General
Shares are usually a capital property of the shareholder and their sale results in a capital gain or a capital loss, depending on whether they appreciated or depreciated in value from the time of their acquisition by the selling shareholder. Only one half of the taxable gain is taxable, only one half of the capital loss is deductible and only against other capital gains.
In certain circumstances the Income Tax Act (“ITA”) provides an opportunity for the taxpayer to receive $800,000 of the sale proceeds tax free. The amount is indexed annually to match the official rate of inflation and currently in 2022, this amount is $913,630. The 1/2 of the capital gain (less any offsetting capital losses) is added to the income and is taxed at the individual taxpayers’ marginal tax rate based on their level of income and province of residence as of December 31. That translates to almost $220,000 tax savings (assuming tax rate of 48%) on the taxable half of $456,815.
The exemption is a lifetime cumulative exemption. This means that a taxpayer can claim any part of it at any time in life upon disposition of qualifying property. It is not required to claim the entire amount at once. For example, $100,000 of exemption can be claimed on sale of qualifying shares in 2004, which would leave $813,630 available to claim in the future.
In order to avail themselves of that opportunity, taxpayers must own and sell shares that satisfy certain tests set out in the ITA. Sections of the ITA that need to be considered and various conditions satisfied in this determination are quite complex and cross-referenced to other sections of the ITA, these factors make this determination quite elaborate. Below is a simplified summary of the requirements that apply to determine that the shares sold are the QSBC shares and the exemption is available.
QSBC Share Tests
Assume that selling taxpayer holds the shares of the Holdco, which in turn holds the shares of the Opco. It is contemplated for the Holdco shares to be sold; thus, it should be determined whether shares of the Holdco are the QSBC shares. In order to do that both corporations, the Opco and the Holdco, must meet the tests set out below.
- Small Business Corporation test – immediately before sale
Sections 110.6(1)(a) and (c) and 248(1)
The shares sold must be shares of a small business corporation. To be a small business corporation a corporation must be a Canadian controlled private corporation (“CCPC”), which uses 90% of the fair market value of its assets in the active business of which at least 50% is carried on in Canada.
To be a CCPC a corporation must be either incorporated in Canada or continued into Canada, its control and “mind and management” must be in Canada and it must be a private (not public) corporation.
For the “mind and management” to be in Canada, the majority of the company’s directors must be Canadian residents and must meet and make business decisions in Canada. For the company’s control to be in Canada, in addition to the directors, the majority of its voting shareholders must be residents of Canada. In some circumstances non-voting shareholders may be found controlling as well: for example, if a shareholder provided 60% of the company’s capital in exchange for non-voting shares, this shareholder is in a position to influence the company’s business and must be taken into consideration.
Under the test the company also must carry on an active business, which means a business other than a personal business (meaning that a person would have been an employee if not for the incorporation) or a specified investment business (meaning a passive investment, when nothing is actively done day-to-day, unless there are six employees that work in the business).
Section 110.6(c)
The market value of the active business assets is attributable to:
- assets used in active business;
- shares of the capital stock or indebtedness of one or more of the other corporations that were connected within the meaning of section 186(4). It should be assumed that each of the other corporation is the payer corporation under section 186(4); and
- combination of the above.
The assets used in and necessary for the active business will be the qualifying assets, such as land for a farm or truck for a truck driver. Examples of non-qualifying assets are investments and other property not related to or used in the active business, cash in excess of what may be required by the active business.
Section 186(4)
Under the section 186(4) the corporations are connected if a particular corporation owns more than 10% of the payer corporation (these 10% must have full voting rights). In other words, the Holdco must own in excess of 10% of the Opco for them to be connected.
It should be noted that if the only asset of the Holdco is the Opco shares, as long as the Opco meets the test the Holdco meets it too.
- Holding Period test – 24 months period preceding sale
Section 110.6(1)(b)
This test requires that throughout the 24 months immediately preceding the sale, the share was not owned by anyone other than the individual or a person or partnership related to the individual. In other words, the shares must be held by the selling taxpayer for at least two years prior to sale.
Section 110.6(14)(f)
Under this section the treasury shares are deemed to be owned by unrelated person before their issue unless these shares are issued as consideration for other shares, a transfer of assets of an active business or paid as a stock dividend. So newly issued shares, except as stated above, even though technically they were not held by anyone will not qualify unless they are held by the individual shareholder for 24 months before sale.
Section 110.6(1)(e)(i)
When during the 24 months period one share was substituted for another share, the share so substituted shall be considered to have met the holding period test if the original share did. In other words, the share of Holdco issued for the share of the Opco will satisfy the test as long as the shareholder’s combined holding period of the shares of Opco and the shares of Holdco is 24 months or more.
- Asset Use test – 24 months period preceding sale
Please note that this test, though similar, is different from the Small Business Corporation test above.
Section 110.6(1)(c)
This test requires the share to be a share of the CCPC with more than 50% of the fair market value of its assets to be attributable to an active RSC1985c1s5_248248(1)248(1)businessbusiness carried on by it at least 50% in Canada during the 24 months immediately before sale.
The Opco must be a CCPC and half of its active business assets must be used at least 50% in a business carried on in Canada for the last 2 years. Half may become 90% as a result of application of the following test, which applies to the Holdco and requires 90% of the Holdco’s assets to be attributable to the active business during the last 2 years:
Section 110.6(1)(d)
Under this section if the fair market value of the active business assets of the corporation connected to the corporation carrying the active business directly is less than 90% during the last 24 months preceding the sale, the Asset Use Test for the corporation directly carrying the active business must meet the 90% test instead of 50%.
If that test is not met and if the fair market value of the qualifying assets of the Holdco is less than 90% during the last 2 years, the fair market value of the active business assets of the Opco must be 90% instead of 50% under this test.