What’s Your Tax Issue?: Surplus Stripping

The Tax Issue:

Can I claim the capital gains exemption if I sell my shares to my brother’s company?

The Answer:

This could be the most common question I get on this topic. The capital gains exemption is intended to shelter the gains from the sale of private company shares. The exemption is available to individuals only, up to a lifetime cumulative limit of $750,000. The shares must meet certain tests which are too complicated to get into here. Suffice to say, you would not want to claim the exemption without consulting a tax professional first.

Generally, any sale of shares that qualifies should be eligible for the exemption, even a sale to a non-arm’s length party, such as your brother’s company. However, if you plan on receiving any consideration other than shares, such as cash, forget it.

Let’s cut to the real question. What you are really asking is, “can I get cash out of a non-arm’s length company without paying tax?” What the CRA calls this is “surplus stripping”, and there are rules in place to stop you.

Specifically, the most common anti-surplus-stripping rule in the Income Tax Act is found in section 84.1, which will convert your capital gain into a taxable dividend if you receive cash as part of your proceeds from the sale of shares to a non-arm’s length company.

If you wish to take back shares of your brother’s company as your proceeds, that’s ok, but any subsequent redemption of those shares will be taxed as a dividend.

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