With the recent Royal Assent of Bill C-208, owners of incorporated small and medium-sized businesses, and their tax advisors, were reminded that proactively monitoring and maintaining qualifying small business corporation (QSBC) share status is essential to make many tax-planning strategies possible. There are many traps that may cause the unintended loss of QSBC share status, and when the time comes to take advantage of available tax planning, it can be too late to correct the problem.

QSBC share status is required to take advantage of many useful tax-planning opportunities, including:

• The lifetime capital gains exemption – As of 2021, Canadian-resident individuals have a lifetime limit of $892,218¹ of capital gains that may be realized tax free² on dispositions of QSBC shares.³
• An exclusion from the tax on split income (TOSI) – A capital gain realized by an individual that would otherwise be subject to TOSI, and thus taxation at the highest rate, is afforded an exclusion from TOSI in some cases if it is realized on a disposition of QSBC shares.⁴
• An exclusion from adjusted aggregate investment income (AAII) – The $500,000 federal business limit, which is the basis for the small business deduction, is reduced gradually if the AAII for an associated group of corporations in the prior calendar year exceeds $50,000. It is eliminated completely once AAII reaches $150,000.⁵ AAII includes many forms of passive income, such as interest, dividends and capital gains. However, capital gains on the disposition of QSBC shares are excluded from AAII.⁶
• Certain transfers of businesses between family members – QSBC share status is a necessary requirement of the legislation contained in Bill C-208, which permits transfers of an incorporated business from a parent to a corporation owned by a child or grandchild, and the division of an incorporated business between siblings, which could otherwise be subject to adverse tax consequences. You can read about the requirements and benefits of this new legislation in more detail in our July 20, 2021 Tax Alert. Though the Department of Finance has announced that the legislation contained in Bill C-208 will be amended to some degree on or after November 1, 2021,⁷ many expect the requirement that shares transferred be QSBC shares will remain.

The benefits of ensuring QSBC share status are obvious, but they can be lost in the blink of an eye. There are three main requirements for shares of a corporation to be considered QSBC shares: ⁸

1. The “90% test” – The corporation must be a small business corporation, meaning that it is a Canadian-controlled private corporation and all or substantially all (generally, 90 per cent or more) of its assets must be used principally in an active business carried on primarily in Canada (by the corporation or a related corporation) and/or shares or debt of other connected⁹ small business corporations.
2. The “holding period test” – The shares cannot have been owned by anyone unrelated to the individual shareholder in the previous 24 months. 
3. The “50% test” – Throughout the entire time the individual shareholder owned the shares in the previous 24 months, 50 per cent or more of the assets of the corporation must be used principally in an active business carried on primarily in Canada (by the corporation or a related corporation) and/or shares or debt of other connected corporations that meet these same criteria.

Following are some of the more common traps that may cause the unwary incorporated business owner to run afoul of the rules, with some strategies to help mitigate the risks:

• Excess cash – Large amounts of cash and marketable securities may cause a corporation to fail to meet the 90% test and/or the 50% test. Cash may be considered used in an active business to the extent that its withdrawal would destabilize the business of the corporation.¹⁰ If cash and marketable securities balances are unnecessarily high, or risk becoming so, it would be necessary and/or prudent to remove the excess in any number of ways, including paying off accounts payable or other debt, acquiring inventory or equipment, bringing required tax instalments up to date, or paying dividends.¹¹ This process is often referred to in the tax community as “purification.”
• Loans to shareholders – Sometimes referred to as “shareholder debits,” these generally are not considered assets used in an active business. If a balance exists at any point, it could cause the corporation to fail to meet the 90% test or the 50% test. Best practices to avoid this problem include increasing salaries to the owner-managers, proper budgeting of personal expenses, ensuring personal expenses are not paid for by the corporation, proactively monitoring shareholder loan accounts, and declaring dividends toward the beginning of a year rather than the end of the year in order to create a credit from which to draw.
• Loans to non-connected corporations – These loans generally do not qualify as assets used in an active business for the 90% test or the 50% test and should be either avoided altogether or restructured so that they are made by another related corporation for which QSBC share status is not required.
• Loans to connected corporations – These loans may also be problematic and may cause a corporation to run afoul of the 90% test or the 50% test where the corporations to which the loans are made are not small business corporations or do not meet the applicable asset tests. As with loans to non-connected corporations, these loans should be made by other related corporations that do not require QSBC share status. Alternatively, additional care is required to ensure the connected corporations comply with the applicable rules.
• Mixed-use assets – Assets that have mixed purposes may be problematic. For example, a building of which 40 per cent of the floor space is used in the corporation’s active business while 60 per cent is rented to unrelated parties may not be considered to be used principally in an active business. “Principally” generally means more than 50 per cent, which could jeopardize the QSBC status under the 90% test or the 50% test. Restructuring the business so that the real estate is held in a separate corporation that is not a subsidiary may be a good solution, depending on the circumstances. Alternatively, the situation may require converting rental space to areas used in the corporation’s active business.
• Foreign operations – Whether foreign operations are housed in a subsidiary that is owned by the corporation, or are carried out through a branch and the corporation owns foreign business assets directly, a foreign operation may become problematic for maintaining QSBC share status. The 90% test and the 50% test require that the assets of the corporation must be used principally in an active business carried on primarily in Canada (i.e., more than 50 per cent). Before foreign operations become significant, consider restructuring the holdings so that foreign operations are held in a sister corporation rather than held directly by the corporation or in a subsidiary.
• Holding period test – Issuing shares from treasury or transferring shares between unrelated parties can cause the shares to fail to meet the holding period test if the transactions are done within the 24 months before the time QSBC share status is required.

Avoiding the traps that may cause a loss of QSBC share status requires experience, foresight and regular monitoring of the corporation’s assets. Steps to restore QSBC share status are often possible, but both the holding period test and the 50% test must be met for a full 24 months. If timing of the tax plan is of the essence, then running afoul of either of these tests could cause the loss of the tax benefits of QSBC share status.

If you plan to sell your shares and take advantage of the lifetime capital gains exemption, or if you are undertaking any other planning where QSBC share status is required, prompt attention to these matters is crucial. Your Baker Tilly advisor can help.