Introduction

This Tax Topic discusses some of the planning techniques available to maximize the use of the $750,000 capital gains exemption.1 A review of the capital gains exemption rules are found in the Tax Topic entitled, “The $750,000 Capital Gains Exemption”. Only the capital gains exemption for qualified small business corporation shares, qualified farm property and qualified fishing property remains; the $100,000 exemption was elimi

 

Inter Vivos (During Life) Planning

(a) Transfers to Minor Children

Previously, the income attribution rules did not apply to capital gains realized on property transferred to children under 18 years of age. However, the August 16, 2011 federal budget extended the tax on split income to include capital gains in the income of a minor from a disposition of shares of a corporation to a non-arm’s length person, if taxable dividends on the shares would have been subject to the kiddie tax. These capital gains will be deemed to be dividends and subject to tax at the top marginal rate. The minor will not be able to use any credits or deductions (except the dividend tax credit) to reduce the tax payable on the dividend. The capital gains exemption is also unavailable in respect of capital gains to which the kiddie tax applies. The kiddie tax can apply even if the minor pays fair market value for the shares or uses a prescribed-rate loan to acquire the shares. The changes apply to capital gains realized on or after March 22, 2011.

The budget contains a statement that “the government will continue to monitor the effectiveness of the tax on split income regime and will take appropriate action if new income-splitting techniques develop”. However, planning opportunities still exist. The kiddie tax does not apply to situations involving a spouse, adult children or amounts realized by a minor in respect of publicly listed shares, employment income or income inherited from a parent. Minors can receive reasonable amounts for services performed in the family business. Additionally, an arm’s length share sale will not attract the kiddie tax and the minor may be able to access the capital gains exemption on the disposition of the shares.

In addition to the kiddie tax, taxpayers should consider the operation of the various attribution rules found throughout the Income Tax Act (the “Act”). Where the kiddie tax applies, however, subsections 74.5(13) and 56(5) generally prevent the application of the other attribution rules.

Many estate freezes contemplate either minor children or a trust with minor beneficiaries subscribing for the common shares of the family business for a nominal amount. As the growth of the corporation accrues to the common shares, the eventual disposition of the shares will result in a substantial capital gain. If the shares are sold to an arm’s length party, the kiddie tax will be avoided and the minor children may be able to utilize their capital gains exemption. It must be kept in mind however, that the minor beneficiary’s lifetime exemption will be reduced accordingly.

1 The 2007 Federal budget increased the capital gains exemption to $750,000 for dispositions on or after March 19, 2007. For dispositions prior to March 19, 2007 the capital gains exemption was limited to $500,000. 2

It should be noted that any transfer of property to a trust is a disposition of property (defined in subsection 248(1) of the Act, unless there has not been a change in the beneficial ownership of the property. Canada Revenue Agency (“CRA”) considers that a settlor and the trust are not at non-arm’s length unless the facts of a particular situation indicate otherwise (see the current version of Interpretation Bulletin IT-209R, Inter-Vivos Gifts of Capital Property to Individuals Directly or Through Trusts). In such cases, section 69 of the Act would apply to deem the proceeds to the settlor to be equal to the property’s fair market value (“FMV”) and the trust to have acquired the capital property at an adjusted cost base (“ACB”) equal to the property’s FMV. Thus, there would be a realization of any capital gain/loss in the settlor’s hands at the time of transfer to the trust. To the extent that it is available, the settlor may utilize his or her capital gains exemption to shelter any such capital gain from tax.

(b) Transfers of an Interest in a Family Farming or Fishing Business to a Child

Subsections 73(3) and (4) of the Act permit certain types of farm or fishing property (including an interest in a family farm/fishing partnership or shares of a family farm/fishing corporation) to be transferred by a farmer/fisher to his or her child on an inter vivos, rollover basis. These types of transfers are more fully discussed in the Tax Topic, Tax Issues Relating to the Transfer of the Family Farm. A farmer/fisher can utilize the rollover provisions to transfer farm/fishing property with unrealized gains to his or her children. The children can then dispose of the farm/fishing property and utilize their exemption to shelter the resulting gain. It should be noted however, that the gain may be attributed back to the parent in circumstances where the transfer is effected under subsection 73(3) of the Act, the transfer was at less than FMV, and the child was under 18 years of age in the year the property was disposed of (subsection 75.1 of the Act).

(c) Transfers to Adult Children

A gift to an adult child of capital property may be made so that future capital gains accrue to the child. The attribution rules do not apply beyond age 17. Section 69 of the Act applies to deem the disposition to occur at FMV; any accrued gains/losses up to the time of the gift are realized in the donor’s hands. Ideally, the property that is the subject of the gift has a FMV close to the ACB of the property so that the gain to the donor is minimal and the potential for growth in the child’s hands is the greatest (e.g. shares of a business that just started up). Again, to the extent that it is available, the donor can utilize his or her capital gains exemption to shelter any gains that result on the gift to the adult child.

(d) Transfers to a Spouse

The attribution rules relating to transfers of property to a spouse generally do not apply if the spouse pays FMV for the property and the transferor elects out of the rollover provisions contained in subsection 73(1) of the Act. Therefore, it may be feasible to transfer appreciating property at FMV to a spouse in order to use the spouse’s exemption to shelter future gains on the property. By electing out of the rollover provisions, and receiving FMV consideration, there is a realization of capital gains/losses in the transferor’s hands against which the exemption, to the extent that it is available, may be claimed.

(e) Estate Freezes

A taxpayer who currently owns an incorporated business may wish to realize a sufficient capital gain now in order to fully utilize the capital gains exemption and carry out estate planning at the same time. This can be accomplished in an estate freeze transaction. In order to trigger the gain, the taxpayer could roll the shares, under section 85 of the Act, of the operating business (“Opco”) to a new corporation (“Holdco”) and take back redeemable preference shares of Holdco with a fixed value equal to the current FMV of the Opco shares. The election under section 85 of the Act would be sufficient to create a capital gain equal to the available capital gains exemption. The deemed transfer price then becomes the ACB of the preference shares. On death or a subsequent disposition of the preference shares, the difference between the fixed redemption value and the “bumped-up” ACB of the preference shares would be taxable as a capital gain. 3

If, at the same time, the taxpayer’s spouse and/or children became the holders of the common shares of the Holdco (by subscribing for shares at a nominal value), the future increase in the value of Opco would accrue to their benefit through the Holdco shareholdings. On a subsequent disposition of the common shares, the spouse and/or children could claim the capital gains exemption available to them thus multiplying the exemptions available to shelter the gain on a sale of the shares. Certain anti-avoidance provisions may apply here if a spouse and/or children become shareholders and the company ceases, at any time, to be a “small business corporation” (section 74.4(2) of the Act). As discussed above, for minor children, the kiddie tax will apply.

(f) Hybrid Method of Buy/Sell
To achieve great outer looks you have to fix the cause of it. cialis discount pharmacy An ED levitra generika medicine could relieve stress and tension. Actually, in pulmonary hypertension, the cheap tadalafil pills blood pressure in lungs. Cybersex is also increasing day by day, vardenafil india where couples engage into video sex.
The shareholders of closely-held companies often agree that when a shareholders dies, the deceased’s shares will be purchased by the surviving shareholders (promissory note method resulting in capital gains to the departing shareholder) or by the company (corporate redemption method resulting in deemed dividends to the departing shareholder). This ensures a smooth transition of the business and a ready market for the shares. The “hybrid method” of a buy/sell agreement combines both methods. The hybrid method enables the deceased shareholder to utilize his or her capital gains exemption to the extent that it is available upon the sale of the shares to the survivors (promissory note method). To the extent that the deceased’s exemption cannot shelter the gain on the sale, the corporation will redeem the deceased’s shares (corporate redemption method).

Planning Considerations Relating to Timing of Use of Exemption

There are planning techniques available to accelerate the realization of capital gains in order to use the capital gains exemption. One of the more common reasons to do this would be the desire to lock in the capital gains exemption while the QSBC shares qualify, for example before the corporation accumulates investment assets.

Prior to undertaking any transactions meant to accelerate the realization of capital gains, the business and tax costs should be analyzed. For example, the transfer of farm property to a trust or family member on a non-rollover basis may result in the recapture of capital cost allowance, land transfer tax, attribution of future income or gains, as well as diminished control of the asset. Capital gains sheltered by the exemption can result in an alternative minimum tax (“AMT”) liability unless there is sufficient other income taxed at full rates (subsections 127.5 to 127.55 of the Act). Although the capital gains exemption is deductible in computing income for AMT purposes (to the extent it was claimed for ordinary tax purposes), AMT may still arise because the exemption is expressed as a deduction at the capital gains inclusion rate (currently 50%) but 80% of the total capital gain is included in computing income for AMT purposes. As a result, 30% of the gain will, in most cases, be subject to AMT.

As well, taxable capital gains will be included in the calculation of “net income”; however, the capital gains exemption is not deducted in the calculation. Many tax credits and the entitlement to other items are calculated based on net income. For example, a taxpayer’s net income can have a significant impact on the old age security clawback, age credit and unemployment insurance repayments. All these “costs” may potentially exceed the tax savings resulting from stepping up the cost base of the asset with the capital gains exemption.

Will Planning

(a) Power to Encroach

Since a trust is generally not entitled to claim a capital gains exemption in respect of gains retained in the trust, it is important that a testator’s will specifically empower the trustees to encroach on the capital of the trust. This will permit the trustees to allocate any gains realized by the trust to the beneficiaries, who in turn may use their capital gains exemption limit to offset these gains. 4

(b) Spousal or Common-law Partner Transfers

Most wills provide for the testator’s estate to be left to the spouse (or common-law partner) or a spousal trust. A spousal trust is one in which the spouse or common-law partner is entitled to all the income of the trust that arises before the spouse’s (or common-law partner’s) death, and in which no person other than the spouse or common-law partner is entitled to the income or capital of the trust while the spouse is still alive. In these circumstances, subsection 70(6) of the Act provides for an automatic rollover, resulting in the testator not realizing any capital gains/losses as a consequence of his or her death. Where the rollover is applicable, the testator’s unused capital gains exemption may be wasted.

This potential problem can be remedied by the taxpayer’s legal representatives electing out of the rollover rules pursuant to subsection 70(6.2) of the Act. The will should therefore contain a specific provision authorizing the legal representatives to make a subsection 70(6.2) election, if desired.

In circumstances where the testator intends to leave his capital property in trust for a spouse, two separate trusts could be created by the terms of the will to ensure that all of the testator’s capital gains exemption is utilized on death. The first trust would be a “tainted” spousal trust, (i.e. a trust where someone other than the spouse, for example a child of the testator, is entitled to receive the income or capital of the trust during the spouse’s lifetime). Assets with accrued gains equal to the deceased’s unused capital gains exemption would be transferred to the tainted trust, and the testator’s exemption would be used to offset these gains. All other assets would be transferred to the second “untainted” spousal trust on a rollover basis.

On the death of the spouse, the assets in the tainted spousal trust could be transferred to the capital beneficiaries on a rollover basis (subsection 107(2) of the Act). Assets in the second untainted spousal trust will be deemed to have been disposed of at FMV on the spouse’s death (subsection 104(4)(a) of the Act). Subsection 110.6(12) of the Act would then permit the untainted spousal trust to shelter all or a portion of the gain realized on the death of the spouse by the amount of the spouse’s unutilized exemption on death. Thus, by providing two spousal trusts in the will, one tainted and the other untainted, the capital gains exemption may be maximized within the family unit.

Conclusion

The capital gains exemption creates additional opportunities (and complexities) in tax planning. Taxpayers should therefore consult with their tax advisors prior to disposing capital property to ensure that they are fully utilizing their exemption without running afoul of the various anti-avoidance provisions contained in the Act.

Last updated: May 2013

The Tax & Estate Planning Group at Manulife Financial writes various publications on an ongoing basis. This team of accountants, lawyers and insurance professionals provides specialized information about legal issues, accounting and life insurance and their link to complex tax and estate planning solutions.

These publications are distributed on the understanding that Manulife Financial is not engaged in rendering legal, accounting or other professional advice. If legal or other expert assistance is required, the service of a competent professional should be sought.