Canadian Entrepreneurs’ Incentive (“CEI”)

Concurrent with increasing the capital gains inclusion rate from 50% to two‑thirds, the government has increased the lifetime capital gains exemption to $1.25 million and introduced a new incentive ⁠–⁠ the Canadian Entrepreneurs’ Incentive (CEI) ⁠–⁠ available to business owners realizing capital gains on the sale of certain qualifying small business corporation shares or qualified farming and fishing properties.

The CEI is a deduction from taxable income that generally reduces the inclusion rate on certain qualifying capital gains by half. It applies to taxation years that begin after 2024.

The CEI is available in addition to the lifetime capital gains deduction. To qualify for the CEI, the disposed shares must be qualified small business corporation shares. Additional criteria must be met:

• • • The corporation cannot carry on certain excluded businesses, such as restaurants, hotels, arts, entertainment, recreation, personal services, finance, insurance, real estate firms and professional corporations.
    • Throughout the 24 months prior to the sale, the individual must have owned no less than 5% of the total voting shares (reduced from 10% as initially announced)
    • The individual must have been actively engaged for a total of not less than three years prior to the sale (changed from the originally announced five years). The three years need not be continuous.
      • Actively engaged means at least an average of 20 hours per week during the portion of the year in which the business operates.
    • The CEI may be claimed in addition to the maximum $1.25 million lifetime capital gain exemption, for a total of $3.25 million in total and partial capital gains deduction. The $2 million maximum for CEI is phased in over five years (changed from 10 years previously announced).

The calculation of the maximum deduction under both the lifetime capital gains exemption and the CEI is by formula. Simply, the deduction threshold for the CEI is reduced by any amount deducted under the lifetime capital gains deduction for dispositions of qualifying CEI property.

Anti‑avoidance rules

There are various anti‑avoidance rules in place, which will deny the CEI deduction under certain circumstances. These anti‑avoidance rules are patterned after those applicable to the lifetime capital gains deduction and are intended to prevent transactions that create capital gains from other types of income.

If a capital gain has not been reported on the tax return for the year knowingly or under circumstances that amount to gross negligence, or the tax return for the year of gain was not filed within one year after the return’s due date, the CRA may deny the deduction if it establishes the facts justifying the denial of the deduction. It is important to ensure any capital gains that may qualify for the deduction are reported on a timely basis.

Another anti‑avoidance rule prevents the conversion of taxable capital gains of corporations into exempt capital gains of individuals. If a corporation disposes of a property by first transferring the property to another corporation for consideration that is less than the fair market value of the property and an individual realizes a capital gain on the sale of the shares of either corporation as part of that series of transactions, the individual will not be permitted to claim the CEI deduction. This would commonly involve a transaction where there is a section 85 tax deferred rollover.

An individual will also be denied a CEI deduction with respect to a capital gain realized as part of a capital gain strip (butterfly) transaction or series of transactions where corporate property is disposed of in an arm’s length transaction, either directly or indirectly, on a tax‑free or tax deferred basis.

The CEI rules must be kept in mind whenever a reorganization is undertaken involving arm’s length parties and one of the intentions is to claim the CEI deduction.

Finally, anti‑avoidance rules exist to prevent the conversion of dividend income into partially exempt capital gains of individuals. These rules are intended to prevent corporations from issuing shares that have attributes designed to facilitate the realization of a capital gain rather than by way of dividends. These rules would apply, for example, to preferred shares that do not pay dividends or pay relatively low dividends but that are retractable or redeemable at a substantial premium. An individual will be denied the deduction with respect to capital gains realized on a disposition of those types of shares. This rule will not apply in the case of prescribed shares (for example common shares).

Generally, an individual may not claim the CEI deduction where it is reasonable to conclude that a significant portion of the capital gain is attributable to the fact that dividend payments on a share have either not been made or have been deferred. For this purpose, dividend payments will be considered to have been deferred where the dividends actually paid on the share in a year are less than 90% of the average annual rate of return on the share for the year.

The average annual rate of return on a share for a year is based on an objective standard, that is, the rate of return that a knowledgeable and prudent investor would expect to receive based on certain assumptions.

If you have any questions, please contact your LCA advisor.