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Real estate and the Lifetime Capital Gains Exemption

By December 16, 2013December 15th, 2021Corporate

So here’s the situation: you are a dentist and you want to sell shares of your dentistry professional corporation.  The thing is that you don’t have a dentistry professional corporation.  But you’ve read on this blog (and perhaps in conjunction with your dental accountant) that you can incorporate prior to the sale and then transfer in your assets to your corporation and then sell the shares on that same day.  And if you do this correctly, you don’t have to own your shares for two (2) years, which is the normal rule.  Everything is going well so far.  But here’s the catch: you have  a practice that is being housed in a building which you also own.  There is no one else in the building.  Your dental practice is the only tenant.  You don’t really understand what is going to happen with the real estate: does it get transferred into your dentistry professional corporation before you sell the shares of that corporation (so it is simply another asset owned by the professional corporation)?  Or do you sell it separately in a plain asset sale?  Or do you transfer it to another corporation (non dentistry professional corporation) and then sell the shares of that corporation?

So many choices… so much possible confusion.  So, although we are neither tax experts or accountants and you SHOULD NOT rely on what is written in this blog, we can offer some observations about the different choices and what might be permissible to allow you to qualify for the lifetime capital gains exemption when you go to sell the shares of your dentistry professional corporation.

As a refresher, you might want to re-read this blog about the various rules that govern eligibility for the lifetime capital gains exemption.

No two (2) year waiting period

So now you know that one of the rules for qualifying for the lifetime capital gains exemption requires you to hold onto the shares for two (2) years before selling.  There is an exception that you are looking to take advantage of.  And that’s found in section 110.6(14)(f)(ii).  That exception says that, while normally there’s a two (2) year ownership rule for the shares to qualify under the lifetime capital gains exemption, this rule won’t apply if the dentist disposed of “all or substantially all of the assets in an active business” to the dentistry professional corporation through a transaction or series of transactions.

To reiterate:

Section 110.6(1) says that a “qualified small business corporation share” of an individual is a share of the capital stock of a corporation that (among other things), throughout the 24 months immediately preceding the determination time, was ONLY OWNED by the individual or a person related to the individual.   That’s your starting point.

Then, section 110.6(14)(f)(ii) says, that, for  the purposes of the definition of “qualified small business corporation share”, shares issued after 1988 to a “particular person” shall be deemed to have been owned immediately before they were issued by a person who was not related to the “particular person” UNLESS the person disposed of property that constituted all or substantially all of the assets used in an active business carried on by that person.

So by combining the rule and exception, we seem to get this: if the individual (i.e. dentist) transfers all or substantially all of the assets comprising an active business over to their corporation, then the shares they receive will be DEEMED to have been owned (before they were issued) by a person who was related to that individual.

Active Business?

So would real estate be considered part of the all of the assets in an active business?

Well, there are a number of considerations here.  An active business is defined as “any business carried on by the taxpayer other than a specified investment business or a personal services business”. Specified investment business generally means a business the principal purpose of which is to derive income from property (e.g. rent, royalties, dividends, etc.), but this doesn’t include, for example, a corporation that has at least 6 full time employees. A personal services business is essentially an incorporated individual who resembles an employee of a client, but this doesn’t include, for example, a corporation that has at least 6 full time employees (s. 125(7) of the ITA).

So we have an idea of what an “active business” is.

Real Estate = asset in an active business?

So would real estate that is used to house the active business be considered an asset in active business (as required by section 110.6(14)(f)(ii))?

Well, in this respect, we have to turn to Administrative Interpretations from the Canada Revenue Agency, as well as Technical Notes, and Court cases.  Administrative interpretations such as technical notes are not binding on the courts, but they are entitled to weight, and may constitute an important factor in the interpretation of statutes.Technical notes are widely accepted by the courts as aids to statutory interpretation.

So with these things in mind:

  • In 88 C.R. – “Small Business Corporation Shares” – “Deemed Ownership of Shares by an Unrelated Person Prior to Issuance”: Where, following an offer for all of the assets of a proprietorship except a building representing 1/2 of the fair market value of the assets, the individual transfers the building to Holdco, transfers the remaining assets to Opco, and sells the shares of Opco, the Opco shares WILL NOT be qualified small business corporation shares (so no lifetime capital gains exemption available).
  • In Boulanger v. The Queen, 2004 DTC 6192, 2003 FCA 332:  A corporation’s only assets since 1992 had comprised a vacant property and a sum owing for the sale of one-half of another property that originally had been intended for the operation of a business. In these circumstances, the Tax Court had not erred in concluding that the corporation DID NOT qualify as a small business corporation when the taxpayers disposed of their shares in 1996.
  • In 88 C.R. – F.Q.37: If property which is owned by the sole shareholder of a corporation but is used by the corporation in its business is transferred to the corporation immediately prior to a sale of the shares of the corporation issued in consideration therefor, those shares WILL BE deemed to have been owned by a person not related to the shareholder.
  • 1988 Canadian Tax Foundation Revenue Canada Roundtable at page 53:9: concerning a situation that involved the transfer of a building (representing 50% of the fair market value of all the business assets) that was owned and used by an individual in a sole proprietorship to a holding corporation (“Holdco”) prior to a transfer of the remaining business assets to an operating corporation (“Opco”). The transfer of the building to Holdco had occurred in contemplation of a purchase and sale offer the individual received for all the proprietorship’s business assets except for the building. In our response, we indicated that in that situation the exception in subparagraph 110.6(14)(f)(ii) of the Act would not apply to the sale of the shares of Opco as they were not issued as part of a transaction or series of transactions in which the individual disposed of all or substantially all of the assets used in an active business carried on by the individual to Opco (note: this was reiterated in a CRA note entitled “Re: Capital Gains Exemption and Paragraph 110.6(14)(f) of the Act” 2011-042433).
  • In Tax Interpretation 2009-0307931E5 “Asset used principally in an active business”: where a corporation owns a building that it partially occupies and rents out the remainder to arm’s length tenants, it is a question of fact whether the shares would qualify as small business corporation shares:

“An individual who realizes a taxable capital gain on the disposition of a share that is a QSBCS, as defined in subsection 110.6(1) of the Act, may be entitled to a capital gains deduction in calculating taxable income pursuant to subsection 110.6(2.1) of the Act. The share must be a “small business corporation” (“SBC“) share at the time of disposition and at least 90% of the fair market value of the corporation’s assets attributable to, inter alia, assets that are used “principally in an active business” carried on primarily in Canada.

The term “principally” generally means more than 50%. We generally regard an asset which is used more than 50% in an active business as one that is “used principally in an active business”. Generally, an asset is considered to be used principally in an active business if its primary or main use is in that business. The “used principally” test is applied on a property by property basis.

It is a question of fact whether a property is used principally in an active business. Although there are no set guidelines as to which factors to use in different situations, there are two aspects to be considered in determining the nature of use of a building – quantitative factors (e.g., the total square footage occupancy in the building) and qualitative factors (e.g., the original intent for purchasing the building, actual use to which the building is put in the course of the business, the nature of the business involved and the practice in the particular industry). The square footage use of a building is generally accepted as a factor to be given significant weight in the determination of the particular use to which the building is put. However, qualitative factors need also be considered. If the fair rental value of the space rented to tenants is greater than the fair rental value of the space used in an active business, this may indicate that a building is not used principally in an active business. Whether such a factor would be decisive in relation to the square footage test would have to be determined on a case by case basis.”

Bottom Line

Basically, if:

  • you have land and building which houses your dental practice,
  • the intent (when you bought the building) was to house your dental practice,
  • more than 50% of the building is used principally to generate income for your dental practice, and
  • the fair rental value of the space rented to tenants (if any) is less than the fair rental value of the space used for the dental practice

then a strong argument could be made that, by transferring the land and building (along with the dental practice) into one professional corporation and selling the shares of that professional corporation immediately thereafter, the shares would qualify for the lifetime capital gains exemption.

If the situation described above (see 4 bullet points) is present and you transfer the land and building to the purchaser directly or to another corporation which is not the dentistry professional corporation, then you may not qualify for the lifetime capital gains exemption if you try selling the shares of the dentistry professional corporation immediately thereafter – because you have not satisfied the exception in section 110.6(14)(f)(ii) that “all or substantially all” of the assets of an active business be transferred.

Now, some clever accountants may try to make the land and building a non-active business asset by transferring it to a non-dentistry professional corporation and then having it charge rent to the dentistry professional corporation.  If this is done, say in advance of the dental practice being transferred to a dentistry professional corporation, then it could be argued that the dentist DID transfer all or substantially all of the active business assets to their professional corporation and thereby satisfy the exception in section 110.6(14)(f)(ii) (so no two (2) year holding period on the shares to qualify for the lifetime capital gains exemption).  The challenge with this approach is twofold: first, the purchaser may miss out on bolstering the lifetime capital gains exemption by not taking into account any appreciation in value of  the land and building.  Second, the CRA may challenge this “series of transactions” on the basis that they were designed to avoid taxes.  This find support in the Capthorne case.

If you personally own the land and building that houses your dentistry professional corporation, you should definitely speak with a dental accountant and dental lawyers to help you organize your legal affairs in the simplest, most tax efficient, and conservative way (so as to reduce the likelihood of getting challenged by the CRA).