Purifying Your Company of Passive Assets Before a Share Sale

Many owners have built up cash or investments inside their company over the years. That is sensible for the business, but it can cause trouble when you sell. If too much of the company's value is passive, the shares may not qualify for the lifetime capital gains exemption.

Purification is the general term for cleaning up the company's balance sheet so that it is mostly active business assets. This article explains why it matters, what the relevant tests look at, and the questions to ask. It does not set out step-by-step purification mechanics, because those are technical and depend on your structure.

Why passive assets can threaten the exemption

To use the exemption, your shares must be qualified small business corporation shares. One condition is that, throughout the 24 months before the sale, more than 50% of the fair market value of the corporation's assets is attributable to assets used principally in an active business carried on primarily in Canada, or to certain shares or debt of connected corporations.

Surplus cash, portfolio investments and other assets not used in the business work against that test. A separate, stricter asset test also applies at the time of sale. The exact threshold should be confirmed with a tax professional against the current definition in section 110.6(1).

The stakes are significant. The limit is $1,250,000 for dispositions after June 24, 2024, and $1,275,000 for dispositions in 2026. Only qualifying shares can use it.

Timing: why last-minute purification may not help

The 50% test applies throughout the 24-month period, not just on closing day. A balance sheet that is clean on the sale date but was heavily passive for most of the prior two years may still fail that test.

The holding-period test also looks back 24 months and asks that the shares not be owned by anyone other than you or a related person or partnership. Some reorganizations issue new shares, and shares issued after June 13, 1988 are deemed to have been owned immediately before issue by an unrelated person, which can break the holding period, subject to exceptions.

For this reason, purification is best treated as a multi-year habit rather than a closing-week task. If a sale is possible within the next few years, start the review now.

Common approaches and their trade-offs

There are several general ways owners deal with surplus assets. Which one fits depends on your structure, your tax position and the buyer, so the table is a map of questions rather than a set of steps.

On the last row, section 84.1 applies when a Canadian-resident individual sells shares that are capital property to a corporation with which the individual does not deal at arm's length. A dividend is deemed paid to the seller, and paid-up capital is reduced. This can apply even when a seller wants to use their exemption, so sales to your own holding company need careful review.

Other points to keep in view

• If the exemption applies, a taxable capital gain is generally one-half of the gain. The proposed higher inclusion rate was cancelled.
• Alternative minimum tax can still be a factor in a sale year, since capital gains are included at 100% for AMT purposes.
• Reductions for allowable business investment losses and cumulative net investment loss can shrink the exemption even if the shares qualify.
• Passive investment income held in the company can also affect other parts of your tax picture, so ask your accountant for the full effect.

Purification can solve one problem and cause another. A step that helps the asset tests may add a tax cost elsewhere, so the plan should be modelled as a whole.

What to do next

• Ask your accountant for a schedule of company assets at fair market value, split between active and passive, at several dates over the last 24 months.
• Identify surplus cash and investments, and decide what the company actually needs for operations.
• Review who has held the shares and whether any new shares were recently issued.
• Ask your lawyer and accountant to confirm the sale-date asset test and to model the tax cost of each option.
• Do not move assets or shares to another company before getting advice on the tax consequences.
• Tell your advisers your target sale date so there is time to plan.

Frequently asked questions