“potential pitfalls can result in unexpected, costly mistakes.”
Capital gains crystallization transactions usually involve the artificial but legal triggering of a capital gain on shares of qualifying small business corporations. The gain that is created is sheltered by the capital gains exemption and the adjusted cost base of the shares is increased. As such, the capital gains exemption has been “crystallized” in the cost base of the shares so any gain on a future sale of the shares (or on a deemed disposition such as on death) will be reduced.
Not considering the potential pitfalls can result in unexpected, costly mistakes. For example, the full benefits of crystallization will not be realized if only a portion of the crystallized shares is later sold. If a shareholder crystallizes $750,000 of potential capital gain on 100% of the shares of his company, the shares will have a new aggregate cost base of $750,000. If the shareholder later sells 50% of his shares for $750,000 he will have a cost base of $375,000 and a capital gain of $375,000. If the shareholder had not crystallized he could have used the full $750,000 of capital gains exemption and had no tax to pay.
The capital gains exemption also reduces the allowable business investment losses (ABILs) that an individual can claim. People who lose money on a business investment are usually unhappy to learn that they can claim the loss only against capital gains because they crystallized their capital gains exemption without realizing any actual tax savings from the capital gains exemption. Similarly, if an individual has claimed an ABIL in the past, their capital gains exemption is ground down. In such cases, part of the “crystallized” gain will be taxable.
Canadian residents who are U.S. citizens may realize a capital gain that they believe will be tax-free as it is sheltered by the capital gains exemption (either upon an actual sale or crystallization). However, as U.S. citizens they are also subject to U.S. tax, and the gain is unlikely to be sheltered by any exemption. The result is U.S. tax being payable on what was otherwise expected to be a tax-free transaction.
Alternative minimum tax and cumulative net investment loss implications must also be considered in capital gains exemption planning.
The capital gains exemption can be a useful and valuable tax planning tool, but it should not be used without full consideration of the implications, restrictions and future consequences of its application.
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.