OK. Buckle up. Things are about to get complicated, but hopefully, after you read this, it will make some sense. Trust me; this stuff is hard enough for accountants and lawyers to grasp. Bottom line: if you’re thinking of selling anytime in the next five years, contact us NOW, or you’ll end up paying more capital gains tax when you sell.
As usual: what I’m writing about isn’t intended to be taken as legal advice; if you need to purify your corporation before selling it, contact DMC.
Lifetime Capital Gains Exemption
Yes, you’ve heard me talk/write about this before. In order to qualify for the lifetime capital gains exemption (and hopefully save a whole bunch of capital gains taxes), a number of tests must be met. For more on that, please read this article and blog post.
Now, here’s the situation: leading up to the sale, it’s sometimes the case that one or both of the two tests that need to be met (namely, the 24 months leading up to the sale + 50% active business assets test OR the day of sale + 90% active business asset test) for the dentistry professional corporation needs to be purified.
Purification means: removing offending non-active business assets from the corporation for the corporation to be considered a “small business corporation” so that you (as a shareholder) can qualify for the lifetime capital gains exemption (see the two asset tests I mention above). Those non-active business assets may include excess cash, investments, securities, and real estate in some cases.
And these assets need to go somewhere. Sometimes, those assets will be transferred out directly to the dentist shareholder and/or their spouse, children and parents as a DIVIDEND. But taking a dividend will typically trigger taxes (only cash dividends up to a certain amount – like $33k in 2016 – paid to an adult child who has no other source of income will have $0 federal tax). And what if the dentist doesn’t want to take all that cash out and pay taxes? What then?
What a Typical Corporation Could Theoretically Do
If we were talking about a typical corporation (other than a dentistry professional corporation), the shareholder would do something called a corporate re-organization in order to transfer assets out of their operating corporation and into a holding corporation. This would be done using steps that look like this:
- The shareholder transfers redeemable shares in the operating corporation to a holding corporation and receives shares in the holding corporation as a result.
- The operating corporation redeems its shares held by the holding corporation, and non-active business assets are used to satisfy the redemption (in other words: offending non-active business assets are moved out or cancelled, etc.).
Now, I know I used a lot of big words there. And I very much simplified what’s going on. But bear with me. The key thing to realize is that: inter-corporate dividends made from a Canadian corporation from another Canadian Corporation are typically received TAX-FREE. The receiving Canadian corporation must report the dividends in income but may deduct the dividends in computing taxable income.
In theory, this structure would have been great for a seller to qualify for the lifetime capital gains exemption – because there’s no immediate tax implications! It would also help the seller convert what would have otherwise been a taxable capital gain (on the sale of the shares when they eventually go to sell the shares of the dentistry professional corporation) INTO an inter-corporate dividend that is tax-free.
Let me paint a picture for you: if the dentist had excess cash, the seller could choose to leave that cash in the corporation. Then the purchaser pays an amount equal to the agreed-upon purchase price PLUS the excess cash. The seller, assuming they’ve used up their lifetime capital gains exemption, will need to record the proceeds of the sale of their shares to INCLUDE the amount paid for the excess cash (because they left it in the corporation). And they’d then have to pay more capital gains tax on the sale of their shares.
Bottom line: removing the excess cash (or other non-active business assets) HELPS the selling shareholders qualify for the lifetime capital gains exemption by meeting the assets threshold tests mentioned above AND also helps them save taxes by converting an otherwise TAXABLE CAPITAL GAIN on the sale of the shares INTO a TAX-FREE DIVIDEND to a holding corporation. WOW! Remember: this is the theory…
OK, now the bad news: with respect to a dentistry professional corporation, there are two nuances: (1) a dentistry professional corporation cannot have a holding corporation (i.e. a corporation that owns its shares), otherwise it would be in violation of the legislation that governs dentistry professional corporations (namely, the Certificates of Authorization regulations) AND (2) in the context of a sale, the Income Tax Act makes it harder to move money on a tax-free basis between two Canadian corporations (basically there are limits on the amount you can move now in the context of a sale). Let’s discuss both of these things, shall we?
NO HOLDING CORPORATIONS for DPCs!
Section 2.2 of the Certificates of Authorization Regulations says WHO can be a shareholder in a dentistry professional corporation. And guess what? Another corporation isn’t one of them. Granted, the exact language of those Regulations says that a dentist or their spouse, child or parent may INDIRECTLY hold their shares in a professional corporation (which presumably means through another corporation), the RCDSO has taken the view that this doesn’t mean that. So, where does that leave us?
Well, despite what the law and the RCDSO say, some dentists will, for a brief moment in time over a weekend or after hours, do a transfer of their shares in the dentistry professional corporation (operating corporation) to another corporation (holding corporation) to transfer non-active business assets out (and it happens in a split second with the redemption/retraction described above). They do it on the weekend or in the evening when the corporation isn’t practicing so that it seems like the corporation isn’t practicing. And in the morning the next day, the dentistry professional corporation is back to normal, having only dentists and their spouses, children and parents as shareholders. Keep in mind: as lawyers, we can only advise you of the risks of your actions; you’re the ones who accept the tax and legal risk(s) and instruct us to proceed.
LIMITATIONS: Section 55(2)
So even if a dentist proceeds to set up a holding company and uses the simple example outlined above to transfer assets out, they may NOT be transferred on a TAX-FREE basis.
Why? Because of section 55(2) of the Income Tax Act. That section is an anti-avoidance rule. When section 55(2) applies, it says that a dividend received by the holding corporation in the context of a share redemption (as was the case outlined above) WILL BE CONSIDERED proceeds of disposition of a share and trigger a capital gain for the holding corporation! So, section 55(2) basically prevents the dentist from converting a higher sale price for their shares (for which more capital gains tax would have been paid) into a tax-free inter-corporate dividend between two corporations they likely control. I hope this makes sense. But if it doesn’t, just read the example above about the dentist who leaves the excess cash in their corporation and would have had to pay more in capital gains tax, theoretically.
To repeat: if section 55(2) applies, it would take aim at the cash or property that is being used to satisfy the redemption of the operating corporation’s shares by the holding corporation. More specifically, it would tax the operating corporation as if those assets were proceeds of disposition (capital gains tax would apply) on the redemption/retraction of those shares.
Are we done yet? No. We need to dig deeper into when section 55(2) applies – because (fortunately) there are exceptions which WOULD allow a dentist to transfer (on a tax-free basis) inter-corporate dividends from a dentistry professional corporation to a holding corporation. In future posts, we’ll dig deeper into when section 55(2) applies and what those exceptions are.
The bottom line is this: if you’re thinking about selling in the next five years, you need to immediately speak with us about purifying your corporation to hopefully avoid capital gains tax. If you wait until the last minute (when you’re in the process of selling), you’ll likely be unable to avoid paying those capital gains taxes when you transfer assets (e.g. dividends, etc.) out of your professional corporation and into a holding corporation.