exemption could be crystallized by filing a Section 85 election. (Form T2057),
thus electing into the gain. This, of course, would save future professional fees in
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DIFFERENT THAN A DOT.COM
BILLIONAIRE SO ARE HIS TAX
PLANNING NEEDS
EXCERPT #2
Tax Planning for Small Business Guide Excerpt: [¶1111] Pros and Cons of Crystallization
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TAX PLANNING FOR SMALL BUSINESS GUIDE One of the most important tax planning strategies pertaining to the $500,000 lifetime capital gains exemption is the “crystallization” of the exemption. Most practitioners know that this strategy involves purposely triggering a capital gain on the shares of a qualifying corporation so as to use the exemption to “bump” the cost base of the shares. But is the strategy a good idea in a specific client situation? The CCH Tax Planning for Small Business Guide provides a comprehensive and easy-to-understand list of considerations – both pro and con – to allow you to provide your clients with sound advice on this key tax-saving strategy.
Part of reorganization [¶1111] Pros and Cons of Crystallization Soon after the capital gains exemption first appeared, there were a great many crystallizations effected, to a large extent, in the belief that the exemption would soon be repealed. Although this, of course, turned out to be the case in respect of the general $100,000 capital gains exemption (which was repealed in 1994), the current government (at the time of writing) has announced in the 1995 federal budget that it has no plans to repeal the exemption. However, even if the capital gains exemption is not repealed, there continue to be a number of reasons why crystallization may make sense.
The corporation's assets may go “offside” In order to obtain the capital gains exemption in respect of qualifying small business corporation shares, at the time of disposition, substantially all of the corporation's assets must be devoted to Canadian active business activities. In addition, there is a “two year hold” requirement whereby certain other "asset tests" must be satisfied. Very often, a successful small business will accumulate non-business assets, establish business activities outside of Canada, and so on, thus possibly disqualifying the shares for the exemption. If there is to be an actual third-party sale of the shares, it is often possible to effect purification techniques prior to a third-party sale (but tax-deferred spinouts of non-qualifying assets may not be available). Also, this procedure is less likely to be available where there is a deemed disposition, particularly on death when the shares pass to a subsequent generation. Crystallizing the capital gains exemption may accordingly leave the corporation free to pursue activities which would subsequently disqualify its shares for the exemption.
Exemption not available in the future Besides a repeal of the capital gains exemption itself, it is possible that the exemption may not be available in the future, particularly due to the build-up of cumulative net investment losses, which may block out the availability of the exemption, to the extent of the shareholders’ CNIL account.
Very often, a reorganization will occur whereby the crystallization of the exemption may be effected as part and parcel of a reorganization, often with little additional cost. In the current context, the crystallization might be effected by electing into a capital gain on the roll of the operating company to the holding company. This may also be the case, if there is an estate freeze: for example, “freezor” would exchange his or her common shares for freeze shares, with new common shares to be held by the children/family trust. When the “exchange” is made, the exemption could be crystallized by filing a Section 85 election (Form T2057), thus electing into the gain. This, of course, would save future professional fees in respect of a crystallization. The following are some reasons why a crystallization may not be advisable:
Minimum tax Minimum tax may apply, particularly to larger gains (e.g., unless the owner-manager receives very large salaries and bonuses). This possibility is increased due to recent reductions to the inclusion rate for capital gains (now 50%). However, the minimum tax liability can be carried forward to apply against normal taxes, for a period of seven subsequent taxation years. Some crystallization methodology staggers the gain over two years or more, thus decreasing the possibility of minimum tax applying.
Exemption not available or blocked As mentioned previously, the exemption might be restricted or blocked due to allowable business investment loss claims in the year or a previous year. A CNIL account or pre-1986 capital loss claims may block out the exemption. While the lifetime exemption is $500,000, if the $100,000 exemption was used prior to its repeal, the exemption will, of course, be reduced. For further discussion of factors that may adversely affect the exemption, including the foregoing, reference should be made to ¶1117 et seq.. (As mentioned in that Section, Subsection 110.6(8) may prevent the exemption in respect of corporations that issue shares having attributes designed to facilitate the realization of a capital gain by restricting the payment of dividends. Care should be taken that the crystallization methodology itself does not involve such shares, thus restricting other shareholders from claiming the exemption.)
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Blockage of future allowable business investment losses Pursuant to Subsection 39(6) , there will be a reduction of a business investment loss in any taxation year to the extent that the individual has claimed the capital gains exemption in a previous year. As mentioned above, there was a spate of crystallizations in the late 80's after the exemption was first introduced. In the recession of the early 90's, many individuals who had crystallized found that allowable business investment loss claims were blocked by the crystallization, thus losing valuable tax relief at a time when it was badly needed.
Wrong shares? The capital gains exemption is, of course, a lifetime exemption. If the individual has crystallized the exemption in respect of one corporation, but sells the shares of another, the exemption will, of course, be restricted. A similar result may occur if an exemption is claimed in respect of qualifying farm property. Similarly, if the individual sells only some of the shares which were subject to a crystallization, only a portion of the benefit of the exemption subject to the crystallization will be enjoyed.
An exemption claim will increase net income The crystallization might have an effect on income-based items, including OAS clawbacks, the age credit, medical expense claims, GST credits, child tax benefits, and so on.
This depends on the mix of shares and other property received as consideration for the transfer. The former tends to result in a paid-up capital reduction and the latter tends to result in an immediate taxable dividend. Suppose, for example, that an individual transfers shares of Opco, which qualifies for the exemption, into Holdco, elects into a $500,000 capital gain, taking back a note for this amount and, say, 1 common share. Section 84.1 would apply to this transaction, the result being a deemed dividend in the amount of $500,000. For further discussion of Section 84.1, reference should be made to ¶1125, below, and ¶845. Also, as has been discussed, qualifying for the exemption itself may be more difficult than it may at first appear. It has been suggested that this risk could be minimized by initially not filing a Section 85 election (but instead choosing the “right amount” of shares for the crystallization procedures). This allows a late-filed election to be filed “as of right” per Subsection 85(7) within three years of the filing deadline; otherwise, Subsection 85(7.1) requires an amendment to an election to be “just and equitable” in the opinion of the CRA. Of course, this approach may give rise to valuation issues. In addition, if the assessment of the transferor is delayed, there may be a “window of opportunity” for an adverse reassessment, outside the "as of right" time limit (alternatively, the CRA could attempt to override the assessment limitation period, e.g., by alleging neglect, carelessness or wilful default). U.S. citizens or residents should review the crystallization methodology. The commentary on this topic is current as of January 2nd, 2005.
Tax misadventure A crystallization can run afoul of tax traps. The most infamous of these is Section 84.1, which is designed to prevent an individual from using his or her capital gains exemption (or cost base stemming from V-Day value) to access corporate-level assets. The section potentially applies when an individual (or other Canadian resident non-corporate transferor) transfers shares of a resident corporation that are capital property to a non-arm's length corporation which, immediately after the transfer, is “connected” with the transferred company (e.g., the holding company has more than 10% of the voting equity of the transferred corporation). If these preconditions are met, the basic rule under Section 84.1 is that the maximum amount that can be received from the transferee corporation as proceeds in the form of nonshare consideration and/or paid capital of shares is restricted to the greater of: the paid-up capital of the transferred shares, and what is referred to as the transferor's “84.1 cost base” of the transferred shares. The “84.1 cost base” basically refers to the pre-existing cost base, but excludes V-day appreciation and exempt capital gains claimed on previous dispositions by the transferor or non-arm's length persons. If these constraints are violated, there will be a paid-up capital reduction of the shares received from the transferee corporation and/or an “immediate” taxable dividend.
Just some of the reasons for making this Guide your planning partner. Feature: Discussion of tax planning for owner-managed and small businesses.
Benefit: Materials deal with the law as it pertains specifically to owner-managers and small business owners.
Feature: Discussion of tax planning for private corporations.
Benefit: Provide value-added advice to your clients on tax planning issues for their private corporations.
Feature: Concentrates on issues that face practitioners on a day-to-day basis.
Benefit: Can quickly understand and give advice on issues that are most likely to crop up.
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TAX PLANNING FOR SMALL BUSINESS GUIDE A REAL LIFE EXAMPLE Determine for yourself whether or not the Tax Planning for Small Business Guide is worth the investment. Check out the following pages that have been reproduced in their entirety from the Guide. You’ll be impressed by their thoroughness and applicability.
Written by Experts The Tax Planning for Small Business Guide is the collaborative product of some of Canada’s leading tax experts. David Louis JD, CA and Samantha Prasad Weiss BA, LLB, both with the law firm Minden Gross LLP, along with Robert Spenceley BA, MA, LLB, analyst with CCH Canadian, and Joseph Frankovic LLB, LLM, PhD, CFA tax lawyer and member of the adjunct faculty of Osgoode Hall Law School, lead a host of contributors whose expertise make this Guide truly indispensable.
David Louis
Samantha Prasad Weiss
Robert Spenceley
Joseph Frankovic
JD, CA
BA, LLB
BA, MA, LLB
LLB, LLM, PhD, CFA
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