1. Tax Lesson 16 YOURLOGO Start Lecture
Note: This screen has no script. Static page.
YOURLOGO
Start Lecture

2. Replacement Property Rules
If a taxpayer has recapture and/or a capital gain on the disposition of capital property used to earn income, and uses the P of D to purchase a replacement property (within a certain time limit), then the taxpayer can elect to defer any recapture and/or capital gain on the disposition
If the disposition is voluntary (meaning it is a decision made by management such as a sale) then the deferral is only available for land and building used in a business and the new property must be purchased within 1 year after the end of the taxation year in which the disposition occurred
If the disposition is involuntary (such as a theft, natural disaster or expropriation) then the deferral is available for all capital assets (other than shares) and the new property must be purchased within 2 years after the end of the taxation year in which the disposition occurred
If the taxpayer buys a replacement property that costs the same or more than the P of D received then all of the capital gain and recapture can be deferred. Any deferred capital gain reduces the ACB of the new asset (and any deferred recapture further reduces the UCC). (If the taxpayer only uses some of the P of D to buy the replacement property then only some of the capital gain/recapture can be deferred)

3. Replacement Property Rules (cont)
Taxpayers who qualify for these replacement property rules should use them to defer tax. The logic behind these rules is you’ve taken all the cash you got from disposing of your old asset and used that money to buy a new (replacement) asset, so you have no cash left to pay tax. These rules allow you to defer paying income tax until you dispose of the new (replacement) property. (Note: you can use these same rules again when you eventually dispose of the new property as long as you meet all the conditions)

4. Capital Gains Deferral
If the taxpayer has a capital gain on the disposition of eligible small business corporation shares then the taxpayer can elect to defer the gain if the taxpayer qualifies
Eligible small business corporation shares are common shares that meet various conditions including: the shares are, generally speaking, shares of a small business corporation (discussed below), the shares were issued from treasury (i.e., they were not purchased from another shareholder) and the corporation has total assets with a carrying value that does not exceed $50 million (based on Canadian GAAP)
To qualify the taxpayer must invest the P of D in replacement eligible small business corporation shares. To defer all of the capital gain, all of the proceeds must be spent on the new shares.
Deferral = (Amount spent on new shares / P of D) x Capital gain
If the amount spent on new shares exceeds the proceeds of disposition from selling the old shares, then this amount (i.e., the amount in brackets) is deemed to be 1. Any deferred capital gain reduces the ACB of the new shares

5. Capital Gains Exemption
Each individual is eligible for a lifetime total $824,176 capital gains ($412,088 taxable capital gains) exemption in This exemption is indexed to inflation hence it increases slightly each year. The capital gains exemption is only available on dispositions of qualified small business corporation (QSBC) shares (or qualifying farm or fishing properties, not discussed in these notes)
A QSBC must meet all of the following three tests:
Small business corporation (SBC) test- At the time of sale the corporation is a SBC. A SBC is a CCPC with 90% or more of the FMV of its assets: (a) used in an active business (primarily in Canada); and/or (b) invested in shares or debt of a connected SBC
Two companies are connected if: (a) one company controls the other; or (b) if one company owns more than 10% of the shares of the other company (representing both voting rights and fair market value)
Note: if you have a CCPC that does not meet this test then prior to selling your shares you should purify the company (i.e., sell non-qualifying investment assets and do something with the cash, like buy more active business assets, or pay down debt, or pay a dividend) so that you meet this test

6. Capital Gains Exemption (cont)
Holding period test- Throughout the past 24 months no one other than the shareholder or a person related to the shareholder has owned the shares
Basic asset test- Throughout the entire 24 month holding period the corporation is a CCPC with more than 50% of the FMV of its assets used in an active business (primarily in Canada). Note: this test does not include shares or debt invested in a connected company
However, if this test is not met the shareholder can use the modified basic asset test. The modified basic asset test is the same as the basic asset test except it allows shares or debt invested in a connected CCPC to be included. (To use the modified basic asset test one company must meet a 90% test and the other must meet a more than 50% test (either company can meet the 90% test, and this complicated 90%/50% test is shown in the example problem)
A capital loss on the sale of shares or debt of a SBC is given special treatment. Such a loss is called a business investment loss (BIL) and is ½ allowable (ABIL). The ABIL can be deducted against any source of income (like a non-capital loss). An ABIL is restricted if the taxpayer claimed the capital gains exemption in the past. And an ABIL will reduce the amount of capital gains exemption that a taxpayer can claim in the future

7. Example Problem Capital Gains Exemption
It is now November 30, 2016 and your client, Michael (a resident of Canada) has come to you for advice. M Co. was incorporated in Ontario in 2000 and has a September 30th year-end. Michael purchased all the shares of M Co. from an unrelated person on January 1, 2009 for $100,000. M Co. operates an active business in Ontario. Michael plans on selling his shares of M Co. and wants to know if his shares are qualified small business corporation (QSBC) shares. If the shares are not QSBC shares what should Michael do?
You learn the following information:
M Co.’s most recent balance sheet dated September 30, 2016 shows the following:
Tax cost Fair market value
Accounts receivable $20, $15,000
Inventory $170, $190,000
Depreciable assets (original cost $200,000) $185, $160,000
Long-term investments in public co. shares $240, $350,000

8. Example Problem Capital Gains Exemption (cont)
Investment in subsidiary $11,000 $400,000
Accounts payable ($15,000) ($15,000)
Michael estimates that the FMV of M Co.’s internally generated goodwill is $145,000
M Co.’s (and the subsidiary’s) asset values have remained stable over the past 2 years
M Co.’s Investment in subsidiary consists of the following investment in a CCPC:
Book value Fair market value
notes receivable $10, $10,000
common shares $1, $390,000
The subsidiary corporation uses 91% of its assets exclusively in an active business carried on in Canada. M Co. owns 100% of the shares of the subsidiary