Individual Tax Series: Lifetime Capital Gains Exemption (LCGE), Part 1: What is the LCGE, Important Terms, and Qualified Small Business Corporations
- Rylan Kaliel
- Jun 20
- 11 min read
The Lifetime Capital Gains Exemption (LCGE) is one of Canada's most valuable tax planning tools, especially for small business owners and individuals owning qualified properties. It allows eligible individuals to significantly reduce or even eliminate taxes on capital gains from the disposition of certain qualified assets. Understanding eligibility requirements, how to calculate and apply the LCGE, and strategic considerations are crucial for optimizing your tax savings.
It is important to note, the LCGE can be an extremely complex and are very often reviewed in detail by the CRA. As such, this blog post will provide a general guide of the rules surrounding the LCGE. It is highly recommended that if you intend to claim this deduction you involve tax professionals to assist.
As this is a significantly longer topic, with a ton of information to understand, this post is broken up into two parts. The first, this post, will be related to what is the LCGE, relevant definitions, and what is a qualified small business corporation. The second will be on what is qualified farm or fishing property, purification strategies, how to calculate this deduction, and other important information.
What is the Lifetime Capital Gains Exemption (LCGE)?
The LCGE is a tax exemption provided to Canadian residents, designed to encourage investment in small businesses, farms, and fishing properties. It provides a deduction on capital gains realized when selling qualified property, significantly reducing tax liabilities associated with the sale of shares and certain assets.
The LCGE is treated as a deduction, however, this is the first deduction we will discuss that is deducted against taxable income, not net income for tax purposes. Please review our Basics of Individual Taxation blog for details.
Types of Qualified Properties
The LCGE can be claimed for capital gains resulting from selling:
Qualified Small Business Corporation (QSBC) shares
Qualified Farm of Fishing Property (QFFP)
Each type of property has specific eligibility criteria to qualify for the exemption.
Qualified Small Business Corporation (QSBC) Shares
QSBC are generally the deduction most people are looking at when they think of the LCGE. In short, where you have a private corporation that meets the definition of QSBC at the time of sale, you could be entitled to huge tax savings via a deduction against taxable income, potentially eliminating the tax completely on the sale of these shares. As this could be the shares of many businesses, from small to large, it is important that you understand how to meet this definition at the time of sale.
There are essentially three requirements to be considered a QSBC, which are generally as follows:
Small business corporation requirement: More than 90% of the fair market value (FMV) of the assets are used principally in an active business carried on in Canada at the time of sale.
Holding period requirement: For at least 24-months leading up to the sale, the sold shares were held by a person, or by a person related to the person.
Asset use requirement: Throughout the 24-months leading up to the sale, more than 50% of the FMV of the assets were used principally in an active business carried on in Canada.
Each of these three requirements will be discussed in more detail below. Before we get into these, however, we will discuss a few key terms you need to understand in relation to these requirements.
Active Business Carried on in Canada
In the Small Business Corporation Requirement and the Asset Use Requirement, the term “active business carried on in Canada” is used. This term can seem straightforward, however, misunderstanding this term and being offside at the time of the sale can be extremely costly.
Let’s break this down first, starting with “active business”. Active business is generally defined, noting that it “means any business carried on by the taxpayer…”. This definition also excludes certain businesses, such as certain investment businesses and personal services businesses, which are businesses that effectively provide the services someone would as an employee, but through a corporation.
Generally speaking, this definition requires that you carry on a business. Carrying on a business would typically entail an active effort towards the business, such as managing staff, taking orders, producing products, etc. What is typically not seen as active is certain assets that do not require any active work to maintain, such as vacant land with no plan to rent or develop, investment portfolios, and similar types of assets.
Once you confirm that you have an active business, you will also need to have this active business carried on in Canada. This means that if you have an active business, but it only employs and operates out of a foreign country, say the US, this may be an active business but not one carried on in Canada and thus may not qualify. You will be looking to ensure that the active business is one carried on in Canada, both the actual operations and assets, such as land, building, inventory, etc.
When it comes to applying this definition to the below requirements, you will be looking to determine the assets that are related to an active business carried on in Canada. Essentially, you will want to determine those assets that are related to an active business carried on in Canada, those that are inactive, and those that are not related to an activity carried on in Canada. You would effectively take the assets that are related to an active business carried on in Canada and divide these by the total assets of the corporation.
Let’s look at this as an example to better illustrate how this type of analysis is performed.
As we can see from the above, we take the assets from the financial statements and classify them into different buckets. Main ones to note are the short-term investments, which we have assumed do not require any active work to maintain and are thus classified as inactive, and the foreign land used in business, which, despite it being used in the business it may still not be considered to be used in Canada.
It is important to note that the above are very high-level assumptions. There can be cases where short-term investments are seen as active, such as it is a requirement of the business to retain cash, as the business is seasonal (think Spirit Halloween). Further, the foreign land could technically be used in an active business in Canada, such as a warehouse that will be built for storing inventory sold abroad.
Further, the concept of Goodwill is not always inherently understood, nor is it always shown on the financial statements. Goodwill would refer to the value created by a business through their reputation, logo, or other assets that are not purchased but rather created. Goodwill is typically calculated by taking the FMV of the business less the net FMV of the assets (net FMV of the assets, for these purposes, is typically FMV of assets minus FMV of liabilities). It is essentially the value created by the business above the value of the assets held.
Let’s assume that a business has a FMV of $1,000,000, the FMV of their assets is $1,200,000 and liabilities is $265,000, for a net FMV of the assets of $935,000. The Goodwill would thus be worth $65,000 ($1,000,000 - $935,000).
Please review our Financial Statement Series blog posts to learn more about financial statements.
Note that these assets can also include shares or debt of another corporation, provided that the corporation and the corporation they hold shares in also meets the Small Business Corporation Requirement and/or the Asset Use Requirement. If the corporation (the parent) holds shares of another corporation (the subsidiary) there is a requirement that either the parent, or the subsidiary, have at least 90% of the assets used principally in an active business carried on in Canada, whereas the other would only be required to hit the 50%. This is what would be referred to as the 50/90 requirement, in that either the parent or subsidiary can meet the 50% requirement but the other must meet the 90% requirement.
As an example, if the subsidiary hit the 50% requirement, then the subsidiary would meet the requirement as an active asset for the parent, but only if with the inclusion of this asset the parent would meet the 90% requirement.
An additional requirement is that the corporations be connected, which means that the subsidiary must either be controlled by the parent or the parent must hold more than 10% of the voting shares of that subsidiary and the shares held by the parent in the subsidiary represented more than 10% of the FMV of the that corporation.
As was previously noted, the LCGE in its entirety is extremely complex and this is just one aspect of this deduction. As such, it is highly recommended that a tax professional be involved in preparing the necessary analysis for this deduction.
Canadian-Controlled Private Corporation (CCPC)
A Canadian-controlled private corporation (CCPC) is a Canadian corporation that is a private corporation and is not public corporation, nor is it controlled by non-resident persons or by a public corporation. Few terms here to understand:
Canadian corporation: This is a corporation that is resident in Canada and was incorporated in Canada.
Private corporation: This is a corporation that is resident in Canada and is not controlled by one or more public corporations.
Public corporation: This is a corporation that is resident in Canada that has their shares listed on a designated stock exchange or elected to be treated as a public corporation.
Non-resident persons: These are any person, whether an actual person, corporation, trust, etc. that is not resident in Canada.
Essentially, a CCPC is a corporation that is incorporated and resident in Canada and is controlled by Canadian residents who are not public corporations. This includes a vast majority of Canadian based businesses, especially those in the small-to-medium sector.
Related Persons
Related persons are persons who are related by blood relationship, marriage, common-law partnership, or adoption. Blood relationship would include siblings, including half-brothers, and half-sisters, parents, and typically grandparents, but does not include nieces and nephews with their aunts or uncles.
Persons can also be related to corporations and trusts, generally depending on whether they control, or are related to a person who controls, them. A full discussion of related status and control of corporations and trusts is outside of the scope of this blog and may be discussed in a future blog post.
Small Business Corporation Requirement
This requirement requires that more than 90% of the FMV of the assets are used principally in an active business carried on in Canada at the time of sale. As was discussed in Active Business Carried on in Canada, this generally requires that you calculated the percentage of active assets over the total assets to determine this percentage. Note, that the 50/90 rule discussed in Active Business Carried on in Canada would require that the sold corporation, the parent, still hit the 90% requirement on the sale.
It is extremely important to note that this is a point in time test. This means that at the time of the sale you must meet this requirement. This can be challenging to do, as you may not always know the specific day or time that the sale will occur and could have limited time to clean up the corporation to meet this requirement. Given this, it is advised that you aim for a higher percentage than 90% to ensure you have extra room in case regular business operations, such as excess cash, push you offside. Some of these strategies will be discussed in part 2 of our blog post under Purification Strategies.
Holding Period Requirement
This requirement requires that for at least 24-months, or 2-years, leading up to the sale the shares were held by either the person disposing of the shares or a person related to them. This requirement would generally mean that if the person would either be required to hold the shares for the full 24-months or have acquired them from a related person and between these persons they held the shares for the full 24-months.
Let’s assume a situation where Mr. A and Mrs. A are married and thus considered to be related (see Related Persons). In scenario 1, Mr. A acquires shares on January 1, 2024 and then sells these to Mrs. A on January 1, 2025. In scenario 2, Mr. A acquires shares on July 1, 2024 and then sells these to Mrs. A on January 1, 2025. In both scenarios, Mrs. A sells the shares to an unrelated third party on December 31, 2025.
In scenario 1, we note that for a full 24-months, either Mr. A or Mrs. A held the shares, which would generally satisfy the holding period requirement. In scenario 2, we note that the shares are only held by related parties for 18-months, July 1, 2024 to December 31, 2025 and thus they would generally not satisfy the holding period requirement.
As such, it is extremely important for family businesses to understand this holding period requirement and monitor who holds the shares and if they are related. This can seem straightforward, however, there are situations where this may not be the case.
Consider a situation where a family trust begins to own shares, which would typically be related to the family members. The issue is that around the time in which the family trust is considered to be related to these persons doesn’t normally start until the trust is settled or comes into existence. This could cause issues as the trust may not be related until it is settled, regardless of previous ownership being between related persons. This illustrates that more complex structures should be monitored closely with regards to this requirement.
Asset Use Requirement
The asset use requirement is very similar to the requirement discussed in Small Business Corporation Requirement, with the key difference is that the required percentage is that 50% of assets are used principally in an active business carried on in Canada and that this must be maintained throughout the 24-months leading up to the sale. How the asset percentage is calculated would be very similar to as was discussed previously.
The key concern with this requirement is understanding that this 50% is throughout the 24-month period, meaning it is not calculated at the end of the year, but at every second throughout this period. This can catch a lot of corporations, if they get an influx of inactive assets even for a day or a moment in a day that pushes them below this 50%, they are still technically offside. As such, for the 24-months prior to a sale close monitoring is required to ensure the corporation stays onside of this requirement. Some strategies to manage this are discussed in Purification Strategies in our part 2 of this blog post.
Let’s take a quick look at how this requirement is often reviewed.
In the above, we look at year 1 first to see if the active percentage is well above the 50% requirement, so it appears safe that this requirement is met for the first year. In the second year the active percentage drops to 66%, which shows that this is decreasing year-over-year. Given year 2 is a bit riskier, we may want to dig a bit deeper into the changes in the assets over the year to verify there is no risk that we dipped below 50% at any time.
Ultimately, we do need to be comfortable that at no point were we below the 50% requirement, but the above will give us a pretty good look at where the corporation stood across the past few years.
QSBC Status and Claiming the LCGE
If all of the requirements above are met, the shares are typically considered to be QSBC shares and would thus be eligible on a sale for a person to claim the LCGE. As was noted above, this requires extremely careful planning and some structuring to avoid major issues down the road. It is thus highly recommended that a tax professional be involved in this determination.
The calculation of the LCGE on these shares will be discussed in Calculating and Claiming the LCGE but also see Purification Strategies, both included in part 2 of our blog post. See part 2 of this blog post for more information.
Summary
The Lifetime Capital Gains Exemption represents a valuable opportunity for Canadian taxpayers, especially entrepreneurs and property owners, to significantly reduce capital gains taxes. Understanding what a QSBC is and how you can fit into this definition is extremely important and can save you a lot of taxes, as we will see in part 2 of this blog post. This deduction can be tricky, so it is highly advised that a tax professional, such as KLV Accounting, assist with this deduction.
Stay tuned for our next blog post, where we'll continue our discussion of the Lifetime Capital Gains Exemption as it relates to qualified farm or fishing property, purification strategies, how to calculate this deduction, and other important information.
KLV Accounting, a Calgary-based accounting firm, is here to help. Contact us today to enhance your financial strategy, minimize your taxes, and drive business success! For a free consultation, call us at 403-679-3772 or email us at info@klvaccounting.ca.
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