Attack on Multiplication of the Capital Gains Exemption

On July 18, 2017 the Minister of Finance (Finance) announced sweeping changes to limit the tax planning that has been the cornerstone of Canadian-controlled private corporations and their shareholders. While the changes announced covered several areas, this document focuses on proposals related to the capital gains exemption.1

Draft legislation was released with the proposals concerning the capital gains exemption. The draft legislation is subject to a commentary period ending October 2, 2017, with the intention that it is effective January 1, 2018.

1 See our August 3, 2017 release (the “August 3 Release”) for information related to income splitting.

Introduction

The August 3 Release summarizes the reasons for action by Finance as it relates to income splitting. Finance, however, offered additional commentary as it relates to the capital gains exemption, as follows:
► Tax planning has promoted so-called “multiplication” arrangements with respect to the lifetime capital gains exemption (LCGE).  A particular concern is the use of family trusts to facilitate arrangements under which the LCGE limits of multiple members of a family may be used to reduce capital gains tax.  Individuals have used these arrangements in a way that permits them to claim the exemption even though they may not have invested in, or otherwise contributed to, the business value reflected in the capital gains they realize on the disposition of property that is eligible for the exemption.

Planning Example (Simplified)

A typical structure that would allow for multiplication of the capital gains exemption would be as follows: Joe and Susan start a company. Susan’s father settles a trust (i.e. the family trust). Joe and Susan’s two minor children are named beneficiaries of the trust. The trust opens a bank account with over-draft protection. Joe, Susan and the trust subscribe for shares of the company, say one-third each. Because the company is just starting off, the share subscription price is low. The trust accesses its over-draft protection to pay for its shares.

The company is successful. Joe and Susan receive an offer to sell the company from an arm’s-length party. The sale is structured as a sale of the company’s shares, and a large capital gain is realized. One-third of the capital gain is realized by the trust since it holds one-third of the shares. The trust allocates the capital gain to Joe and Susan’s children, who are still minors. Joe and Susan prepare the children’s tax returns reporting their share of the capital gain allocated from the trust, and the capital gains exemption is claimed by each child sheltering tax on the capital gain.

In 2017, a capital gain of roughly $835,000 could be realized and sheltered by the capital gains exemption.2

2 Alternative minimum tax might apply. The capital gains exemption in respect of qualified farm or fishing property is $1 million.

Proposed Measures

Measures are being proposed to limit multiplication of the capital gains exemption. First, individuals would no longer qualify for the capital gains exemption in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18 years. Second, the capital gains exemption would generally not apply to the extent that a taxable capital gain from the disposition of private corporation shares is included in an individual’s split income (see August 3 Release). Third, subject to certain exceptions, a gain that accrued during the time that the shares were held by a trust would no longer be eligible for the capital gains exemption.3

The proposed measures would apply to dispositions after 2017. However, special transitional rules are proposed and are discussed below.

3 The proposed measures also apply to qualified farm or fishing property, which includes the shares of a family farm or fishing corporation.

Key Concepts

Age limits
Individuals will no longer qualify for the capital gains exemption in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual turns 18. In the implified planning example above, the capital gain would be reported in the children’s personal income tax returns, but the capital gains exemption would not be available as the children are minors.

Reasonableness Test
The reasonableness test would mirror the tax on split income (TOSI) measures, as described in our August 3 Release. The reasonableness requirement will prohibit access to the capital gains exemption where the amount of the gain attributable to the individual is greater than the reasonable value of labour or capital provided to the corporation by the individual. This proposal will limit access to the capital gains exepmtion by spouses or other family members where they are inactive or "silent partners".

In the simplified planning example above, and assuming Joe and Susan’s children were adults and held their shares of the company directly, the capital gain would be reported in the children’s personal income tax returns, but because it is not reasonable (ie: the children were not involved in the business), access to the capital gains exemption would be denied.4

Trusts
Individuals will no longer qualify for the capital gains exemption in respect of capital gains that accrue during a period in which a trust holds the shares. An exception would be provided for capital gains that accrue while the shares are held by a spousal or common-law partner trust, or an alter-ego trust – trusts often used in estate planning contexts – or, where the trust in question is an employee share ownership trust.

Again, in the simplified example above, the capital gains exemption would not be available as the capital gain accrued while the shares were held in the family trust.

4 The capital gain will also be subject to tax on split income (TOSI).

Transitional Rules

The proposals contain transitional rules that would allow an individual or trust to “crystallize” accrued capital gains in 2018 and utilize the capital gains exemption where it may not be available going forward. The benefit of the crystallization would be to increase the cost of the shares and to reduce or eliminate a capital gain on a future disposition of the shares.

The date of the crystallization is subject to the taxpayer’s discretion; however, it must be sometime in 2018. The shares in question must be owned by the taxpayer continuously from the end of 2017 to the date of the crystallization. Therefore, notwithstanding that the crystallization is to occur sometime in 2018, taxpayers must start planning for the crystallization in 2017.

The crystallization would be undertaken by the taxpayer reporting a deemed disposition of the shares – that is, electing to dispose of the subject shares for an amount between the cost and the fair market value of the shares. If the elected disposition amount exceeds the fair market value of the shares, penalties will apply. The election itself would be filed with the taxpayer’s 2018 income tax return.

In light of the possible application of penalties, it would be prudent to consider obtaining a valuation to support the fair market value of the shares.

A crystallization will not be available in respect of the shares of a private corporation to the extent the taxpayer is under the age of 18 in 2018. This is regardless of whether the minor holds the shares directly or the intention is to allocate a crystallized capital gain from a trust to the minor. However, a minor will be permitted to access the capital gains exemption in 2018 to the extent the minor (or a trust) disposes of the shares to an arm’s length party – which in the private corporation context may not be possible or be desirable.

What’s Next?

There will likely be a significant amount of feedback provided to Finance by the October 2, 2017 deadline. It is difficult to predict what changes, if any, Finance will make.

The new proposals are complex and it is prudent to review existing tax planning arrangements to determine whether a capital gains crystallization should be undertaken.

To the extent a crystallization is to be undertaken, timing and valuation will be considerations, and professional assistance will be needed. Conversations with advisors need to start early as it is possible that some action will need to be taken in 2017.

It will be important for individuals and their private corporations to stay informed and perhaps increase the level of communication with their advisors.

For more information, please contact us.

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