularly useful where the gain is in excess of $1,000,000 or there is some uncertainty over the fair market value of the property.

In addition, it allows buildings to be elected upon separately so that no recapture of depreciation is triggered - assuming the appropriate elected amount is used.

Triggering the exemption on land or quota, for example, can allow debt to be absorbed by the corporation so that it can be paid with higher after tax dollars.

If little or no debt exists, the triggering of the capital gain on incorporation can often result in a tax paid shareholder loan that can be drawn on in the future by the shareholder without further tax.

A reserve to avoid alternative minimum tax (AMT) or other tax consequences is not available on a transfer of assets to a controlled corporation. See section on Corporations for more information.

Sale to a Partnership
A partnership is a very good option that can provide both income splitting and use of the capital gains exemption where a corporation is not warranted.

For example, Mr. and Mrs. X could form a partnership to carry on the farming business. Farming assets could be transferred to the partnership and the appropriate capital gain triggered on any qualifying assets.

It is very important that the appropriate income tax election is filed - otherwise the transfer of the property to the partnership would occur at fair market value, and recaptured depreciation and other income could result on the transfer as well as capital gains.

Mr. and Mrs. X would then continue farming and splitting income according to the partnership agreement.

One concern with this arrangement might be what would happen on death. If the partnership agreement is properly structured, a beneficiary could have the following choices:

1. Receipt of property in settlement of a right to partnership property;

2. Undivided interest in each and every asset of the partnership; and

3. The beneficiary might simply become the new partner (replacing the deceased) if the partnership agreement provides for that event. See “Partnerships” for more information.

Sale to a Trust
It may also be possible to crystallize the capital gain exemption by transferring the qualifying farm asset to a trust.

As transfers to most trusts are recognized as a disposition for tax purposes, the capital gains exemption could be used. However, caution should be exercised to ensure the trust is appropriate for the circumstances. The Act does not permit a “rollover” to most trusts.

As a result, the full amount of the capital gain will be realized. The concern should be to ensure that the amount of capital gain exemption available to the transferring taxpayer is sufficient to offset the capital gain. In addition, the transfer could trigger recapture of depreciation on assets such as any buildings located on the subject farm land. Of course, the exemption is not available to offset this recapture.

Tips and Traps
While the capital gain exemption may be available to fully offset the capital gain, remember that the capital gain is included in net income, and the exemption is deducted in calculating taxable income. Therefore, items that depend on net income such as benefits for children, provincial senior’s benefits and the clawback of Old Age Security could be affected.

Alternative Minimum Tax (AMT) can also result when triggering a capital gains exemption. To avoid this result, you may wish to plan the transaction so that a capital gains reserve is available to reduce the amount of capital gain reported in a future year. For example, a note payable due 30 days after demand vs. note payable on demand. No reserve is available on a sale to a controlled corporation.

Always consider the impact of the Goods and Services Tax on any proposed transaction. In the case of shares, there may not be a significant concern. However, for the transfer of other property, you may wish to ensure the purchaser is a registrant for GST purposes before proceeding with any crystallization.

The General Anti-Avoidance Rule (GAAR) is always a concern in tax planning. Information Circular 88-2 provides that the crystallization of a capital gain exemption is an avoidance transaction since it is undertaken primarily to achieve a tax benefit. However, it is not a misuse of the Act, nor is it an abuse with regard to the Act as a whole. Therefore the Canada Revenue Agency would not seek to apply GAAR to normal transactions undertaken to crystallize the capital gain exemption.

It is common for a company to issue more than one class of common shares. In many cases, the company's Articles of Incorporation may require the retained earnings to be allocated equally among those common shares. Any dividends are restricted on those shares to the extent of retained earnings applicable to the particular class of common shares.
In a technical interpretation, the Canada Revenue Agency suggested these shares would not qualify for the enhanced capital gains exemption if dividends had not been paid on them in each and every year because they failed to meet the definition of prescribed shares.

Did a $100,000 capital gains election taint property for the purposes of the $1,000,000 capital gains election?
If a taxpayer used the $100,000 capital gains election on their 1994 personal tax return on property that would have otherwise qualified for the $1,000,000 Capital Gain Exemption, the taxpayer should be aware that the election could affect his/her ability to claim the enhanced capital gains exemption in the future.

Use of the 1994 election resulted in a deemed sale and reacquisition of the property. Therefore, the farm property would have to meet the more stringent tests that apply for property acquired after June 17, 1987, to be eligible for the enhanced capital gains exemption in the future.

Some uncertainty also exists over whether the new 24-month "holding period" would also need to commence on February 22, 1994. Since the answer is not clear, one might try to meet the 24-month test after February 22, 1994, before attempting to trigger the $1,000,000 exemption.

Can land be transferred to a company to crystallize the exemption followed by immediate transfer back out to the individual who owned the land originally?
A strategy followed by some taxpayers would be the sale of land to a company at fair market value for a note. The land would then be withdrawn by the individual from the company against the note payable. The hope would be that that land would now have a higher cost base as a result.

It is very likely that the Canada Revenue Agency would find this type of transaction offensive and treats it as a sham or uses the General Anti-Avoidance Rule to remove the benefit of the transactions. In either case, the result would be no use of the exemption and no increase in the cost base.

Note, however, situations do occur where there are bona-fide reasons for land to be sold to a company and then sold back to the original seller. The company should then report a gain if the land value increased while held by the company (with no offsetting exemption). The Canada Revenue Agency should not be able to attack this type of transaction with the General Anti-Avoidance Rule.

 
 
 
 
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For more information about the content of this document, contact Joel Bokenfohr.
This document is maintained by Nicole Halvorson.
This information published to the web on July 21, 2014.
Last Reviewed/Revised on October 20, 2014.