Tax-free? Are you sure? Is it risky? Is it legal? Will CRA audit me?
These are some questions I hear when I tell clients about the capital gains exemption.
Yes, there is the ability to realize a gain on certain property and not pay taxes on it. While we can’t guarantee CRA won’t audit the claim, it is perfectly legal.
In fact, over twenty years ago individuals were able to shelter up to $100,000 of a gain on any type of property. While those days are long gone (the exemption is now only available on certain type of property), the exemption amount has increased to $800,000 and is now indexed to inflation (for 2017 the exemption limit is $835,716). What that means is a potential tax savings of almost $200,000 (for individuals taxed at the top marginal tax rate and living in BC).
There are mainly three types of property that can benefit from the capital gains exemption – qualified small business corporation shares, qualified farm property, and qualified fishing property.
We will limit this discussion to the qualified small business corporation shares.
As with any benefit under the tax rules, there are certain conditions that must be met:
- The shares must be shares of a Canadian-controlled private corporation. That is, not a public or foreign corporation.
- More than 90% of the fair market value of the assets of the company must be used in its active business carried on in Canada. This is generally referred to as the small business corporation test.
- For 24 months prior to the sale of the shares, no one other than the individual selling the shares must have owned the shares. This is the holding period test.
- For 24 months prior to the sale of the shares, more than 50% of the fair market value of the assets of the company must be used in its active business carried on in Canada. This is the asset test.
Of course, nothing in tax is that straight forward, so naturally for each of the conditions noted above, there are subtleties that must be reviewed. For example, in the small business corporation test and the asset test the assets held by the company don’t necessary have to be used by the company but can be used by a related company for use in their active business in Canada. Also, an exception to the holding period test is if a sole proprietor transferred all the business assets to a new company and then sold the shares of the company, the holding period test could be met.
Alternative Minimum Tax Rules
The one item that is often overlooked in dealing with the capital gains exemption is the alternative minimum tax rules. These rules were brought in to ensure that individuals aren’t able to claim large deductions from their income and end up paying little to no tax. These rules require a separate calculation of the individual’s income but do not take into account certain deductions such as interest deductions, tax shelter deductions, etc.
The capital gains exemption deduction is one of the items that is not taken into account in the alternative minimum tax calculation. The result of this separate calculation is that an individual can end up with no income taxes owing as a result of the capital gains exemption but could end up with alternative minimum tax owing. This is quite a surprise come tax time for the individuals who haven’t planned for it.
Now, before you say “I knew it was too good to be true!”, the alternative minimum tax is refundable over a seven year period. That is, the alternative minimum tax paid in one year can be used to reduce future income taxes. In a sense, you pre-pay your future income taxes. Of course, proper planning is required to ensure that you receive the proper type of income in the future to ensure the alternative minimum tax is fully recovered. Just one more reason to ensure you are speaking with your local Rise CPA professional.
The above information is of a general nature only and should not be relied upon for specific situations. The Income Tax Act contains many complex rules that could apply depending on certain facts. Rise CPA should be contacted to review the specific facts of your situation.