There are several tax planning strategies that are used to minimize the capital gains tax that is payable when a business owner sells the shares of his or her company. One of the most common strategies involves structuring the transaction so that the vendor can rely on the $750,000 lifetime capital gains exemption. This exemption is only available if the shares being sold are shares of a qualified small business corporation ("QSBC shares").
The rules relating to the exemption are complex, but in general terms, in order to qualify as QSBC shares, the shares must pass three separate tests:
- The small business corporation test: The first test involves determining if the company is a small business corporation ("SBC") at the time of the sale. In order to be a SBC, the company must be a Canadian-controlled private corporation of which at least 90% of its assets (based on fair market value) are assets used principally in an active business carried on in Canada, share or debt of other "connected" small business corporations, or both.
- The holding period ownership test: The second test focuses on who held the shares prior to their sale, and requires that the shares must not have been owned by anyone other than the individual claiming the exemption, or by a related person, throughout the 24 months preceding the sale (the "holding period").
- The holding period asset test: The third test deals with the value of the company’s active business assets during the holding period. In cases where the shares are held directly, this test requires that more than 50% of the fair market value of the company's assets at all times during the holding period to have been attributable to assets used in an active business, certain shares or debt of connected corporations, or both. However, where the assets making up the 50% include shares or debt of connected corporations, an additional set of rules must be considered and the asset composition of the connected corporations must be reviewed.
Many tax planning strategies involve removing non-qualifying assets (such as cash or investments) from a company in order to ensure that the company's asset mix meets the first and third tests described above. This process is often referred to as the "purification" of the company. In situations where the non-qualifying assets are liquid, the following straightforward techniques are often used:
- Distribute non-qualifying assets to employees or shareholders: A company can distribute its non-qualifying assets by paying reasonable salaries or bonuses to employees, or by paying a dividend to its shareholders, either in cash or in kind.
- Pay down debt: A simple way of eliminating non-qualifying assets from a company involves paying down debt and other financial obligations. Obviously, this option is the most useful where the non-qualifying assets consist of cash, or other investments that can easily be transferred to creditors in satisfaction of outstanding liabilities.
- Purchase of additional business assets: A company can use excess cash to purchase additional business assets, such as inventory, to increase the portion of the company's value that is attributable to assets used in an active business.
In situations where the non-qualifying assets are not liquid, or have significant accrued gains, purification may be achieved through a corporate reorganization. The complexity of the reorganization will depend on a number of factors, such as the nature of the assets and shareholding structure. The basic goal of the reorganization would be to move the non-qualifying assets into another entity, preferably on a tax-deferred rollover basis.
Due to the rules and restrictions contained in the Income Tax Act that may limit the availability of the capital gains exemption, advance planning is required in order to ensure the exemption will be available when shares of a business are sold.