Corporate purification is the pre-closing process of stripping a target corporation of passive assets — investment portfolios, redundant cash, the cash surrender value of life insurance — so its shares still meet the active-business tests a seller needs for the lifetime capital gains exemption, and so a fund is not paying enterprise-value multiples for idle capital.
Section 110.6’s definition of a qualified small business corporation share runs two asset tests: throughout the 24 months before the sale, more than 50% of the corporation’s fair market value must have been active-business assets, and at the moment of disposition, all, or substantially all must be. A corporation that has been quietly accumulating cash or a securities portfolio inside the operating entity can fail that second test — which is why purification, not paperwork, is what actually protects the seller’s exemption claim.
The usual toolkit is an inter-corporate dividend of the passive assets up to the seller’s own holding company, sometimes paired with a note or a redemption. It is not a free move: section 55(2) can recharacterise a dividend paid as part of a series aimed at significantly reducing a capital gain back into a capital gain itself, unless it is paid out of the target’s safe income or another exception applies. For the fund, purification is normally a pre-closing covenant in the purchase agreement — and because it changes the balance sheet between signing and closing, the deal team needs to see the purification plan before it agrees the working-capital peg, not after.
A target holds $3,000,000 of core operating assets and a $1,200,000 marketable-securities portfolio left over from a strong prior year — clearly passive, and large enough to put the “all, or substantially all” test at risk. Before closing, the $1,200,000 portfolio is paid out as an inter-corporate dividend to the seller’s personal holding company, structured within the target’s safe income so section 55(2) does not apply, restoring the operating company to almost entirely active-business assets by closing.
See also: Lifetime capital gains exemption · Deemed dividend · Crystallisation.
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