Foreign Operations & The Capital Gains Exemption

“Shares of foreign corporations may render a corporation ineligible for the capital gains exemption.”

Most people are aware that non-active business income-generating assets such as marketable securities may cause a corporation to lose its qualified small business corporation (“QSBC”) status and not qualify for the current $750,000 capital gains exemption. However, most people are not aware that certain types of active business assets may render a corporation ineligible for the QSBC capital gains exemption.

The two tests for the capital gains exemption that rely on an asset test are the “point in time” test and the “24-month test.” The point in time test requires that at least 90% of the fair market value of the active business assets must be used principallyin an active business carried on primarily in Canada at the time the individual claimshis capital gains exemption. The 24-month test states that, for the 24 months precedingthe individual uses his capital gains exemption, 50% of the fair market value of the total assets of a corporation must be attributable to assets used principally in an active business carried on primarily in Canada. The Canada Revenue Agency administrativelyinterprets the words “principally” and “primarily” as being 50%.

It is evident from the requirements of the two definition of the point in time and 24-month tests that, if the fair market value of investment assets (like marketable securities) are excessively high when compared with the total assets that are both identified and not identified (e.g., goodwill) on the balance sheet, a corporation’s shares may not qualify as QSBC shares. If CANCO was the parent of a US subsidiary and the USCO shares were over 50% of the fair market value of the CANCO assets, as well as having a significant accrued gain, would the shares of CANCO qualify as QSBC shares?

The answer is no. In both tests, it is critical that the assets must be used in an active business carried on more than 50% of the time in Canada. The operations of the US subsidiary are carried on in the US and not in Canada, so its assets would not be considered Canadian active business assets for the purpose of the capital gains exemption tests.

A simple solution would be to create a SISTERCO with the same ownership structure as CANCO to hold USCO. The USCO profits could still be repatriated free of income taxto SISTERCO (withholding tax 5%) and the CANCO shares would qualify for the capital gains exemption. A tax advisor needs to be consulted on the implementation of this or more complex structures, given the complexity of both transborder corporate taxation and the capital gains exemption.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

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Cadesky Tax