If you’re a business owner considering selling, the new Canadian Entrepreneurs’ Incentive (“CEI”) could significantly reduce your tax (if you’re in specific sectors). Starting in 2025, this incentive will lower the capital gains inclusion rate to one-third (instead of two-thirds) for up to $2 million in eligible capital gains over your lifetime. This lifetime limit will increase gradually by $400,000 per year starting in 2025, reaching the full $2 million by 2029 as follows:
| Year | Cumulative Canadian Entrepreneurs’ Incentive |
| 2025 | $400,000 |
| 2026 | $800,000 |
| 2027 | $1,200,000 |
| 2028 | $1,600,000 |
| 2029 | $2,000,000 |
The government released draft legislation in August. In this article, we answer some key questions and discuss what we would like to see ironed out in the final version of the legislation.
Who Qualifies?
The Canadian Entrepreneurs’ Incentive is available where all the following conditions are met:
- QSBC Shares: At the time of sale, the individual Claimant must directly sell qualified small business corporation shares[1]. One requirement is that 90% of the corporation’s value is derived from assets used in an active business carried on in Canada (other than the “excluded businesses” mentioned below).
- 24-Month Holding Period and Minimum Ownership: For at least 24 continuous months before the sale, the claimant must have owned at least 5% of the shares (having full voting rights under all circumstances). The minimum ownership period can be any continuous 24-month period at any time since the business’ founding[2].
- Active Engagement: The claimant was actively engaged in the business activities on a regular, continuous, and substantial basis for three years. This can be any combined three-year period at any time since the founding of the business[3].
Not Available to Which Businesses?
The following are considered “excluded businesses”. If you have capital gains from the sale of the following businesses, you do not qualify for the CEI.
- Professionals: such as accountants, lawyers, notaries, doctors, mental health practitioners, healthcare workers, veterinarians, optometrists, dentists, chiropractors, engineers, or architects.
- Businesses where the main asset is employee expertise or reputation.
- Consulting services.
- Financial Services: handling financial assets, transactions, credit facilitation, or changing ownership of assets.
- Insurance Services: covering underwriting, selling insurance, reinsurance, or related services.
- Property Services: appraising, renting, leasing, selling, or managing real property, including short-term lodging or vacation services, like hotels and campgrounds.
- Food and Beverage: preparing and serving food for immediate consumption.
- Cultural & Entertainment: running events, exhibits, sports, and recreation services, or showcasing historical and artistic interests.
When Does it Take Effect?
CEI would apply to sales that occur on or after January 1, 2025.
What if I Claim the Lifetime Capital Gains Exemption?
The CEI would apply in addition to any available capital gains exemption. To the extent that the seller qualifies for both the lifetime capital gains exemption (LCGE) and the CEI, they can take advantage of both tax incentives. See the example below.
Can I Undertake a Corporate Reorganization to Qualify for CEI?
There are some anti-tax avoidance rules to watch out for.
First, there are rules to prevent using what is commonly known as “butterfly” transactions, where corporate assets are split off or sold to convert the corporate capital gain into a capital gain that qualifies for the CEI.
Second, there are also rules to deny the CEI, where a corporation sells assets to another corporation for less than the fair market value of the assets, and an individual realizes a capital gain on the sale of the shares of either corporation.
Rules to Prevent Converting Dividends to Canadian Entrepreneurs’ Incentive
Normally, dividends are taxed higher than capital gains. Some people might try to avoid paying tax on dividends by setting up shares that don’t pay dividends or pay very low dividends. Instead, they plan to sell these shares later at a high price and claim the CEI. There is an anti-tax avoidance rule that says you cannot claim the CEI if the capital gain you made from selling shares is because the company didn’t pay enough dividends (less than 90% of what would be a normal return on that share). The dividend that should be paid be equal to the rate of return that a knowledgeable and prudent investor would expect to receive.
While this rule aims to prevent tax avoidance, it introduces a level of uncertainty and subjectivity. Determining what constitutes a “normal return” or what a “prudent investor” would expect may lead to inconsistent interpretations. This could create challenges for business owners and shareholders, adding complexity and risk, especially in cases where companies have legitimate reasons for reinvesting profits rather than paying dividends. It raises the question: is the Canada Revenue Agency (CRA) best positioned to make these determinations about what constitutes a reasonable rate of return?
Given the nuanced and varied nature of private business operations, it may be difficult for the CRA to consistently assess what an appropriate dividend payout would be for each business. First, it could discourage reinvestment in businesses requiring growth capital or create uncertainties for entrepreneurs trying to plan for the future. Second, it adds more red tape and work for CRA. As such, we believe that this anti-avoidance rule may not be the most effective approach and would benefit from further clarification or guidelines to provide more certainty and reduce the risk of inconsistent application.
Example: Sale in 2029
In 2029, Larry sells the shares of his tech business for $3 million. Let’s assume that Larry has $1 million remaining in the Lifetime Capital Gains Exemption (LCGE) and that the sale qualifies for the CEI.
After applying his remaining LCGE of $1 million, Larry has $2 million in capital gains left. Under normal rules, with a two-thirds inclusion rate and a $250,000 capital gains allowance at a 50% inclusion rate, $1,291,667 would be taxable. However, with the CEI, the inclusion rate drops to one-third, so only $666,667 is taxable. At Ontario’s top tax rate of 53.53%, this results in estimated tax savings of around $335,000. As you can see the benefit could be significant.
Canadian Entrepreneurs’ Incentive and Family Trust Structure
Please note that these rules are still in draft form at the time of writing, and further clarification may be needed as the legislation evolves.
One notable comparison is with the LCGE, which allows individuals to claim a deduction on capital gains from the sale of Qualified Small Business Corporation (QSBC) shares. If a trust allocates capital gains from such shares to a beneficiary, the beneficiary may claim the LCGE, provided the shares meet the necessary qualification criteria.
In contrast, the CEI, based on the draft legislation, seems to apply more narrowly. It appears to exclude gains on trust-held property from eligibility, meaning that even if a trust allocates the gain to a beneficiary, the CEI deduction may not be claimed. The CEI is reserved for individuals who directly own and sell the qualifying shares. As a result, gains allocated through a trust may not qualify for the CEI, even if the shares themselves would otherwise meet the criteria. This is a key difference from the LCGE, which allows trust-allocated gains to flow to beneficiaries. However, if a trust rolls out shares to an individual beneficiary just before the sale, and the beneficiary sells them directly, the CEI may apply. In this scenario, the beneficiary is considered the direct owner of the shares, and if all CEI conditions are met, they may claim the deduction, avoiding the trust exclusion.
Our Comments on the Daft Legislation
The benefit is good for entrepreneurs. However, we are hoping future versions of the legislation will:
- Address Family Trust Structures: Address issues like trust ownership with more clarity so that entrepreneurs with more complex structures – including family trusts – can qualify.
- Expand the list of qualifying businesses: Under the draft rules, businesses whose “main asset is employee expertise or reputation” are explicitly excluded from CEI eligibility. However, these types of businesses, such as a dental practice or a consulting firm, often assume significant risks and play a key role in Canada’s entrepreneurial ecosystem. A dentist running their practice does not qualify. Similarly, a marketing consultancy or software development firm may also be ineligible because their main assets are tied to the knowledge and skills of their employees. Despite this, these businesses require substantial investment, face market volatility, and carry considerable operational risks. By expanding eligibility to include more “expertise-based” businesses, the CEI could better reflect the entrepreneurial spirit across a broader range of industries, aligning it more closely with the LCGE and supporting a broader range of business owners. One suggestion is to allow businesses exceeding a certain number of employees to qualify (such as more than 5 full-time employees).
- Remove Rules to Prevent Converting Dividends to CEI: Many small businesses reinvest profits instead of paying dividends. These rules introduce unnecessary uncertainty and complexity, potentially discouraging small business owners from utilizing the benefit due to concerns that the CRA may later reverse the claim. The business cannot be cash-rich anyway because of the QSBC test, which requires 90% of the value of the assets to be deployed in an active business. So, this may not be required.
Footnotes:
[1] Note the property could also be qualified farm or fishing property, but we only cover this article in the context of qualified small business corporation shares.
[2] Government announces details on new Canadian Entrepreneurs’ Incentive – Canada.ca
[3] See note 2.
