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The Capital Gains Exemption And Incorporating Professionals

Subject: Capital Gains Exemption Number: 08-01 Date: 1/18/2008

Sale of sole proprietor can be tax-free with planning

The first $750,000 of the capital gain on qualified small business corporation (“QSBC”) shares is exempt from personal income tax by virtue of the capital gains exemption. There are three basic tests for the capital gains exemption:

1. 24-month holding period test: Throughout the 24 months immediately preceding the sale, the shares were not owned by anyone other than the individual or a person related to the individual.
2. 24-month asset test: Throughout the 24 months immediately preceding the sale, at least 50% of the fair market value of the assets were used principally in an active business carried on primarily in Canada while the share owned by the individual was of a Canadian controlled private corporation (“CCPC”).
3. Point in time asset test: At the time of sale, at least 90% of the fair market value of the assets of the corporation must be used principally in an active business carried on primarily in Canada.

Since professional associations have recently permitted the incorporation of professionals, it has become more popular for professionals to incorporate their practices to take advantage of lower corporate tax rates and access to the capital gains exemption.

As a relieving measure, two of the three tests for the capital gains exemption are relaxed in those circumstances where the professional corporation has not been in existence for a minimum of 24 months. There is a provision in the Act that states that prior to the incorporation of the professional practice, the shares of the corporation shall be deemed to be owned by a related person provided that at least 90% of the assets of the unincorporated practice were transferred to the corporation. If the condition is met, then the 24-month holding period test will be met as well because a related person of the individual selling the shares shall be deemed to own the shares for the required amount of time.

The 24-month asset test is also relaxed by virtue that it only has to be met for the period that the corporation was a CCPC. Therefore, if the professional practice were incorporated just prior to the sale, this test would only have to be met for the period of time that the corporation was in existence.

The point in time test still has to be met for the individual to qualify for the capital gains exemption. However, if this test is not immediately met, there are various purification techniques that the professional can pursue with his tax advisor to ensure qualification for the capital gains exemption.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.