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Lifetime Capital Gains Exemption for Dentists: the 50 % Asset Test…

By April 5, 2015December 15th, 2021Corporate

I have blogged extensively about how dentists can qualify for the lifetime capital gains exemption in this blog. I’ve blogged about certain nuances here (dealing with real estate) and here (dealing with issuing shares). In the next series of blogs, I’m going to tackle some more of the nuances surrounding the lifetime capital gains exemption (LCGE) to help educate dentists on how they can qualify to take advantage of potentially huge tax savings. In this blog, I’m going to tackle that 50% asset test.

Recall that the Income Tax Act says that shares of a qualifying small business corporation (typically, your dentistry professional corporation) will only qualify for the LCGE if, for the 24 months leading up to the sale, more than 50% of the fair market value of the assets of your dentistry professional corporation was used principally in an active business carried on primarily in Canada.

OK, so there are a lot of things going on with this test. Let’s dive in deeper, shall we?

Relationship with 24 Month Share Ownership Rule

Does this test require a dentistry professional corporation to exist and have assets for at least 24 months prior to the sale? No. The section of the Income Tax Act says that this asset test must be met throughout the period while the shares of the dentistry professional corporation were owned by the shareholder (i.e. the dentist). Now, yes, there is a general 24 month share holding rule (which I discussed in a previous blog here) in order for a dentist shareholder to qualify for the lifetime capital gains exemption. But I also talked about an exception to the rule: a dentist sole proprietor who owns their practice personally can incorporate their business shortly before a sale (i.e. transfer their practice to their corporation on a tax-deferred or rollover basis), sell shares of the dentistry professional corporation and claim the LCGE. And in this situation, the 50% asset test can be met – even if the dentist shareholder held their shares for less than 24 months! Nice…

Going Offside

If at any time the fair market value of the corporation’s non-active business assets comprise more than 50% of the overall value of its assets, then the corporation will be offside and the shares won’t qualify for the LCGE. This could happen because of a mistake – for example, failing to transfer excess reserve cash out of the corporation. If this happens, then the 24 month clock STARTS ALL OVER AGAIN! Ouch!

Active Business

I’ve blogged about this previously. An active business is defined in section 248(1) of the Income Tax Act as any business carried on by the dentistry professional corporation OTHER THAN: (1) a specified investment business or (2) a personal services business. For a specified investment business, think: a business that primarily generates income from passive income from property (e.g. rent, royalties, etc.).   So a corporation that owns and rents out real estate, or is an investment holding corporation, and which has only three or four employees will NOT qualify as an active business.   A personal services business is essentially an incorporated employee in disguise. Think: an associate who is essentially an employee of a practice but who incorporates to take advantage of all the tax benefits of having a corporation (but in reality, they’re still an employee) and their corporation has only a few employees involved.

Fair Market Value

Now, when we’re looking at “fair market value”, we’re actually looking at the GROSS FAIR MARKET VALUE of the assets (not net of liabilities!). So if a dentist shareholder advances funds to a dentistry professional corporation to allow it to pay off its liabilities leading up to a sale, the amount advanced will be viewed as an asset and the corresponding liability to the shareholder (which is normally the case) will be ignored for the purposes of determining whether 50% of the fair market value of the assets of the dentistry professional corporation are active business assets. This was stated to be the case in CRA technical interpretation 2003-0030045 dated October 10, 2003.

The term “Used”

At least 50% of the dentistry professional corporation’s assets have to be “used principally” in an active business. The CRA has stated the following in CRA technical interpretation 9606355 dated March 16, 1998 concerning its interpretation of the term “used” in an active business:

“It is a question of fact whether a property is used principally in an active business. Factors to be considered in determining whether a property is used in an active business include the actual use to which the asset is put in the course of the business, the nature of the business involved and the practice in the particular industry. The issue of whether property was used or held by a corporation in the course of carrying on a business was considered by [Ensite Limited]. The court held that the holding or using of property must be linked to some definite obligation or liability of the business and that a business purpose test for the use of the property was not sufficient. The property had to be employed and risked in the business and used to fulfil a requirement which had to be met in order to do business. In this context, risk means more than a remote risk. If the withdrawal of the property would have a decidedly destabilizing effect on the corporate operations, the property would generally be considered to be usedin the course of carrying on a business”.
You can read my previous blog post about whether things like cash will be determined to be used in an active business.

The term “Principally”

The word “principally” in the term “used principally” has been interpreted by the CRA to mean at least 50%. The CRA will look at each asset of the corporation and determine, in light of various factors, whether it is “used principally” in an active business carried on by that corporation. Some assets have more than one use – like real estate. So what about a building that is owned by a dentistry professional corporation and which houses the dental practice?   Well, if that building leases more than 50% of its space to tenants other than the dentist and their dental practice, then the entire real estate assets may NOT be used principally by the dentistry professional corporation. I’ve blogged extensively about real estate and whether it will qualify for the lifetime capital gains exemption here. But if the dentistry professional corporation uses most of the building to house the dental practice and less than 50% for other tenants, then the entire asset may qualify as an asset “used principally” in an active business.

The Term “Carried On”

For an asset to be “carried on” in an active business, this is a pretty simple test to meet: the asset must assist the corporation in carrying on an active business. So if the asset is simply sitting there and not being used to carry on an active business, it won’t qualify (think: vacant land held by the dentistry professional corporation for re-sale) and could put the dentistry professional corporation offside.

The Term “Primarily in Canada”

Recall that the asset must be used principally in an active business carried on “primarily in Canada”. This would be an easy enough rule for an Ontario dentistry professional corporation with operations (a dental practice) located in Ontario, Canada.

In the next blog, I’m going to talk about the 90% Asset Test