Generally, three tests must be met in order for shares to be considered QSBC shares:

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1 December 23, 2013 The Capital Gain Exemption on the Sale of Shares By Jonathan Charron There are various ways to structure the sale of a business in a taxefficient manner. These include a share sale, an asset sale or a hybrid transaction. From the vendor s perspective, a key consideration in choosing a sale structure is his or her entitlement to the $800,000 capital gain exemption on the sale of qualifying shares. This paper aims at summarizing the statutory requirements which governs the availability of the capital exemption for a taxpayer on the sale of shares. The Income Tax Act (the Act ) provides a lifetime exemption in respect of capital gains realized on the disposition of, inter alia, socalled Qualified Small Business Shares ( QSBC ). The current lifetime exemption is $750,000 and will increase to $800,000 for the 2014 year (such amendment to the Act is contained in Bill C-4 which is currently at second reading in the House of Commons). The capital gains exemption normally applies only to Canadian resident individuals. The definition of a QSBC share is applicable at a point in time, referred to in the definition as the determination time, which is the time at which the share is being disposed. Generally, three tests must be met in order for shares to be considered QSBC shares: i. at the determination time, the share is a share of the capital stock of a small business corporation (as defined in the Act) owned by the individual, the individual s spouse or common-law partner or a partnership related to the individual (the 90% test ). A personal trust and a person or partnership are also deemed to be related for purposes of the capital gain exemption for any period throughout which the person or partnership was a beneficiary. In addition, in respect of shares of the capital stock of a corporation, a personal trust is deemed to be related to the person from whom it acquired those shares, in cases where all of the beneficiaries, except registered charities, were related to that person (or would have been if that person were then living) at the time when the trust disposed of the shares; ii. the shares must not have been owned by anyone other than the individual or a person or partnership related to the individual, throughout the 24 months immediately preceding the determination time (the holding period test ); and iii. a 50% active business asset test must be met. In particular, throughout the 24-month period immediately preceding the determination time (i.e., this test must be continuously satisfied during

2 the 24-month period), the share must have been a share of a Canadian-controlled private corporation ( CCPC ) more than 50% of the fair market value of the assets of which was attributable to (a) assets used principally in an active business carried on primarily in Canada by the corporation or a corporation related to it, (b) shares or indebtedness of one or more other corporations connected with the corporation for tax purposes which otherwise meets the 50% test, or (c) any combination of (a) and (b) (the 50% test ). The term small business corporation is defined in the Act for tax purposes. It requires that the corporation be a Canadian-controlled private corporation ( CCPC ) for tax purposes, of which all or substantially all of the fair market value of its assets are attributable to assets that are: (i) used principally in an active business carried on primarily in Canada by the corporation or by a corporation related to it, (ii) shares of the capital stock or indebtedness of one or more connected small business corporations, which generally includes corporations that are controlled by the shareholder corporation or the shareholder corporation owns more than 10% of the voting shares of the corporation having a value of representing more than 10% of the value of the corporation, or (iii) assets described in (i) and (ii) above. An active business is defined in subsection 248(1) of the Act, generally, as any business other than a specified investment business or a personal services business. The latter two terms are defined in subsection 248(1) and derive their meanings from definitions in subsection 125(7) of the Act. The concept of an active business has its ordinary meaning that has been developed generally in the case law considering the meaning of a business carried on by a taxpayer. The Canada Revenue Agency's ( CRA ) position (which has been generally accepted) with respect to the phrase all or substantially all is that it at least 90% of the assets of the corporation must be involved in an active business. In addition, the term principally generally refers to more than 50% and in determining whether assets will meet the 50%, the CRA position is that the principal use test has to be applied on a property by property basis. Also, in determining whether an asset is used in a particular active business, the Supreme Court of Canada has established in Ensite Ltd. v. R., [1986] 2 S.C.R. 509 ( Ensite ), that an asset must be employed or risked in a business. Furthermore, the Court held that the term risked meant more than a remote risk; it meant that the withdrawal of the property would have a destabilizing effect on the business operations themselves. Generally, a CCPC includes a private corporation resident in Canada other than a corporation controlled, directly or indirectly in any manner whatever, by one or more nonresident persons, by one or more public corporations (other than a prescribed venture capital corporation), by one or more corporations having a class of shares listed on a designated stock exchange, or by any combination thereof.

3 The Act contains specific deeming rules that must be taken into account is assessing whether a corporation is a small business corporation or a CCPC. In particular, the Act provides that where a taxpayer has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently to acquire shares of a corporation, the taxpayer is deemed to own the shares. However, for purposes of the capital gain exemption, this deeming rule does not apply in respect of a right under a purchase and sale agreement. Accordingly, the entering into a share purchase agreement by a vendor should generally not jeopardize the small business corporation status even if the closing date is subsequent to the execution date. The holding period test does not necessarily require the individual to hold the shares for 24 months, but merely that no unrelated person holds the shares during the holding period. Rules contained in the Act reduce the 24-month holding period test to a shorter period in some circumstances. These include the following situations: A partner of a partnership who has become a shareholder of a newly incorporated small business corporation on the transfer of the partnership business to the corporation can claim the capital gains exemption even though the corporation has been in existence for less than 24 months; A person and a corporation are deemed to be related where the person has transferred shares of another corporation to the corporation and all or substantially all of the consideration received therefor by such person consists of common shares of the recipient. This paragraph is intended to ensure that the transfer of shares of an otherwise qualified company to a holding company will not affect the individual's entitlement to the capital gains exemption. When new shares are issued as consideration for other shares, provided the old shares meet the holding period test, the new shares issued will also meet the holding period test. This exception is particularly relevant for situations involving estate freezes whereby a common shareholder exchanges its shares for preferred shares having a fixed redemption value (i.e. so-called freeze shares ). A person who was carrying on a sole proprietorship business and who transfers all of his or her business assets into a corporation and receives common shares of the corporation as consideration is generally exempt from the requirement of holding the shares for a 24-month period prior to sale. The Act also provides that dispositions of identical shares (i.e. shares of the same class and series) are deemed to be disposed of in the order in which they were acquired. Such a rule is useful in the situation where, for example, an individual has qualifying and nonqualifying shares and sells a portion of them. The individual would be unable to claim that the shares which were sold were the qualifying shares unless they were acquired first. The availability of the capital gain exemption may be restricted if, inter alia, the shareholder has incurred cumulative net investment loss ( CNIL ) or allowable business investment loss ( ABIL ) in the past.

4 The definition of a cumulative net investment loss in the Act provides that an individual's cumulative net investment loss at the end of a taxation year is the amount by which investment expenses claimed in the year or in a preceding taxation year ending after 1987 exceed the investment income earned during the same period. The account carries forward from year to year so that it is not possible for an individual to have exempt capital gains in a year to the extent of the individual's CNIL account. An ABIL is defined as 3/4 of a business investment loss. To qualify as a business investment loss, an amount must first be a capital loss. An ABIL is basically a capital loss from a deemed disposition to which subsection 50(1) of the Act applies, or to an arm's length person, of shares or debt of a small business corporation. Three-quarters of this loss is an allowable business investment loss. The Act also contains other restrictions on the use of the capital gain exemption, including the potential impact of alternative minimum tax. As mentioned above, one of the requirement to claim the capital gains exemption in respect of the disposition of QSBC shares is that at the determination time, all or substantially all of the fair market value of the corporation s assets must be used principally in an active business carried on primarily in Canada. Where this test is not met, steps may be taken to purify the corporation that is, to remove assets from the corporation that are not used in an active business being carried on in Canada. Common types of assets owned by a corporation that may prevent the determination time test from being met include cash and cash equivalents in excess of operating needs, unused land, buildings that generate rental income, and loans receivable, unless the company is in the business of lending money. In respect of non-qualifying assets other than cash (in particular, non-qualifying assets with accrued capital gains), a purification may sometimes be accomplished by way of a reorganization by which the non-qualifying assets are transferred on a tax-free basis to a newly formed corporation (ie, a butterfly ), provided that no sale to an arm's length party of the shares of the small business corporation is contemplated at the time of the reorganization. Another mechanism for removing non-qualifying assets from a small business corporation would be to distribute the assets via a dividend in kind. The shareholders would be subject to tax on such a dividend and the tax costs would have to be weighed against the benefit of receiving the capital gains exemption in respect of the disposition of the shares of the now qualifying small business corporation. Simple purification measures may also include the following: the sale of non-qualifying assets and the purchase of qualifying assets; the borrowing of funds to purchase qualifying assets to increase the ratio of qualifying versus non-qualifying assets; the use of non-qualifying assets to pay off liabilities of the corporation; and returns of capital or payments of capital dividends to reduce cash reserves. In sum, the capital gain exemptions may provide considerable tax benefit for an ownermanager who is planning to sell his or her business and may be a key incentive in

5 structuring the sale as a share sale. However, as summarized above the Act contains numerous technical requirements and deeming rules which must be considered in assessing whether a shareholder is entitled to the capital gain exemption. It is advisable that you seek tax and legal advice if you intend to sell your business in order to structure the sale in the most effective way from a business and tax perspective. Perley- Robertson would be pleased to assist you in this respect. Jonathan Charron is a Lawyer in our Tax Law Group. Jonathan can be reached at or jcharron@perlaw.ca. To view his bio, please click here.