Anonymised, illustrative composite. The company being sold owned more than its operating business. It also owned a parcel of land bought years earlier for an expansion that never happened — and that parcel put the whole tax plan for the sale at risk.
At a glance
A seller preparing to sell the shares of an operating business was counting on the lifetime capital gains exemption to shelter part of the personal gain on the sale — standard planning for a Canadian owner-manager exit, and standard enough that nobody on the deal team had questioned it when the process began.
The operating corporation owned more than its operating business. Years earlier, it had purchased an adjacent parcel of land for a planned expansion that never went ahead; the parcel had since been leased to an unrelated third party and sat on the balance sheet, generating rental income unrelated to the company’s core operations. Total corporate assets were valued at $6.0 million, of which the passive parcel accounted for $900,000 — leaving $5.1 million, or 85%, used in the active business.
The seller’s tax advisors raised the issue directly: the LCGE, under ITA s.110.6 together with the s.248(1) definitions, requires the shares to be those of a qualified small business corporation — broadly, one where all or substantially all of the fair market value of its assets is used principally in an active business carried on in Canada. Neither section attaches a specific percentage to that phrase, and none is asserted here as one; what the advisors flagged was that a leased, non-operating parcel generating passive rental income sat awkwardly against a test the Act states in words, not numbers — and that leaving it inside the corporation created a real, live risk to the exemption, not a technical footnote.
The fix was a pre-sale purification: transferring the passive parcel out of the operating company before the shares were sold, so the company being sold held only assets used in the active business. The parcel’s fair market value was $900,000; its original cost, and adjusted cost base, was $310,000. Under an ITA s.85(1) joint election, the parcel was rolled into a newly formed holding company — a PropCo — at an elected amount equal to its $310,000 cost base, deferring rather than eliminating the $590,000 gain the transfer would otherwise have triggered immediately.
After the transfer, the operating company’s asset base was $5,100,000, all of it used in the active business — 100%, not 85%. The shares of the operating company were then sold for a price reflecting the operating business alone, with the seller’s taxable gain on that sale now eligible, cleanly, for the LCGE’s usual $625,000 shelter of taxable gain, per the ½ inclusion rate in s.38(a).
The s.85(1) rollover is what made the parcel movable without an immediate tax cost: the elected amount is deemed to be both the transferor’s proceeds and the transferee’s cost, capped at fair market value, so setting the elected amount at the parcel’s existing cost base carried the gain forward into PropCo rather than crystallising it on the internal transfer. The LCGE test itself did not change — what changed was which corporation the shares being sold actually represented.
Had the shares been sold with the passive parcel still inside the corporation and the active-asset test later challenged, the exposure was not a reduced deduction — it was the entire $625,000 shelter, denied outright if the shares turned out not to qualify at the moment of sale. Losing the deduction entirely, rather than merely narrowing it, was the exposure the purification transaction was built to close, and it closed it before the shares changed hands rather than leaving it to be argued after the fact.
The tell is a balance sheet asked one question it is rarely asked years before a sale: for every asset the corporation owns, is it actually used in the day-to-day business, or simply owned and leased out, idle, or held for appreciation? A parcel bought for an expansion that never happened is exactly the kind of asset that quietly sits on the books for years, unremarkable until a buyer’s or an advisor’s diligence, right before a sale, is the first time anyone asks what it is actually for.
The purification closed roughly six weeks before the share sale, with PropCo retaining the parcel and its existing third-party lease, and the operating company’s shares sold with a clean, defensible claim to active-business status. The seller’s tax filing position on the LCGE was materially stronger than it would have been selling the combined entity.
Related case files
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