Capital Gains Exemption

Planning Techniques

Introduction

This Tax Topic discusses some of the planning techniques available to maximize the use of the $500,000 capital gains exemption. Only the $500,000 capital gains exemption for qualified small business corporation shares and qualified farm property remains; the $100,000 exemption was eliminated in 1994.

Note: these tax topics are distributed on the understanding that neither Life-Quotes.ca nor Manulife Financial is engaged in rendering legal and accounting advice.

Last updated: March 2012

Inter Vivos (During Life) Planning

(a) Transfers to Minor Children

The income attribution rules generally do not apply to capital gains realized on property transferred to children under 18 years of age. Therefore, capital property can be transferred to a trust for the benefit of minors without the transferor being concerned about future capital gains on that property being included in his or her income. When the property is disposed of by the trust, the capital gains can be allocated to the minor beneficiaries, and their capital gain exemptions can be used to avoid paying tax on this gain. It must be kept in mind, however, that the minor beneficiary's lifetime exemption will be reduced accordingly.

It should be noted that any transfer of property to a trust is a disposition of property (defined in subsection 248(1) of the Income Tax Act "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 and the trust to have acquired the capital property at an adjusted cost base equal to the property's fair market value. 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 Farm to a Child

Subsections 73(3) and (4) of the Act permit certain types of farm property (including an interest in a family farm partnership or shares of a family farm corporation) to be transferred by a farmer to his or her child on a 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 could utilize these rollover provisions in order to transfer farm property with unrealized gains to his or her children. The children could then dispose of the farm 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 2 transfer is effected pursuant to subsection 73(3) of the Act, the transfer was at less than fair market value, 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 would apply to deem the disposition to occur at fair market value so that any accrued gains/losses up to the time of the gift would be realized in the donor's hands. Ideally, the property that is the subject of the gift has a fair market value close to the adjusted cost base (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 gain that does 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 fair market value 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 fair market value 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 fair market value 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 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, he or she would roll the shares of the operating business (“Opco”) to a new corporation (“Holdco”) taking back fixed value (current fair market value of the Opco shares) redeemable preference shares of Holdco. The taxpayer would make an election under section 85 of the Act so that the deemed transfer price is sufficient to create a capital gain in the amount of the available exemption. This deemed transfer price would become 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 "bumpedup" ACB of the preference shares would be taxable as a capital gain.

If, at the same time, his or her 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 values of Opco via Holdco would accrue to their benefit. On a subsequent disposition of their shares, they could claim any exemption available to them, thus multiplying the exemptions available to shelter any capital gains on a sale of the shares. Certain antiavoidance provisions may apply here if a spouse and/or minor children become shareholders and the company ceases, at any time, to be a “small business corporation” (section 74.4).

(f) Hybrid Method of Buy/Sell

The shareholders of closely-held companies often agree that if any of the shareholders die, that deceased's shares will be purchased by the surviving shareholders (promissory note 3 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 buy/sell agreement combines both methods. It 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), and to the extent that the gain on the sale cannot be sheltered by the deceased's exemption, the corporation will redeem the deceased's shares (corporate redemption method).

Planning Considerations Relating to Timing of Use of Exemption

Due to the uncertainty surrounding the length of time the exemption will remain available in its present form, the most basic planning technique is to utilize the full amount of the exemption available whenever possible.

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 (sections 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), alternative minimum tax 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 which result from using the capital gains exemption to step up the cost base of the asset.

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 exemption to offset these gains.

(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 spouse trust. A spouse 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 commonlaw 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 4 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 fair market value on the spouse's death (paragraph 104(4)(a) of the Act). Subsection 110.6(12) 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 of capital property to ensure that they are fully utilizing their exemption without running afoul of the various anti-avoidance provisions contained in the Act.

* Please note:

  • the source material for these topics are various Manulife Financial articles, courtesy of Manulife Financial.
  • Life-Quotes.ca will strive to keep these articles updated and current.
  • these tax topics are distributed on the understanding that neither Life-Quotes.ca nor Manulife Financial is engaged in rendering legal and accounting advice.

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