Lifetime Capital Gain Exemption (LCGE), interestingly, as the name indicates, is not an exemption but a deduction!
In this post:
Important Disclaimer: This post is for information purposes only. The readers must exercise extreme caution while making any decision to regarding LCGE based on this post alone. The rules surrounding capital gains exemption can become quite complex so it is always better to take tax advice from a professional tax accountant. This is not a tax advice. The information presented here is current at the time of writing, however, no future updates by the author are anticipated.
Lifetime Capital Gains Exemption (LCGE)
LCGE is claimed against the income included under Capital gains from the eligible property by an eligible taxpayer. As mentioned before, this is a deduction despite of the word exemption used.
The deduction is against the capital gains, not the income. As Capital gains are included in the income first and the LCGE is claimed as a deduction against those capital gains, it affects various personal tax credits, AMT, an income-tested benefits and repayments. Therefore, extra caution needs to be exercised if a taxpayer plans to trigger a capital gain for crystallization purposes.
There have been multiple changes to LCGE limits. The last change to LCGE was in 2014 when it was raised to $800,000 at that time and subsequent limits were set to be indexed to inflation. In 2021, the LCGE exemption limit is $892,218.
Further, LCGE is cumulative. The remaining limit is reduced based on the cumulative claims to date.
LCGE – Who is eligible to claim?
An individual, other than a trust, who is a resident of Canada throughout the year. Subsection 110.6(5) allows a taxpayer to claim LCGE if the taxpayer was a resident of Canada at any time in the current year and throughout the preceding year or the following year.
Can you claim LCGE in the year of emigration or immigration?
Yes, there is a deeming rule that deems a taxpayer to have met residency requirements during the year of immigration or emigration.
A trust cannot claim LCGE, however, if it passes the capital gains to its beneficiaries and makes appropriate designations, the beneficiaries may be able to claim LCGE subject to their own limits. This is often used as a tool to multiply Capital gains exemption over multiple beneficiaries of a trust.
LCGE – What is the eligible property?
LCGE has evolved over the years since its first introduction. As of now, there are only two types of properties eligible for Capital gains exemption:
- Qualified Small Business Corporation Shares (QSBC Shares)
- Qualified Farm or Fishing Property (QFFP)
There are strict and complex requirements related to the holding period, 90% or more asset test, and 50% or more asset test.
There is an enhanced capital gains exemption on the disposition of QFFP where LCGE increases to $1,000,000 (not indexed to inflation).
How much is the deduction?
As per subsection 110.6(2), an individual taxpayer can deduct the least of the four below amounts :
- The amount as determined by the formula in paragraph 110.6(2)(a). This is essentially the total limit for the current year less the amounts deducted in previous years. The subsection provides a formula that takes into account the adjustments to capital gains inclusion rates over the years.
- Cumulative Gains Limit of an individual taxpayer at end of the year as provided in paragraph 110.6(2)(b).
- Annual Gains Limit for the year as per paragraph 110.6(2)(c)
- Paragraph 110.6(2)(d) the amount that would have been included under paragraph 3(b) if the only properties at the time of disposal were qualified farm, qualified fishing property, or QFFP.
5 Restrictions and Anti-Avoidance provisions affecting LCGE
Income tax act has anti-avoidance provisions whenever there is a potential of abuse or the sole motivation of carrying out transaction is to avoid taxes. There are five restrictions and anti-avoidance provisions applicable to LCGE.
Subsection 110.6(6) Failure to report the capital gain
Under subsection 110.6(6) capital gain deduction is denied if the Minister establishes that the taxpayer knowingly did not file the tax return within one year from the due date, or did not report the capital gains in the year they occurred. In order for the deduction to be denied, there must be an intent to deceive at the taxpayer’s part. A taxpayer claiming the position of an honest mistake may have a better chance to have sympathies of court. For example, considering the capital gains were exempt and did not need to be reported is an honest mistake depending on the taxpayer’s overall profile.
Subsection 110.6(7) is intended to avoid the extension of the Capital gain exemption to the corporate taxpayers. If the dispositions are part of transactions subject to (only) subsections 55(2) and 55(3)(b), the deduction is denied. However, the deduction is not denied due to the application of subsections 55(2) and 55(3).
(Note: This is an advanced corporate income tax area and the client must consult a professional corporate tax accountant.)
Capital gains due to insufficient dividends
Subsections 110.6(8) and (9) remove the access to LCGE for the shares where surplus is accumulated due to insufficient dividends issued for those shares.
Both subsections are specific anti-avoidance rules. The former disallows the deduction if the dividends issued in the tax year and preceding tax years were less than 90% of the average annual rate of return for those shares, the latter defines the Average annual rate of return referred to by the former. Regulations 6205 set out the conditions for prescribed shares where these anti-avoidance rules are not applied. These regulations make it possible for the shares issued under typical freeze structures to be eligible for the deduction.
Property acquired at Less than FMV
LCGE is not permitted if the underlying property is acquired at less than fair market value. Less than FMV transactions are indicative of non-arm’s length relationship between transacting parties. Taxpayers should know the rules related to shareholder benefits as per subsection 15(1) and inadequate consideration as per subsection 69(1).
Subsection 110.6(7) provides that deduction is not permitted if the capital gains result from the disposition of property acquired, by a partnership or a corporation, in a series of transactions considerably less than FMV. This subsection denies a deduction for the gains arising out of a corporate merger or an amalgamation, gains as a result of winding down of partnership or a corporation, or distribution of property by a trust against the capital interest of a corporation either in full or part.
Tax-deferred rollover under the subsection of 85(1) often involves ACB lower than the FMV. In case the total consideration received is equal to the fair market value of the underlying property, both share and non-share consideration together, the above-mentioned anti-avoidance rule is not applicable. The gain under 85(1) is deferred by issuing a non-share consideration equal to the ACB of the property transferred and a share consideration equal to the FMV less ACB, i.e. deferred gain. In such a case, since the total consideration is equal to FMV, so subsection 110.6(7) does not apply.
Expanded capital gains to individuals compared to income by trusts and partnerships
Subsection 110.6(10) is another anti-avoidance rule that does not allow deduction if the driving purpose of the transaction is to allocate higher capital gains to individuals in order to avoid taxes. Partnerships and trusts may allocate higher capital gains to individuals whereas income to corporate partners or beneficiaries since individuals are eligible for this deduction.
Subsection 110.6(10) uses the phrase “one of many reasons” here. If the individuals are allocated higher capital gains as compared to their percentage interest in the income from the partnership or trust, the deduction is not allowed. However, in the past, a relatively lower threshold is accepted by the CRA for “one of many reasons”.
Trust above does not include Personal Trust.
LCGE Planning Strategies
There are quite a few income tax planning strategies to take advantage of Lifetime Capital Gain Exemption. Such strategies are broadly categorized as either Purification or Crystallization strategies.
- Purification strategies are used when the underlying shares do not meet the criteria set for QSBC or QFFP. Income tax planning is done to make those shares eligible for LCGE.
- Crystallization strategies are used to take advantage of LCGE where the shares already meet the criteria for QSBC (or QFFP).
These strategies revolve around the two objectives. First to meet the 90% and 50% asset test and second to meet the requirement of 24 months holding period.
Income tax planning strategies for both purification and crystallization are discussed further below at a very high level. Readers must take note to consult their professional income tax accountant specializing in LCGE before making any decision.
Purification strategies can be taxable, non-taxable or tax-deferred.
Taxable Purification Strategies
Taxable strategies result in taxable events in the hands of the shareholder or the corporation depending upon how is it applied. Three of such strategies are as below:
- Dispose of or sell the passive assets. The cash generated by such dispositions can be utilized as working capital.
- Distribute the passive assets as Dividends in-kind to the shareholders. This results in the dividends included in the shareholders’ individual tax returns and gains or profit at a corporate level under paragraph 69(1)(b) of ITA. Be aware of the affiliated stop-loss rule if the corporation distributes assets with accrued losses to the shareholders as per subsection 40(3.4).
- Payout the salaries or dividends to the shareholder(s). Utilize the redundant assets to issue salaries, bonuses, or dividends.
One of the concerns with dispositions of passive assets at the corporate level is the payment of higher taxes on investment income generated in that year. However, timing the distribution of dividends can offset the impact due to the Refund of Refundable dividend on hand.
Non-Taxable Purification Strategies
Non-taxable purification strategies, as they sound good, do not involve any tax liability, neither at corporate nor at shareholder level!
- Pay off shareholder loans and amounts due to related parties. These parties can utilize the cash at their discretion.
- If there is a balance in the capital dividend account, pay off tax-free capital dividends to the shareholders.
- A corporation can repay its paid-up Capital, tax-free if it helps achieve the right asset mix.
- Expand the business by investing in assets that generate active income.
In the case of tiered structures, sometimes an amalgamation or pre-sale disposition provides an overall net tax benefit, if not tax-free.
Tax-Deferred Purification Strategies
Instead of removing the redundant assets to the shareholder, these assets can be removed from corporations into tax-deferred vehicles. As a result, there are no immediate tax consequences.
- A corporation can pay either salaries or bonuses to its shareholders if they have enough RRSP contribution room. This can defer the tax payment at the shareholder’s level until there is a withdrawal from RRSP.
- Pay retiring allowances that are eligible for transfer to RPP or RRSP.
- Contemplate corporate reorganization strategy that results in purification.
One such corporate reorganization strategy is to issue stock dividends, redeemable and retractable preferred shares, with nominal amounts. These preferred shares can be transferred to a new corporation using section 85(1) rollover. The new corporation can redeem these preferred shares and extract surplus cash from the issuer corporation. This is a purification strategy that defers the immediate tax liability as neither corporation will have any tax payment. Deemed dividend of the new corporation is deductible under subsection 112(1). This strategy works well in simple situations, however, the effects of section 55 of ITA must be considered in length to avoid any unintended tax consequences. Read more here.
Crystallizing the Lifetime Capital Gain Exemption
There are a couple of reasons behind crystallizing the LCGE. An operating company that qualified as a QSBC today may not be a QSBC tomorrow! or one-day LCGE may be removed at all!
Using crystallization strategies, the ACB of the shares, of the now Qualified small business corporation, is increased. The individual taxpayer can realize the gain and the deduction at the same time. This takes away the stress related to the ongoing or future purification strategies.
There are two crystallizing techniques commonly used:
Crystallization using Holding Company
If a corporation(Opco) qualifies as QSBC today, you can crystalize LCGE by setting up a holding corporation (Holdco). The shareholder transfers the shares of Opco to Holdco under subsection 85(1). The desired gain is triggered in the hands of the individual shareholder who can claim the deduction.
A joint election must be filed on time by both the corporation and the individual shareholder for this rollover.
Crystallization “without” the use of Holding Company
Another common technique to crystalize is to sell the shares back to the corporation. The individual shareholder can then receive the new shares from the same corporation. Crystallization happens by triggering the desired capital gain by jointly electing under subsection 85(1).
Important to know with this technique are:
- The joint election under subsection 85(1) is needed to avoid subsections 51 or 86 application to this transaction, and to trigger the desired gain.
- The shares issued under this rollover must be different than the shares sold back to the corporation.
- Paid-up capital of new shares should not be more than the paid-up Capital of old shares to avoid the deemed dividend under subsection 84(3).
Some other crystallization strategies that do not involve the use of Holdco are:
- An individual shareholder can either sell or gift the shares to a relative.
- LCGE is also available at the time of emigration and can be utilized during deemed disposition.
- The corporation can return the paid-up capital of the shares with low ACB and higher paid-up capital.
Benefits of Crystallization
To claim LCGE, the underlying shares must be Qualified small business corporation shares. The shareholders constantly need to monitor the QSBC status of the corporation. Crystallization ensures that there is no such monitoring anymore.
- Capital gains inclusion rate and lifetime capital gain exception itself have undergone a few changes in the past. Crystallizing LCGE today removes the uncertainty if the government decides to repeal the exemption in future.
- The fair market value of the shares might be higher today, and if there is room available for an individual’s LCGE limit, it might be a good idea to crystallize it. This is particularly helpful in an unexpected deemed disposition due to emigration or untimely death of the shareholder. Crystallization provides a step-up of ACB of shares, and at the time of disposition or deemed disposition, this can lower the overall income tax impact. Even if such a disposition is lower than the ACB, the capital losses are available to be offset against the capital gains of other assets.
- There is always a risk associated with pre-sale purification strategies due to section 55. If the corporation is eligible today, crystallizing LCGE today helps avoid the complexities surrounding section 55 and safe income allocations.
Drawbacks of Crystallization
As mentioned above, crystallizing LCGE is an important tool, but there are a couple of drawbacks or disadvantages to consider as well.
Section 84.1 Surplus Stripping – Tax Trap
Taxpayers often use Section 85(1) to transfer the shares of Opco to Holdco while triggering a capital gain. Often, an ill-planned section 85(1) rollover to crystallize capital gains may result in capital gain deduction challenged by the CRA. This can happen when the individual shareholder transfers shares to HoldCo with significant retained earnings, claiming LCGE, and later on withdrawing this excess equity from Holdco as a tax-free return of Capital.
In this particular case, Section 84.1 of ITA is an anti-avoidance rule that deals with surplus stripping or dividend stripping. As per Sec 84.1, such a withdrawal is considered deemed dividend. Whenever a taxpayer falls into this trap, the unintended tax consequences are extremely punitive since dividends are included in taxable income in full as compared to the capital gain.
Alternative Minimum Tax (AMT) Implications
Alternative minimum tax a.k.a. AMT, is an alternative method to calculate income taxes in Canada. Though the capital gains on the disposition of QSBC shares become non-taxable up to the individual’s LCGE limit, it does trigger AMT. If an individual does not expect to have income in the future years (subsequent 7 years), this AMT might not be recovered. The future dividends do not help recover AMT.
If crystallization is part of estate planning, it might be better not to crystallize but maintain QSBC status by monitoring it regularly. When crystallization occurs during the year of death, AMT is not triggered.
Sometimes, in subsequent years, withdrawing from RRSP or capital gains eligible for capital reserves can be added to income to recover AMT. An improper tax planning can result in making AMT a permanent tax cost rather than a temporary one.
Positive Cumulative Net Investment Loss
A positive Cumulative Net Investment Loss (CNIL) can reduce an individual’s capital gain exemption. CNIL balance is an excess of investment expenses of current and preceding tax year over the investment income of current and preceding tax year after 1987. investment expense and investment income for CNIL purposes are defined in subsection 110.6(1).
Clawback of Income-tested Benefits and Credits
Many benefits and credits depend on the net income of an individual such as Canadian child benefit, Old age security, age credits, GST/HST credit and provincial tax credits.
Crystallizing LCGE generates a net income for the taxpayer and that affects these benefits and credits.
Multiplication of LCGE using Trusts
An often asked question is whether multiple family members can take advantage of their Individual LCGE limit on the sale of QSBC shares.
The short answer is “Yes! Use the family trust”.
A trustee (or trustees) of trust makes decisions related to the allocation of income and capital gains to the beneficiaries. A properly allocated capital gain by the trust allows the multiplication of Lifetime Capital Gain Exemption by its beneficiaries.
What about the TOSI rules?
TOSI rules are a complex set of attribution rules. If an income is caught under TOSI rules, such an income is taxed at the top marginal rates.
- If the beneficiary of a trust is eligible to claim capital gain exemption on the sale of QSBC shares in an arm’s length transaction, she can claim it regardless of her age. Interestingly, even if she has been the beneficiary of the trust for less than two years. Where the capital gain is allocated to multiple beneficiaries, all of them (if eligible) can claim LCGE resulting in the multiplication of the exemption. Reference subsection 120.4(1)
- In the case of non-arm’s length transactions, for a minor who has gain whether directly or indirectly, twice the amount of gain is included in that minor’s individual income as a non-eligible dividend. Reference subsections 120.4(4) and (5).
Lifetime Capital Gain Exemption, though seemingly simple and attractive, is subject to complex tax rules. Various tax planning techniques interplay with many other sections of ITA, adding to its complexity. This is extremely important to seek the right professional tax advice in such a situation.
Maroof HS CPA Professional Corporation is a Toronto-based CPA firm providing individual and corporate income tax services in Ontario and Alberta. Our goal is to make premium income tax services involving complex income tax issues accessible to small and medium businesses in Canada. Get in touch with us today!