Purifying Your Company Before Selling Shares: Ontario Owners' Guide

If your company has built up cash, investments or other assets that are not used in the business, you may find that its shares no longer qualify for the lifetime capital gains exemption. That can be a surprise when a buyer finally appears.

Purification is the planning work of bringing a company back within the asset tests. This article explains the tests, why timing matters, and what else can limit the exemption, so you can ask better questions before you sign anything.

What the exemption does

An individual who sells qualified small business corporation shares (QSBCS) may claim the capital gains deduction, often called the lifetime capital gains exemption, on line 25400 of the return. For 2025 and for dispositions after June 24, 2024, the limit is $1,250,000 of capital gains, a maximum deduction of $625,000.

The deduction is built on a $625,000 formula in the Income Tax Act, and any deduction claimed in earlier years reduces what is left. That $625,000 amount is indexed to inflation for taxation years that begin after 2025, so check the current figure before you plan around it.

The three tests your shares must pass

Shares qualify only if they meet each of the following tests. Purification is aimed mainly at the asset tests.

Why excess cash and investments cause trouble

The 90% test applies only at the time of sale, while the more-than-50% test must be met throughout the 24 months before the sale. A company holding too much cash or investments that are not used in the active business must bring its non-active assets below those thresholds, at the right times, for the shares to qualify.

In practice this means the two tests work on different clocks. Fixing the balance sheet just before closing may help with the 90% test, but it does not repair a period when the company failed the 50% test during the prior 24 months.

What purification involves, and why advice matters

Purification generally means reducing or reorganizing the assets that are not used in the active business so that the company meets the tests when it needs to. The right method depends on the company, its shareholders and its history, and there is no single standard approach.

Some steps, such as moving funds between corporations or paying dividends, can trigger other tax rules, including anti-avoidance rules. A tax lawyer or accountant should review the plan before any money moves.

Dividends also matter in another way. The deduction can be denied where a significant part of the gain can reasonably be attributed to dividends not being paid on a share, or being paid at less than 90% of the average annual rate of return.

Other things that can reduce or deny the exemption

• Earlier claims: deductions used in prior years reduce what remains.
• Cumulative net investment loss (CNIL): the amount by which your investment expenses since 1987 exceed your investment income since 1987 reduces the deduction available.
• Allowable business investment losses (ABILs): an ABIL claimed for 2025 reduces the deduction for 2025 and future years.
• Deferred gains: gains held back under a reserve or deferral do not qualify.
• Residency: only an individual resident in Canada throughout the year can claim it, though a person resident at any time in the year is deemed resident throughout if also resident throughout the year before or the year after.
• Newly issued shares: shares issued after June 13, 1988 are deemed owned by an unrelated person before issue, so the 24-month clock starts at issue, except for shares issued in exchange for other shares, for all or substantially all the assets of an active business, or as a stock dividend.
• Alternative minimum tax: a large gain sheltered by the exemption can trigger AMT, which is calculated on Form T691.

If an owner dies, a share that would have qualified except for the 90% asset requirement is still treated as qualifying if it qualified at any time in the 12 months before death.

What to do next

• Ask your accountant for a current breakdown of active and non-active assets at fair market value.
• Look back 24 months to see whether the more-than-50% test was met throughout.
• Gather your past returns to confirm earlier deductions, CNIL and any ABILs.
• Complete Form T657, and Form T936 if you had investment income or expenses in any year from 1988 to 2025.
• Speak to a lawyer and accountant before signing a letter of intent, since the timing of steps matters.

Frequently asked questions