Business Law Blog

On August 12, the Department of Finance Canada (“Finance Canada”) released proposed amendments to the Income Tax Act (the “Act”) implementing the new Canadian Entrepreneurs’ Incentive (the “Incentive”). The Incentive aims to reduce the capital gains inclusion rate to one-third on a lifetime maximum of $2 million in eligible capital gains.

The Incentive will apply to taxation years after 2024.

Background

The Incentive was introduced in April as part of the 2024 federal budget (“Budget 2024”) to mitigate the impact of the increased capital gains inclusion rate for Canadian entrepreneurs. The Incentive was announced alongside other tax changes that alter the way capital gains are taxed, such as circumstantially increasing the capital gains inclusion rate from 1/2 to 2/3.

Finance Canada states that the purpose of the Incentive is to ensure that most middle class Canadians and entrepreneurs do not pay more tax through the recent increase in the capital gains inclusion rate.

The Incentive

The Incentive applies to individuals (but not trusts), and effectively reduces the taxable portion of a lifetime amount of qualifying capital gains by enabling the individual to claim a deduction from taxable income not exceeding 1/2 of the taxable portion of the qualifying gains subject to a lifetime limit. The Incentive generally requires that the individual apply the lifetime capital gains exemption (the “LCGE”) before applying the deduction available in the Incentive. The LCGE is available for capital gains realized on the disposition of “qualified small business corporation shares” (“QSBC Shares”) among other properties and generally exempts gains up to the lifetime limit of approximately $1,000,000. The Federal Government intends to increase the current limit to $1.25 million effective June 25, 2024.

The Federal Government is phasing in the Incentive, with a deduction limit of $133,333 (or a full deduction in respect of a capital gain of $400,000 with an inclusion rate of 2/3). That limit will increase by the same amount each taxation year until the lifetime limit is reached after five years.

Numeric Example

Assume, for example, that John founded a software company three years ago and has decided to sell his shares in 2025 to a third party and those shares qualify for the Incentive. John earns $2 million in capital gains in 2025 on the sale. If John does not claim the LCGE or the Incentive he will have approximately $1.29 million of taxable income ($250,000 x 1/2 + $1,750,000 x 2/3).

If John can claim the maximum Incentive and the LCGE on the sale, his taxable income will be reduced to $325,000 since he is able to deduct $833,333 ($1,250,000 x 2/3) from the LCGE and $133,333 ($400,000 x 2/3 x 1/2) from the Incentive in computing his taxable income.

Incentive Requirements

The Incentive applies where capital gains are realized from the disposition of qualifying Canadian entrepreneur incentive property. The requirements are similar to the requirements of QSBC Shares for the purpose of the LCGE, but with a few further conditions.

To qualify, the shares must first meet the requirements of QSBC Shares, meaning:

• It is a share of a small business corporation owned by the individual or related person.
• For 24 months before the disposition of the share:
  • it is a share of a Canadian-controlled private corporation where more than 50% of the fair market value of the assets were used in an active business in Canada or certain shares or debts of a related corporation; and
  • the share was not owned by anyone other than the individual or related person.

Next, the individual must have held shares representing 5% or more of the corporation for a period of 24 continuous months prior to the disposition. That individual must also have been actively engaged on a regular, continuous and substantial basis in the activities of the business for three years or more prior to the disposition.

Finally, the active business of the corporation cannot be an “excluded business.” Excluded businesses include the following:

• professional practices (e.g., lawyers, notaries, dentists, accountants, engineers or architects);
• consulting services or businesses whose principal asset is the reputation, knowledge or skill of one or more employees;
• financial services;
• insurance services;
• real property businesses;
• rent, lease or license of tangible or intangible property;
• short-term accommodation businesses;
• operation or service provider businesses in relation to cultural, entertainment and recreational activities; and
• restaurant or grocery related businesses.

Anti-Avoidance Rules

The proposed amendment includes many of the anti-avoidance rules that are included in the LCGE provisions of the Act. These rules are generally intended to prevent the conversion of income that would otherwise be taxed as dividend income into capital gains eligible for the LCGE or the Incentive.

Filing Obligations

The Incentive is not available if an individual knowingly fails to file his or her tax return within one year after the filing due date or fails to report the capital gain in his or her return in a taxation year.

Looking Forward

The draft legislation might surprise those that followed Finance Canada’s announcement of the Incentive in Budget 2024. Many of the requirements in the draft legislation released last week have changed from those previously announced in Budget 2024. Notably:

• the phase-in of the Incentive has accelerated to $400,000 annually instead of $200,000;
• the ownership interest requirement has been reduced from 10% to 5%;
• the holding period before disposition of the share was shortened from five years to three years;
• the individual’s five year active involvement requirement was reduced to three years; and
• the language surrounding a “founding investor” was not included.

As the Federal Government has invited comments on the draft legislation until the middle of next month, the final version of the Incentive may change. However, this draft legislation provides Canadian entrepreneurs and investors with a starting point to prepare for using the Incentive beginning 2025.

More Information

For any inquiries regarding this topic, please contact Max Walker or any member of the Tax Group.