Taxes | Sep 4, 2024

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How Canadian Entrepreneurs Can Maximize Tax Savings with the LCGE and New Tax Incentive

On August 12, 2024, Finance Canada proposed changes to the Income Tax Act that included the Canadian Entrepreneurs' Incentive (CEI). This new incentive seeks to lower the taxable component of capital gains to help some entrepreneurs mitigate the tax burden of up to $2 million in qualifying capital gains during their lifetime.  As of 2025, Canadian entrepreneurs will have the opportunity to benefit from CEI alongside the Lifetime Capital Gains Exemption (LCGE). Together, LCGE and CEI can reduce taxable gains by up to $3.25 million (lifetime) when you sell your qualifying business.

How CEI Works (Phased in over 5 years)

• The Incentive lowers the eligible capital gains inclusion rate to one-third (33.33%), so only one-third of the capital gains will be included in taxable income, rather than the standard two-thirds (66.66%), up to a lifetime cap of $2 million in eligible capital gains. This means that over an entrepreneur's lifetime, they can benefit from the reduced inclusion rate on up to $2 million in capital gains.
• To qualify for CEI, the capital gains must come from the sale of a qualified small business corporation shares or qualifying properties.
• The Incentive must be used according to the phased in limits, and any unused incentive amounts cannot be carried forward.
• The full benefit of CEI will be available by 2029, which includes up to $2 million in eligible capital gains.

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The Incentive will be phased in over a five-year period, starting in 2025.

• 2025 - Year 1: Entrepreneurs can apply the Incentive to reduce their taxable income by up to $133,333 on eligible capital gains of $400,000.
• 2026 - Year 2: Entrepreneurs can apply the Incentive to reduce their taxable income by up to $266,666 on eligible capital gains of $800,000.
• 2027 - Year 3: Entrepreneurs can apply the Incentive to reduce their taxable income by up to $400,000 on eligible capital gains of $1,200,000.
• 2028 - Year 4: Entrepreneurs can apply the Incentive to reduce their taxable income by up to $533,333 on eligible capital gains of $1,600,000.
• 2029 - Year 5:  The total CEI deduction limit will reach the lifetime maximum of up to $666,667, fully covering of up to $2,00,000 in eligible capital gains.

Entrepreneurs can efficiently minimize their taxable income over time by strategically timing the sale of their firms to take advantage of tax benefits provided by CEI.

Note that the Lifetime Capital Gains Exemption (LCGE) is different than CEI and allows entrepreneurs to exempt capital gains up to $1.25 million (effective June 2024) from being taxed when they sell their qualifying business or property.  Once the LCGE is applied, CEI is used to further reduce taxable income.  Entrepreneurs need to understand how both LCGE and CEI work together and who qualifies.  Let's look at a detailed example below.

Image: Freepik/garetsvisual

Example: How Linda Would Benefit from the LCGE and CEI

Assume Linda founded a software firm three years ago and intends to sell her shares in 2025 for a $2 million profit. She would have to pay taxes on approximately $1.29 million of her earnings, if no deductions were taken. However, Linda may lower her taxable income to $325,000 if she takes advantage of both the LCGE and CEI. She would do this by deducting $133,333 from CEI and $833,333 from LCGE, leaving her with significantly less taxable income and a smaller tax payment.

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Let's break it down...

1. Understanding Capital Gains and Taxable Income

• Capital Gains - A capital gain is the profit you get when you sell an asset for more money than you originally paid for it. For instance, the $2 million is seen as a capital gain if Linda sells her shares for a $2 million profit and she originally put in sweat equity.
• Taxable Portion - Not all of this gain is taxed. The capital gains inclusion rate determines how much of your capital gains are taxed by the Canadian government.

2. Capital Gains Inclusion Rate

• Prior to June 25, 2024, the old inclusion rate of 1/2, or 50%, only $1 million of Linda's $2 million in capital gains would be subject to taxes.
• After June 25, 2024, the new capital gains tax inclusion rate is 2/3 (or about 66.67%). So now, if Linda has $2 million in capital gains, $1.33 million will be taxable.

3. Calculating Linda's Taxable Income WITHOUT DEDUCTIONS

If Linda does not claim any deductions like the LCGE or CEI:

• On the first $250,000, the inclusion capital gains tax rate of 1/2 is applied, so the taxable income from this portion is $250,000 × 1/2 = $125,000.
• On the remaining $1,750,000, the inclusion rate of 2/3 is applied, so the taxable income from this portion is $1,750,000 × 2/3 = $1,166,667.
• That makes the Total Taxable Income $125,000 (from first portion) + $1,166,667 (from second portion) = $1,291,667. So, without any deductions, Linda's taxable income would be about $1.29 million.

4. Applying the LCGE (Lifetime Capital Gains Exemption)

The LCGE allows Linda to exclude up to $1.25 million (lifetime limit) from her taxable income at the new inclusion rate.  So by applying the LCGE, Linda can reduce her taxable income by $1.25 million × 2/3 = $833,333.

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5. Applying the Incentive Deduction

Applying CEI further reduces the taxable income. The maximum deduction under CEI in 2025 is $133,333, based on a capital gain of $400,000 at the new inclusion rate.  So by applying CEI, Linda can further reduce her taxable income by $400,000 × 2/3 × 1/2 = $133,333.

6. Final Taxable Income Calculation

So now subtract the deductions from Linda's initial taxable income from the sale of her shares.

• Initial Taxable Income: $1,291,667.
• Subtract LCGE Deduction: $1,291,667 - $833,333 = $458,334.
• Subtract Incentive Deduction: $458,334 - $133,333 = $325,001 (rounded to $325,000).

RECAP Bringing it all together AFTER DEDUCTIONS

1. Without any deductions, Lindas's taxable income from the $2 million capital gain is $1,291,667.
2. Applying the LCGE reduces her taxable income from the sale by $833,333.
3. Applying CEI further reduces her taxable income from the sale by $133,333.
4. Her final taxable income after all deductions is $325,000.

* Takeaway*  by applying the LCGE and CEI tax benefits, Linda owes much less tax and gets to keep much more of the capital gains she generated from the sale of her qualifying business shares.

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Eligibility for CEI and LCGE are similar but not the same.  Both apply to capital gains from the sale of qualified small enterprises, although they differ in many ways and have extra criteria - see below.

Image: Freepik/aleksandarlittlewolf

Who Qualifies for LCGE?

• The LCGE applies to capital gains obtained from the sale of "Qualified Small Business Corporation (QSBC) Shares" or qualified farm/fishing assets.
• A Qualified Small Business Corporation (QSBC) has to satisfy the following criteria:
  • The company is a Canadian-controlled private corporation (CCPC).
  • At the time of sale, at least 90% of the company's assets are employed to run an operating business, largely in Canada.
• More than half of the company's assets must have been used in an active business in Canada within the 24 months before the sale.
  • During the 24 months preceding the transaction, the shares must have been owned only by the taxpayer or a connected person.
• The LCGE exempts up to $1.25 million lifetime limit (starting June 2024) of capital gains from taxation.
• Certain businesses are excluded, including consulting businesses, professional practices (e.g., lawyers, accountants), financial services firms, and real estate rental businesses.

Who Qualifies for CEI?

• Like the LCGE, CEI applies to capital gains on the sale of QSBC Shares or other qualifying small company properties.
• The same general QSBC criteria apply: the corporation must be a CCPC and use a significant majority of its assets in active business activities conducted principally in Canada.
• The CEI also requires that the LCGE be maxed out before the entrepreneur may use the CEI. After the LCGE has been fully utilized, the CEI serves as an additional deduction.

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• The entrepreneur must own at least 5% of the corporation's shares for a continuous period of 24 months before to the sale and have been actively engaged in the business for at least three years.
• The CEI has a lifetime maximum of $2 million in qualifying capital gains that can qualify for the lower capital gains inclusion rate.
• The same exclusions apply as for the LCGE (consulting, financial services, real estate rental firms, and some professional professions). However CEI also has special anti-avoidance procedures in place to discourage taxpayers from restructuring companies to falsely qualify for CEI deductions.

Key Differences Between LCGE and CEI Eligibility

1. The CEI adds additional conditions, such as the entrepreneur must have been actively involved in the firm for at least three years previous to the sale, to the LCGE's requirement that the company be a QSBC. For the LCGE, this prerequisite is not as clearly stated.
2. A ceiling is placed on the yearly amount of capital gains that can be eligible for the lower inclusion rate during the five-year phase-in of the CEI (2025–2029).  Conversely, LCGE is not phased in.
3. CEI is used to offset further taxable capital gains only after the lifetime LCGE cap has been used. The LCGE is applied first. It is not possible to utilize the CEI without the LCGE.

Potential for Unintended Consequences

While planning strategically to maximize the tax savings by applying LCGE and CEI can be highly effective, it may lead to unintended consequences, so here's a list of potential pitfalls to avoid:

1. Adverse Impact of Business Decisions

• In order to qualify for the LCGE and the Incentive, entrepreneurs may be enticed to change their business models or operations. This might result in decisions that prioritize tax benefits over the long-term sustainability and growth of the company.  For example, a consulting firm may try to diversify into qualifying activities putting strain on their core business.

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• Further, businesses would be negatively impacted if they structured their business to take advantage of LCGE and CEI but then policy changes occurred that altered the program's benefits, qualifications or timing that was misaligned with the restructuring efforts.

2. Increased Tax Complexity and Compliance Costs

• Due to more complicated tax planning and unique requirements of these tax incentive programs, it may be necessary for entrepreneurs to hire attorneys and tax experts on a more frequent basis, which would increase expenses.
• Given the complexities of the eligibility requirements of LCGE and CEI, it could lead to an increase in strategic planning errors and non-compliance leading to fines, exclusion from benefits or audits.

3. Impact on Timing of Business Exit

• LCGE and CEI benefits may skew the timing of when entrepreneurs decide to sell their companies.  They may for example postpone selling their shares to qualify for a tax benefit but at the same time miss investment opportunities in new ventures as a result.

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• Additionally, as we've seen with the quick implementation of LCGE, many qualifying investors with multiple properties rushed to sell their assets to avoid paying extra taxes.  This pressured timing of when to exit a business may result in less favourable conditions or incentivized selling when share prices and valuations may not be ideal.
• Strategic planning of multiple businesses can become even more complex.

4. Misalignment with Investors

• Investors may be looking for speedy exits or other company strategies that do not comply with CEI requirements, causing a conflict of interest between optimizing shareholder value from tax advantages and investor demands.

Remember, CEI is currently a proposal and draft regulations have been published for comment

Provide your feedback and share your voice before Sep 11, 2024 (it's not too late)

Conclusion

Although the LCGE and the (proposed) Canadian Entrepreneurs' Incentive provide substantial tax benefits, business owners must carefully weigh the possible unintended implications of strategic planning in order to optimize these advantages. It's important to consult with tax specialists and legal counsel.

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