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Lifetime Capital Gains Exemption & QSBC

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Overview
The Lifetime Capital Gains Exemption (LCGE) is a once-in-a-lifetime tax deduction that is available for every Canadian resident individual on up to $913,630 CAD (2022, and indexed to inflation on an annual basis) of capital gains realized on the sale of Qualified Small Business Corporation (QSBC) shares and certain other capital properties. In order to claim the LCGE, the capital gain must be realized by an individual, trust, or partnership (with the gain allocated to an individual) with an available LCGE balance.

Qualifying Criteria
There are three tests that must be met to ensure the shares meet the definition of QSBC shares and therefore qualify for the LCGE:

lifetime-capital-gains-exemption-QSBC

Summary and Takeaways

The Lifetime Capital Gains Exemption (LCGE) is a once-in-a-lifetime tax deduction available to Canadian residents that can be taken on gains from the sale of Qualified Small Business Corporation (QSBC) shares. But in order to take the deduction it’s necessary to meet certain eligibility requirements.

Key Takeaways

  • Shares must meet the definition of QSBC shares in order to qualify for the one-time exemption.
  • The deduction can be applied to up to $913,630 CAD of capital gains realized on the sale of QSBC shares, but if you use only a portion the rest may be applied at a future date.
  • There are also strategies one may use to maximize the use of the LCGE or even multiply it through a family trust.
  • Developing a tax efficient strategy to leverage the Lifetime Capital Gains Exemption is critical.
  • U.S. citizens residing in Canada may also utilize the deduction, but this can result in a U.S. tax with no offsetting Canadian foreign tax credit.
  • Because the rules regarding taking advantage of the LCGE are nuanced and complex, expert guidance from a qualified tax planning professional is strongly recommended.

1. Small Business Corporation Test
At the time of sale, the shares must be shares of a Small Business Corporation (“SBC”). Generally, an SBC is defined as a Canadian-Controlled Private Corporation (“CCPC”) where all or substantially all (at least 90%) of the fair market value of the corporation’s assets is attributable to assets that are:

  1. Used principally (more than 50%) in an active business carried on primarily (more than 50%) in Canada;
  2. Capital stock or indebtedness of one or more SBCs that are connected to the corporation; or
  3. A combination of (a) & (b).

Note that:

  • Active business assets exclude the following: excess cash, investments, investments in real estate, and other assets not essential to the operation of the business.
  • A corporation is connected to a particular corporation if it controls the particular corporation or owns more than 10% of the issued capital of the particular corporation in terms of both the fair market value and voting rights.
  • A CCPC is a private corporation resident in Canada that is not controlled directly or indirectly by non-residents or public corporations.
  • It is common planning to “purify” a company in order for it to qualify as an SBC at the determination time. As an example, excess cash can be paid out to the shareholders of the corporation or used to pay down outstanding debts. Alternatively, investments with accrued gains can be donated without triggering taxes payable and even providing a corporate tax deduction. Non-qualifying assets of the corporation can even be moved to another corporation.

2. Holding Period Test
The shares must not have been owned by anyone other than the individual or a person related to the individual throughout the 24 months preceding the disposition. Usually, newly issued shares must be held for at least 24 months in order for the shares to be QSBC shares. However, there are exceptions to this rule in a number of circumstances, including where the shares are issued as payment for other shares, as payment of a stock dividend, or in connection with an incorporation of the business.

3. Fair Market Value Asset Test
Throughout the 24 months immediately preceding the sale of the shares, the shares were those of a CCPC where more than 50% of the fair market value of its assets was attributable to assets used principally (more than 50%) in an active business carried on primarily (more than 50%) in Canada by the corporation or a corporation related to it.

Using the LCGE
As mentioned above, the LCGE is a once-in-a-lifetime tax deduction that is available for every Canadian resident individual on up to $913,630 CAD (2022, and indexed to inflation on an annual basis) of capital gains realized on the sale of QSBC shares and certain other capital properties. If only a portion of the exemption is used, the remainder is available for future use. Furthermore, as the exemption is indexed to inflation, every year the available LCGE grows larger. In other words, a “new” amount of LCGE will accrue even if an individual has previously used their total available exemption.

It is important to note that the $913,630 CAD (2022) is on a gross basis. The amount of total “taxable capital gains” that may be sheltered is $456,815 CAD, since only 50% of capital gains are taxable in Canada. Other balances that need to be analyzed when deciding to leverage the LCGE, as they could potentially decrease the amount of LCGE available, include your:

  • Cumulative Net Investment Loss (“CNIL”); and
  • Allowable Business Investment Losses (“ABIL”).

Planning Opportunities
Common planning opportunities surrounding the Lifetime Capital Gains Exemption include:

  1. Estate Freeze – Crystallization Using the LCGEAn individual can use the LCGE not only on a disposition of their shares, but also in succession planning when passing on their shares. The LCGE is not currently scheduled to disappear, but crystallization of the LCGE is a viable option should it be repealed in the future. By crystallizing the LCGE, an individual triggers a capital gain at a time when the shares qualify for the exemption without actually disposing of the shares. The crystallization transaction can occur during the shareholder’s lifetime or upon their passing, increasing the cost basis of the shares transferred to the deceased individual’s beneficiaries.
  2. Multiplying the Lifetime Capital Gains Exemption
    It is possible, through the use of a family trust, for each beneficiary to use their available LCGE to reduce or eliminate tax payable on a sale of QSBC shares. This multiplication can also be used in conjunction with the crystallization planning above. As an example, if there is a family trust with mom, dad, and their three children as capital beneficiaries, it is possible to utilize the Lifetime Capital Gains Exemption and pay no Canadian tax on up to $4,568,150 CAD of capital gains on the shares disposed of or crystallized during 2022.

Implications for U.S. Citizens
If you are a U.S. citizen resident in Canada, you are still entitled to utilize the LCGE on your Canadian tax return. However, the U.S. will not realize the LCGE, so you will not receive a corresponding tax deduction on your U.S. tax return. This can lead to U.S. tax payable with no offsetting foreign tax credit from Canada, which is why it is important to allow adequate planning time and model out the use of the Lifetime Capital Gains Exemption.

Developing a tax efficient strategy to leverage the Lifetime Capital Gains Exemption is critical. Whether you are a Canadian tax resident or a dual tax resident of Canada and the U.S., it is important to garner professional advice. Contact Cardinal Point for more information.

Terry Ritchie featured in the Globe and Mail: Foreign Exchange

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Terry Ritchie gives his insights and tips when dealing with foreign exchange options.

From the Globe and Mail article:

“I’m not a big fan of the banks,” said Terry Ritchie, a financial adviser who works both sides of the Canada-U.S. border. “They’re great for convenience. But if you can take the time and wait a day or two, there are better bets.”

Read the article here

How a U.S. resident can receive tax-free alimony from a Canadian

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While most people know that alimony is normally taxable income to the recipient and tax deductible by the payer, in the case of cross-border taxes, alimony can be received tax free while the payer still gets a tax deduction.

Let’s look at an example where this would apply.

Sarah is a U.S. Citizen who has been transferred to Toronto for a job opportunity. While living in Canada, she meets and falls in love with John, a Canadian citizen. After a few years of dating, Sarah and John decide to get married and live together in Toronto. Five years into their marriage, due to irreconcilable differences, they decide to divorce. Sarah chooses to return to the U.S. to live close to her family. As part of the divorce settlement, John must pay Sarah alimony.

Since John is a Canadian tax resident, he will be able to deduct the alimony payments to Sarah on his Canadian tax return. But with the right cross border tax planning, Sarah can exclude her alimony from U.S. tax. How? By including specific language required by the IRS in the divorce agreement. In our couple’s case, they would include language along the lines that John agrees not to deduct the alimony payments for U.S. tax purposes. Since John is a Canadian tax resident only, he is still able to deduct the alimony on his Canadian taxes and is not affected by the agreement.

While this is a very simplified example – the rules to make this legitimate are more complex – the fact remains that in Sarah’s case, a U.S. resident can receive alimony tax free for U.S. tax purposes. In John’s case, he also gets to reap the tax benefits from this strategy, unless he decides to take up a job in the U.S. and become a U.S. tax resident.

Canadian Expat – Principal Residence

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Question:

I am looking to move to the U.S. and am not sure if I will sell my home before I leave Canada. Could you please outline the tax ramifications if I were to sell it before departing Canada versus selling while a tax resident of the U.S.?

Answer:

You have requested that we provide you with some comments related to the tax implications of the upcoming disposition of your Canadian residence.  This analysis has been completed based on the following assumptions:

  • The property is a residence located in Canada
  • The property was purchased while you were a tax resident of Canada
  • You have been a tax resident of Canada during the entire period of ownership of the residence
  • The property has always been a personal use property and has never been used as an income producing property
  • There is no other property for which the principal residence exemption has been used during the period of ownership
  • You will become a non-resident of Canada at some time during 2018, and the sale of the residence may potentially take place while you are a non-resident of Canada.

Canada

Property Sold as a Resident of Canada
If the property is sold while you are still a tax resident of Canada, you will report the disposition and will claim the principal residence exemption in the exact same manner as if you were a Canadian tax resident for the entire year. In other words, you will disclose the disposition on Schedule 3 of your 2018 Canadian income tax return, and will also complete Form T2091, Designation of a Property as a Principal Residence by an Individual.  The property will qualify for the full exemption, and no special reporting is required.

Property Sold as a Non-resident of Canada
Capital Gains Exemption
If the property is sold while you are a non-resident of Canada, some additional analysis is required. Based on the assumptions above, the property is eligible for the principal residence exemption for any year that you own it as a Canadian resident, even if you are a Canadian resident for a portion of the year. In other words, if you were to become a non-resident of Canada in 2018, you are still able to claim the exemption for the entire 2018 tax year. In addition, the principal residence exemption formula contains a “plus one” in the numerator (only applicable if the property was purchased while you were a tax resident of Canada). As such, based on our assumptions, it would be possible for you to sell the property in 2019 as a non-resident of Canada and have the ability to exempt the entire gain from Canadian taxation.

Reporting Requirements
If the property is sold as a non-resident of Canada, some additional compliance is required, even if there is no taxable capital gain.

By default, the purchaser of the property is required to remit 25% of the gross proceeds from the sale to CRA, unless a clearance certificate is obtained from CRA. They must do this even if they know that the property was sold at a loss, or if the entire gain is exempt from taxation. In order to avoid this, you must file Form T2062, commonly referred to as a clearance certificate, to request that only the potential taxable gain be subject to the 25% withholding tax. Assuming that there will be no taxable gain based on the principal residence exemption, the clearance certificate would be to request that no Canadian withholding tax be remitted. If the form is properly filed, CRA will send the approved form to the purchaser of the property, and you will be able to receive your entire proceeds without having any Canadian tax withheld. We will not go into detail on the specifics of filing the clearance certificate at this time, but are happy to assist you in the future in the event that it is required.

Assuming that the property is sold in 2018, a Canadian non-resident tax return will need to be filed by April 30, 2019 to report the disposition of the residence, even if there is no tax payable. Schedule 3 and Form T2091 will need to be completed.

USA

Property Sold as a Non-Resident of the U.S.
There will be no U.S. tax implications if the sale of the Canadian property occurs prior to U.S. tax residency.

Property sold as a Resident of the U.S.
Based on the assumptions that we have listed, the property will meet the criteria of having been your principal residence for at least 2 of the last 5 years. The U.S. does not have any requirement that the property be owned as a U.S. resident for 2 of the last five years, just that the property be the principal residence. There are other criteria that need to be met, but it is highly likely that these would be met so they do not require analysis.

For U.S. income tax purposes, there is a limit to the amount of gain that can be excluded. However, there is an article in the Convention between the United States and Canada (the Treaty) that provides for a bump-up in the cost basis of the principal residence when an individual becomes a non-resident of Canada and a resident of the U.S. This makes it highly likely that your capital gain on the disposition of your residence would be minimal for U.S. tax purposes. It is highly likely that the entire capital gain, if one exists at all, will qualify for the principal residence exemption from a U.S. tax perspective.

It is not necessary to report the sale of a principal residence on a U.S. resident income tax return if the property is sold at a loss, or if the entire amount is exempt from taxation.

One often overlooked U.S. income tax rule is that of the currency exchange gain that can result when a U.S. resident pays off a foreign mortgage. If you pay off a Canadian mortgage while you are a U.S. tax resident, depending on exchange rates, it could be possible that you have a foreign currency gain. We would require more information to determine if this is applicable to you. If it was applicable to you, it would be in your best interest to pay off the mortgage prior to U.S. residency, if possible.

 

Is the Stock Market too Concentrated?

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It probably doesn’t come as a surprise that Amazon, Netflix, Microsoft, Apple, Alphabet and Facebook have been some of the best performing stocks in the first half of this year. But what may be surprising is that those six stocks made up 98% of the S&P 500 Index returns for the first half of 2018 according to a recent CNBC article1!

Many headlines over the last year have pointed out just how large these tech giants have grown For the first time since 20002, the tech sector now represents 25% of the S&P 500. When viewed another way, the market capitalization- the amount investors have deemed the companies are worth of the top (largest) five companies is approximately equal to the bottom (smallest) 282 companies in the S&P 500, as illustrated by the amazing pie chart below created by Michael Batnick of Ritholtz Wealth Management3.

 

Weight of top 5 companies in S&P 500 versus bottom 282 companies

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In other words, the bottom 56% of the S&P 500 has the same market capitalization as the top 1%. That’s a lot of companies. Those 282 listed include many household names such as Chipotle, Kohl’s, Clorox and H&R Block, all of which are multi billion-dollar firms on their own. Which begs the question, is it typical for a handful of the largest companies to dominate an index?

It turns out that historically it’s not uncommon for the largest companies to represent an enormous percentage of the index. Today the largest 10 companies represent a little over 20% of the large cap space  That’s right about the average we’ve seen over the last few decades, and significantly lower than it was in the 1960s, according to a recent study by Travis Fairchild at O’Shaughnessy Asset Management4. This study also found that on average, about 6-7 of the top 10 names fall out of the top 10 within the following decade, suggesting that many of the current top ten companies will be replaced in the next ten years.

This phenomenon isn’t limited to just the U.S. According to Benjamin Felix of PWLCapital, through July 13th of this year, 75% of the S&P/TSX return came from just 10 of its 246 stocks, led by Suncor Energy, Toronto-Dominion Bank and Shopify5. This may lead you to ask, is there anything I should be doing as an investor to take advantage of this?

First off you should note that well diversified portfolios likely hold all the names mentioned in this piece; Amazon, Apple, TD, etc. are some of the largest holdings for most North American investors. But investing a portfolio solely in those largest companies has two pitfalls- undue concentration of risk and missed opportunities in other areas of the market.

The first pitfall of investing solely in individual names – even some of those red-hot tech stocks, came home to roost at the end of July. Both Facebook and Twitter reported earnings which fell short of market expectations. On July 26th, the day after their quarterly earnings announcement, Facebook fell by a whopping 19%, erasing $120 Billion USD in value! This amount is greater than the entire value of large companies like GE, Nike or Starbucks. A day later, following Twitter’s earnings announcement, that stock also fell 19%. Twitter had been one of the best performing stocks over the previous year prior to that announcement.

While these companies are included in most major stock market indexes, the performance of any individual company is going to be relatively small in comparison to the entire index- for example the S&P 500 was basically flat on July 26th, even with Facebook falling dramatically. But if you owned them individually- they would likely represent a far greater percentage of your overall assets.

Another major downside of only holding those largest of companies is missing out on large potential gains elsewhere. Small companies outperformed their large cap counterparts in the U.S. and Canada significantly over the second quarter of this year. And academic research shows that historically small companies have outperformed their large counterparts over decades6. Yet for the average investor, it’s difficult to not want to go all in on the large gains you’ve recently seen on familiar companies you likely interact with every day.

If outperforming were as easy as picking the recent winners and calling it a day, active fund managers would have a far better track record than they currently do. But as we’ll explore in a future blog, the record of both U.S. and Canadian active stock managers is poor, supporting the idea that it’s extremely difficult to outsmart the market and predict in advance who the winners of tomorrow will be.

Like the Apples or TDs of today, or the IBMs or Blackberrys of the past, a few large high-flying companies will often garner the headlines. Yet the key to reaching your financial goals is not the fool’s errand of trying to guess what the wonder company of tomorrow will be, but in keeping a well-diversified portfolio that will own all the companies that may provide that growth.

By Matthew Carvalho, Chief Investment Officer

1Just three stocks are responsible for most of the market’s gain this year, CNBC, Jul 10, 2018
https://www.cnbc.com/2018/07/10/amazon-netflix-and-microsoft-hold-most-of-the-markets-gain-in-2018.html

2S&P 500 Hits Tech-Heavy Milestone Last Seen With Dot-Com Bubble, Bloomberg, Feb 28, 2018
https://www.bloomberg.com/news/articles/2018-02-28/s-p-500-hits-tech-heavy-milestone-last-seen-amid-dot-com-bubble

3@michaelbatnick tweet, July 18, 2018
https://twitter.com/michaelbatnick/status/1019680856837849090/photo/1

4@tbfairchild tweet, Jun 6, 2018
https://twitter.com/tbfairchild/status/1004375185179529217

5@benjaminwfelix tweet, July 13, 2018
https://twitter.com/benjaminwfelix/status/1017869943226937345/photo/1

6 Common risk factors in the returns on stocks and bond, Journal of Financial Economics 1993, Fama and French