Canadian Entrepreneurs’ Incentive: How incentivized will Canadian entrepreneurs be?

Background

Tax proposals contained in the 2024 Federal Budget (the “2024 Budget”) propose to increase the capital gains inclusion rate from one-half to two-thirds:

• for capital gains realized by corporations and trusts on or after June 25, 2024; and
• for the portion of capital gains realized by individuals on or after June 25, 2024 in excess of an annual $250,000 threshold.

As a means to assuage the brunt of the change to the capital gain inclusion rate, the 2024 Budget introduced the new Canadian Entrepreneurs’ Incentive.  For more information on the incentive first announced in the 2024 Budget, see Miller Thomson’s 2024 Budget Summary.

Draft legislation of the new incentive was first released in August 2024 (the “August Draft Legislation”). The purpose of this article is to briefly review the Canadian Entrepreneurs’ Incentive and highlight some of the new changes announced in the August Draft Legislation that are generally designed to broaden the application of the new incentive.

Overview of Canadian Entrepreneurs’ Incentive

The new incentive is applicable to dispositions of “qualifying Canadian entrepreneur incentive property” by eligible individuals that occur on or after January 1, 2025.  The incentive reduces the inclusion rate for capital gains taxation purposes to one-half of the prevailing inclusion rate at the time of disposition. In other words, the incentive provides an eligible individual with a 1/3 inclusion rate on capital gains realized from the disposition of qualifying property. Note that the incentive applies in addition to the lifetime capital gain exemption.

Under this incentive, an individual resident in Canada throughout the year is entitled to access the reduced inclusion rate for up to $2,000,000 of applicable capital gains during their lifetime. The $2,000,000 limit is to be phased in gradually, by $400,000 increments each year (up from $200,000 as first announced in the 2024 Budget), starting January 1, 2025 and ending January 1, 2029 (instead of ending in 2034 as first announced in the 2024 Budget).

Some of the parameters for the disposition of “qualifying Canadian entrepreneur incentive property” include:

• if the property is a share, it must be a share of a “qualified small business corporation.” As such, the shares must be shares of the capital stock of a “small business corporation.” However, unlike the test for the lifetime capital gain exemption, the new incentive specifically excludes an “excluded business”
  • “excluded business” includes professional corporations (lawyers, dentists, physicians, veterinarian, optometrist, engineer, etc.), a corporation whose principal asset is the reputation, knowledge or skill of one or more employees, certain types of businesses (including consulting, a business in the financial, insurance, real estate, food and accommodation, cultural, recreation, or entertainment sector);
• The incentive also applies to the disposition of qualified farm or fishing property;
• The property must be owned by an individual (other than a trust);
• If the property is shares, the individual owned not less than 5% of the issued and outstanding shares (having full voting rights under all circumstances) throughout a period of at least 24 continuous months prior to the disposition. Similar rules exist for interests in a partnership; and
• The property is an interest in a business in which the individual was actively engaged on a regular, continuous and substantial basis in the activities of the business for a total period of not less than 3 years.

Notably, the incentive has been broadened to now apply to business owners (subject to the above tests) and not only founders of a business. This is an important improvement. As well, the minimum ownership requirement is reduced down from 10% to 5%. Another improvement is that the minimum time a business owner must be actively engaged in the business is reduced to any three year period (instead of a five year period immediately prior to the sale).

The August Draft Legislation also includes some anti-avoidance measures where the deduction is sought in circumstances where property is transferred from one corporation to another corporation for consideration that is less than fair market value and an individual realizes a capital gain on the sale of shares of either corporation. Additional anti-avoidance measures include where the capital gain results from the sale of shares where it is reasonable to conclude that a significant portion of the gain is attributable to the fact that dividends were either not paid or deferred on the shares. In the event any of the anti-avoidance provisions apply, the gain will be denied the capital gains deduction otherwise available under this new provision.

The August Draft Legislation does broaden the scope of the new incentive from the measures first announced in the 2024 Budget. While improvements were made, the incentive would likely have broader appeal if the entire $2,000,000 limit were to be available starting in 2025 instead of a phased in approach over 4 years. It will be interesting to see whether any other improvements are made to the incentive as the August Draft Legislation is reviewed. The August Draft Legislation is open for comments until September 11, 2024. It will also be interesting to see how much traction the new incentive will have in terms of spurring investment and the entrepreneurial spirit in Canada.

For more information regarding the new Canadian Entrepreneurs’ Incentive, or how it may apply to a proposed transaction you are considering, please contact a member of the Miller Thomson LLP Corporate Tax group.