Basics of Tax and Capital Gain
Tax law isn’t written in the most accessible language, but it is extremely detailed. It basically lays out the formulas for calculating the value of the money and property (like the value of shares in a company) you gained in the year as “Income” and what tax rates apply. “Inclusions” are the amounts of your income that can be taxed, like your salary, while “Exemptions” are the amounts you gained that are protected from being taxed, like a gift. The amounts you can subtract from your taxable income are the “Deductions” and include things like legitimate expenses of running a business. Tax shelters refer to exemptions made by the government, usually to encourage society to invest in certain activities. Tax rollovers refer to “rolling over” or deferring taxes to other years, usually to maximize exemptions or deductions.
An important concept to selling shares of a corporation is the “Capital Gain,” which refers to the net amount you gained from having bought and sold some property. Types of property included in this calculation can be anything from a car or home to cashing in on shares of a corporation. The actual act of selling is called a “disposition” because you are disposing of the asset, and the value of the capital gain becomes taxable upon disposition.
Canada started taxing capital gains in 2012 and only half the capital gains are included as taxable income (the other half is always exempt, see Table 1). America, however, taxes all the capital gains, but the rates depend on how long you’ve held the shares. Due to the Tax Cuts and Jobs Act in 2017, shares held for a year or less are taxable at “short-term” rates, while shares held for longer are included in the overall taxable income. So, unless the shareholder disposes of the shares immediately, holding onto the shares long-term is more beneficial to optimize overall gains.
A better legislative vehicle to increase your savings, is by qualifying for a tax shelter. Canada offers exemptions up to $446k with the Lifetime Capital Gains Exemption, which is adjusted for inflation every year, while America’s counterpart offers a minimum $10MM exemption. A shareholder does not need to wait for an IPO or acquisition to qualify for this exemption, the shares only need to meet the residency and time requirements. Because various exits and shareholder transactions can trigger this tax shelter, the exemption promotes investment into small businesses and encourages entrepreneurs to initiate more start-up ventures.
How-To guide on Holding Corporations
Sometimes an opportunity for a sale may arise before a shareholder qualifies for the tax shelter, or a shareholder could be taxed on dividends that could otherwise be reinvested in shares. This is where the Income Tax Act section 85 allows for a great tool for deferring dispositions: The Holding Corporation.
What is it?
A Holding Corporation (HC) is incorporated for the express purpose of holding onto shares or assets of an Operating Corporation (OC, one that has normal business operations) and does not usually engage in any other business.
How does it work?
The general steps are as follows:
- Taxpayer and Corporation fills out form T2057, which requires:
- Contact information of the taxpayer and the director of the corporation
- Information on the shares transferred by the Corporation to the Taxpayer (number, class, value etc)
- Information on the assets transferred by the Taxpayer to the Corporation
- Signatures and agreement to s85
- Corporation must authorize transfer, which requires:
- The shares be made and are available
- A passing vote to approve the transfer (usually through normal quorum of the board; depends on articles)
- The Taxpayer signs onto the shareholders agreement or a stock subscription restriction agreement
- Taxpayer must ensure value of assets, which includes:
- Getting the valuation at fair market value
After these first three steps, if the taxpayer is actually a shareholder (SH) in an operating corporation, they may have to immediately pay taxes on dividends or may want to increase their deductions before selling the shares, or may just want to protect the shares until they meet the qualifications for the lifetime capital gains exemptions. In such a case, the SH may incorporate a new company for the express purpose of holding assets (the HC).
In this scenario, the first 3 steps are the same as the above:
- SH and HC fill out form T2057 (The SH wants to put the shares into the holding company)
- HC must authorize the transfer of shares
- SH must get the proper valuation
But, because the assets being transferred are actually shares, the SH, HC, and OC must also take these additional steps:
- OC must authorize SH’s transfer (or sale) of shares to HC
- HC must sign on to the shareholders agreements and other obligations to OC
The HC is owned entirely by the shareholder of the OC. Although the point of the HC is to create an extension of the shareholder to incur tax and protection benefits, they are still a recognized entity in the law. Because of this, the HC must separately sign on to the OC’s shareholders agreement. A shareholders agreement that contemplates the use of HC by its shareholders usually demands that the HC be bound to extra obligations, such as not incurring debt, restricting the HC’s ability to sell its own equity, and preventing the HC from engaging in other business. This stops potential abuse of the HC’s status as a separate legal entity and helps control the distribution of shares and corporate information.
What are the benefits?
- Security of assets – by transferring properties
- Optimizing Tax
Table 2: Taxing Capital Gains in Canada vs America (As of 2021)
|Jurisdiction||Canada (Income Tax Act)||America (Internal Revenue Code)|
|Capital Gains||Section 110||Section 26(h)|
|50% of the gains taxed at taxable income||100% of gains taxed as short-term rates (0%, 15%, 20% or over 28%) or long-term rates (included as taxable income)|
|Tax Shelter||Section 80.03(8)||Section 1202|
|“Lifetime Capital Gains Exemption”|
Requirement: Canadian Corporation, shares must have been held for 2 years
|“Qualified Small Business Exclusion”|
Exempted: at least the first $10MM
Requirement: US Corporation, shares must have been held for 5 or more years
|Tax Rollover||Section 86||Section 1045|
|Rollover to a different qualified business permissible||Rollover to a different qualified business permissible|
A special thank you to Samson (Sung An) for his help and contributions to this article!
The content of this article is written for general information purposes only and does not constitute specific legal advice. This article should not be used as a substitute for competent legal advice from a licensed lawyer. Please contact us at 416-238-5527 if you’d like to speak to an Emerge Law lawyer.