The Building Inside the Company Almost Cost Them the Exemption

The situation

Arjun had built his construction company from a two-truck operation into a firm with a permanent crew, running commercial and residential build contracts across the Markham area. Eighteen years in, at 58, he decided it was time to sell. His wife Ines held a minority stake in the corporation alongside her own separate work as a commercial landlord, leasing out office and warehouse space she owned personally in a different building entirely. Sanjay, who ran a larger regional contracting firm and had been quietly trying to acquire smaller competitors for two years, made an offer to buy the company outright: roughly $4.5 million for all the shares, structured as a straightforward purchase rather than an asset sale.

Arjun and Ines liked the number and liked Sanjay's plan to keep the crew on, so they signed a non-binding letter of intent setting a target closing roughly eight months out, once financing and due diligence were complete. Before signing anything binding, they brought the deal to our office to have the structure and the tax side reviewed. That timing turned out to matter more than either of them realized going in.

What the review found

When an individual sells shares of a Canadian-controlled private corporation at a gain, the lifetime capital gains exemption can shelter a substantial portion of that gain from tax entirely — but only if the shares meet the definition of qualified small business corporation shares under the Income Tax Act. That definition turns on what the corporation actually owns, not just what it does. At the moment of sale, at least 90% of the fair market value of the corporation's assets must be used in an active business carried on primarily in Canada. Looking back over the 24 months before the sale, at least 50% of asset value must have met that same active-business test throughout. Cash sitting idle, marketable securities, and real estate that isn't actively used in the business all count as passive assets that work against both thresholds, no matter how legitimately the money was earned.

Reviewing the corporation's financial statements, we found two things sitting on the balance sheet that Arjun had never thought to question, because neither one was a problem for running the business — only for selling it. First, the company had accumulated roughly $850,000 in retained cash and short-term investments over the years, well beyond what the operations needed for working capital, parked in GICs and a modest securities portfolio the corporation's accountant had recommended as a place to hold surplus profit. Second, and more significant, the corporation still owned a small commercial unit it had purchased a decade earlier as an overflow storage yard, which the business had since outgrown and moved away from. For the past several years that unit had been leased out to an unrelated tenant, generating rental income that had nothing to do with pouring concrete or framing houses.

Valued together against the rest of the company's assets, the investment portfolio and the rented-out unit came to roughly 24% of the corporation's total fair market value — comfortably above the 10% ceiling the 90% active-business test allows. Left untouched, the shares Arjun and Ines were about to sell would very likely have failed to qualify as qualified small business corporation shares at all, for either of them.

What we did

1. Quantified the passive-asset problem precisely. Working from the corporation's balance sheet and a preliminary valuation prepared for the sale, we calculated the fair market value of the passive investment portfolio and the rented-out commercial unit against the value of the operating assets, confirming the corporation sat well outside both the 90% and 50% thresholds as it stood.
2. Coordinated a purification plan with the couple's accountant. Cleaning up a corporation's asset mix before a share sale, often called purification, is a tax and corporate law exercise done together, not separately. We worked alongside the accountant who prepared the corporation's financial statements to design a plan that would move the passive assets out of the company without triggering an unnecessary tax bill on the way out.
3. Moved the commercial unit out on a tax-deferred basis. The rented-out unit was transferred from the operating corporation into a newly incorporated holding company wholly owned by Arjun and Ines, using a rollover provision in the Income Tax Act that allows property to move between a shareholder-related corporation without immediate tax on the transfer. Ines, already experienced managing leased commercial space in her own right, took over administering the tenancy from the new holding company going forward.
4. Distributed the excess cash and investments as dividends. Rather than transferring the investment portfolio, we recommended the corporation pay Arjun and Ines a series of taxable dividends over several months, drawing down the surplus cash directly to their personal hands. This avoided creating a second passive-asset problem inside the new holding company and let them reinvest the money personally however they chose.
5. Built in enough runway to satisfy the 24-month look-back test. Because the qualification test also looks backward over the two years before closing, we mapped the purification steps against the target closing date and confirmed the corporation would clear the 50% threshold throughout that full look-back period, not just at the moment of sale. This is why starting the review eight months out, rather than at closing, mattered — a same-month cleanup would have satisfied the 90% test on closing day but failed the 24-month test regardless.
6. Added qualification representations to the purchase agreement. We worked with the lawyer handling the share purchase agreement to include representations confirming the shares' status as qualified small business corporation shares as of closing, giving Sanjay's side the assurance they needed and giving Arjun and Ines a clear record of the facts they were relying on.

The outcome

The sale closed roughly on schedule, about eight months after the letter of intent, at the agreed price of $4.5 million. By closing, both the commercial unit and the surplus cash had been out of the operating corporation for well over the required period, and the company's asset mix comfortably cleared both the 90% test at closing and the 50% test across the full look-back window. Arjun and Ines each reported a substantial capital gain on their shares, and each was able to claim the lifetime capital gains exemption against their portion, sheltering roughly $1.8 million of their combined gain from tax entirely.

Had the sale closed with the passive assets still inside the corporation, the shares would very likely have failed the qualification test for both shareholders, and the exemption claim would have been vulnerable to reassessment on audit. On the sheltered portion of the gain, that would have meant combined federal and provincial tax exposure of roughly $480,000 that Arjun and Ines never had to pay — not because a dispute with the tax authority was won after the fact, but because the disqualifying facts were fixed before the return was ever filed.

Ines's holding company now owns the commercial unit outright and continues collecting rent from the same tenant, entirely separate from the sale and from Sanjay's new ownership of the construction business. Arjun stayed on for a short transition period at Sanjay's request before stepping back from the business full time.

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