On 18.7.2017 the Department of Finance released a paper on taxes and draft legislation. In it there were three main tax issues raised, income sprinkling, passive income and conversion of regular income into capital gains. The issue of capital gains and the capital gains exemption is raised in many areas of the government’s proposals. In particular, new sections of the act have been drafted to limit the amounts that may be deducted under the lifetime capital gains exemption (LCGE).
The changes to LCGE are very significant and if enacted, will materially affect existing structures and how we plan for the future. The government commented in the income sprinkling section of their report that in some cases structures were put in place for family members to take advantage of the lifetime capital gains exemption. Multiplication of the LCGE was targeted as an income sprinkling strategy. The 2017 LCGE, fyi, is $835,716 and is indexed to inflation (the limit is $1,000,000 for qualified farm or fishing property). Family Trusts were particularly targeted under the income sprinkling commentary as inappropriately facilitating the multiplication of the LCGE. As such the government wants to constrain this multiplication of the LCGE.
Note also that the proposed legislation has been amended to add two new definitions, one for an “eligible employee beneficiary” and an “eligible LCGE Trust”. These are for a topic of another day.
There will be some transitional rules as relating to the utilization of the LCGE. Under certain circumstances, the 24 month hold rule would be reduced to 12 months.
I plan to comment on this further in future posts. This topic will be part of our November 23rd, presentation.
But first a brief refresher.
The rationale of this first commentary on LCGE is to serve as a reminder as to what qualifies for the LCGE.
The purpose of this article, as mentioned above, is not go into the new proposals, but to serve as a reminder of the basic rules of eligibility for the lifetime capital gains exemption. You need to assess whether the corporation in question qualifies before worrying about the impact of the proposed rules.
So let’s just recap, on a summary level, the basics of how to qualify for the lifetime capital gains exemption. There are three basic conditions:
1. The 90% rule or determination time test. Under the 90% rule,
• The corporation must be a Canadian Controlled Private Corporation (CCPC).
• All or substantially all of the FMV of the assets at that time is attributable to assets that are
▪ Principally used in an active business carried on primarily in Canada by the corporation or by a corporation related to it.
▪ Shares of the capital stock or indebtedness of one or more small business corporations that are at the time connected with a the particular corporation, or
▪ Assets described in the two points above.
All or substantially means greater than 90% of the fair market value of all of the assets of a corporation must be used principally in an active business. In determining FMV goodwill, internal IP, customer lists must and should be valued in coming to this determination. CRA tax interpretation 9200145 and court case of Wood v. MNR, 87 DTC 312 address this 90% rule.
2. The 50% rule, or holding period asset test
The above noted interpretation 9200145 goes on to say, if more than 50% of an asset is used in an active business then that asset will be considered to be used principally in an active business. Standard practice is to review actual use of each asset in evaluating this test.
3. The 24 month ownership test (and note above the 12 month transitional proposal)
• Throughout the 24 months immediately preceding the determination time, the shares must not have been owned by anyone other than the individual or a person or partnership related to the individual.
• During the 24 month period the asset values must be reviewed each moment during the relevant time period to determine whether 50% or more of the assets on a FMV were used in an active business. If you are offside, the clock is restarted when you move back onside.
• Intercompany investments in shares and debt can count toward the 50% test, provided certain conditions are met.
There are exceptions to the above for:
• Shares issued in exchange for other shares
• Shares issued in exchange for assets of a business
• Shares issued in exchange for a partnership interest where assets used in the business
• Shares issued as a stock dividend.
There’s a lot more detail and explanation that can go with the above, however, the intent here is to be a reminder of the basic rules to determine whether the new proposed rules will apply in your situation.
There are several proposed rules which will affect every owner that might otherwise qualify for the LCGE. So as noted above, first see if you qualify for the LCGE, then determine what impact the proposed rules.
In the 18.7.2017 draft legislation one term or concept that has been questioned and analyzed by the tax profession with respect to the draft legislation is “reasonableness”. This concept of reasonableness has been raised on several issues by the tax community. In particular the draft legislation relative to “income sprinkling” would be subject to “reasonableness testing”. As a reminder, in broad general terms, income sprinkling relates to a business or trust paying dividends or salaries to family members who may or may not be active in the business. The reasonableness test will also apply to the capital gains allocations in certain scenarios.
Reasonableness is subjective and requires judgement. There is considerable debate on this terminology and rightly so. How does one define it? There are many scenarios which result in this debate. Take salaries as an example. Is what’s reasonable in expensive cities like Toronto and Vancouver the same as small town Canada? As I’ve heard in so many courses, the phrase “it depends” comes up a lot!
I receive a lot of tax news releases and do my best to keep up with what’s going on in the tax world. Just recently I came across a court case, Peach v The Queen. The case dealt with “reasonableness of business expenses”. It made reference to section 67 of the income tax act that requires an expense to be reasonable. That’s fine, but doesn’t answer much. A couple points made were that S. 67 is a mechanism to reduce or eliminate an expense but not to second guess business decision making. This was affirmed in a Supreme Court Ruling in Stewart v. The Queen, 2002.
So having read the above, I dug a little deeper. Unfortunately, there was not a specific answer. I found references to court cases such as Moloney v. the Queen concluding there is no mathematical or scientific formula to answer the question. In Safety Boss Ltd v. the Queen the judge stated it required judgement and common sense of an objective and knowledgeable observer. In tax ruling 9520875 one of the lines states “There is no standard or gauge to determine reasonableness and thus the courts may freely determine what is reasonable in any assessment that is appealed. Clearly what is reasonable in any situation can only be determined on a case by case basis.”
So what does it mean? First you determine whether the expenditure, at any level, is a business expense. Then it’s a judgment call as to what’s reasonable. Unfortunately, from what I see the scope for what is reasonable is going to be very widely interpreted according to one’s objectives. Thus what will be reasonable to the Canada Revenue Agency will likely be at odds to what the business owner considers reasonable. No doubt, this will become a source for numerous tax rulings, interpretations and court cases down the road.