The Capital Gains Exemption – Share Ownership Is Important

“In a typical family estate freeze, this anti-avoidance rule will not likely apply.”

Some business owners may be surprised to discover that the capital gains exemption that they thought would be available is denied when they sell their Canadian private company shares.  The capital gains exemption provides an individual resident in Canada with $750,000 of tax-free capital gains on the disposition of shares of a Canadian private company that operates a business, provided certain technical requirements have been met.

The Income Tax Act (the Act) contains an anti-avoidance rule to deny the capital gains exemption in situations where share value has been enhanced (intentionally or not) by the failure to pay dividends. These rules are designed to prevent the conversion of dividend income into capital gains that are sheltered by the capital gains exemption.

These rules can inadvertently apply in where shares of a company have been frozen and growth shares have been issued to others (directly or through a trust). In many of these “freeze” situations, dividends are paid on the growth shares but not on the frozen shares.

In these circumstances, the capital gains exemption cannot be claimed on either the common shares or the frozen, fixed value, preferred shares, unless all shares of the corporation meet either of the following attributes:

  1. Common shares with all of the typical common shares attributes; or
  2. Fixed value preferred shares that meet the following conditions:
  • The preferred shares were issued as part of an arrangement, the main purpose of which was to allow the growth in the corporation to accrue to other shares that qualify as prescribed shares (e.g., the common shares);
  • The common shares of the corporation at the time of issue of the preferred share or at the end of the arrangement were owned by:

i   The person to whom the preferred shares were issued (the “freezor”);

ii   A person who did not deal at arm’s length with the freezor (e.g. the freezor’s children and spouse);

iii A trust, none of the beneficiaries of which were persons other than the freezor or a person who did not deal at arm’s length with the freezor; or

iv  Any combination of the above.

  • The common shares were owned by employees of the corporation or a corporation controlled by the particular corporation; or
  • The common shares were owned by any combination of the above.

In a typical family estate freeze, this anti-avoidance rule will not likely apply but it must be considered.  We have seen scenarios where a freezor wishes to include an arm’s length key employee as a beneficiary of the family trust. This term would be enough to jeopardize the capital gains exemption on the common and preferred shares, if appropriate dividends are not paid on the preferred shares.

If one of the goals is to provide equity ownership to an arm’s length employee, the employee should be issued the shares directly.

Your TSG specialist would be happy to discuss these rules with you.

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