What is the Proposed Canadian Entrepreneur's Incentive (“CEI”)?

Introduction

The Department of Finance Canada (“Finance”) announced the new CEI in its 2024 Federal Budget (the “2024 Budget”). The CEI gives certain owners of eligible businesses access to a reduced capital gains inclusion rate when they sell shares of their business. On August 12, 2024, Finance announced additional changes and released draft legislation in respect of the CEI.  If enacted, the CEI will be added as new section 110.63 of the Income Tax Act (Canada) (the “Act”) and will be available as of January 1, 2025.

Given that the 2024 Budget proposed a general increase of the capital gains inclusion rate from 50% to 67%, the new CEI is, presumably, meant to reduce the impact of this increase on the sale of shares of certain businesses in Canada.

This article provides a short overview of the proposed CEI and the changes announced in August 2024.

Key takeaways

• The CEI will reduce the “inclusion rate” from the proposed two-thirds to one-third on a lifetime maximum of $2 million in eligible capital gains.
• In August 2024, Finance announced certain changes to the CEI, including the elimination of the “founder” requirement, the reduction of the minimum ownership and engagement periods, and the acceleration of the rollout period.
• The CEI’s reduced inclusion rate is applied to gains that exceed the individual’s lifetime capital gains exemption (“LCGE”).
• Individuals are still eligible to claim their reduced capital gains inclusion rate of 50% on the next $250,000 of capital gains, making it possible to claim the CEI, the LCGE, and the new $250,000 exemption on the same share sale.
  

How does the CEI work?

The CEI reduces the inclusion rate to one-third on a lifetime maximum of $2 million in eligible capital gains when an entrepreneur sells their business. Combined with the increased LCGE of $1.25 million announced in the 2024 Budget (up from $1,016,836) and the individuals’ reduced capital gains inclusion rate, entrepreneurs will have preferential tax treatment up to an aggregate $3.5 million when selling all or part of a business once the CEI is fully rolled out.

The CEI limit will increase by $400,000 each year, starting in 2025, until it reaches $2 million in 2029.

Requirements to qualify for the CEI

Proposed subsection 110.63(1) of the Act defines “qualifying Canadian entrepreneur incentive property” as property that:

(a) at the time of its disposition is:

1. a share that would be a qualified small business corporation share (as defined in subsection 110.6(1)), if the words “used principally in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it” in paragraph (a) of the definition small business corporation, in subsection 248(1) were read as: “used principally in an active business (other than an excluded business, as defined in subsection 110.63(1)) carried on primarily in Canada by the particular corporation or by a corporation related to it”, or
2. qualified farm or fishing property (as defined in subsection 110.6(1)).

(b) is, throughout a period of at least 24 continuous months preceding the disposition time,

1. if the property is a share, the individual owned not less than 5% of the issued and outstanding shares (having full voting rights under all circumstances) of the corporation,
2. if the property is an interest in a partnership, the individual’s specified proportion of the partnership for its most recent fiscal period is not less than 5%, and
3. if the property is not described in subparagraph i or ii, the fair market value of the individual’s interest in the property was not less than 5% of the total fair market value of the property; and

(c) is an interest in a business in which the individual was actively engaged on a regular, continuous and substantial basis (within the meaning of paragraph 120.4(1.1)(a)) in the activities of the business for a total period of not less than three years.

As per paragraph 120.4(1.1)(a), an individual is deemed to be actively engaged on a regular, continuous, and substantial basis in the activities of a business in a taxation year of the individual if the individual works in the business at least an average of 20 hours per week during the portion of the year in which the business operates.

Exclusions from the CEI

Exclusions from the CEI underscore the legislative intent to promote technology entrepreneurship.

Similar to the LCGE, a trust is not directly eligible to claim the CEI incentive. However, unlike the LCGE, there does not appear to be a mechanism by which the deduction can be allocated to a beneficiary. In any case, it may be difficult for a beneficiary to meet the actively engaged requirement and to the extent that a beneficiary can meet this requirement, the trustees could consider rolling out the property to such beneficiary prior to disposition (and relying on subsection 110.63(7) as discussed below).

Second, certain “excluded businesses” are not eligible for the CEI. Excluded businesses include:

1. a professional practice[1],
2. a business whose principal asset is the reputation, knowledge or skill of one or more employees,
3. the provision of consulting services,
4. the provision of financial services,
5. the provision of services or instruments relating to insurance,
6. the provision of services relating to property including real property, tangible and intangible property, and rental property,
7. the purchase, sale and rental of real property,
8. the provision of services or sale of goods relating to providing short-term lodging and complementary services to travellers, vacationers and others,
9. the provision of services or sale of goods relating to preparing meals, snacks and beverages, for immediate consumption on or off the premise, and
10. operating facilities or providing services relating to cultural, entertainment and recreational interests.

The August 12 changes to the CEI slightly expand the eligibility of the CEI to include sales of qualified farm or fishing property, as well as additional small businesses including personal care services which were originally mentioned in the 2024 Budget, but most of the original exclusions announced in the 2024 Budget remain.

Full rollout by 2029

In the original proposal, the $2 million lifetime maximum would have been rolled out, starting in 2025, over 10 years (i.e., full rollout by 2034) at $200,000 per year. The August 2024 changes to the CEI accelerate the rollout to allow individuals to maximize their CEI benefits in 5 years (i.e., full rollout by 2029) at $400,000 per year.

2-year continuous holding period

A qualifying CEI property must be a “qualified small business corporation share” (as modified by subsection 110.63(1)) or a “qualified farm or fishing property”. One of the conditions for a share to be a qualified small business corporation share, is that throughout the 24 months immediately before the share was disposed of, no one owned the share other than individual claiming the exception or incentive or, a partnership of which the individual was a member, or a person related to the individual.

Existing subsection 110.6(14) provides certain miscellaneous rules regarding this continuous share ownership requirement that are helpful in many cases. Proposed new subsection 110.63(7) provides similar miscellaneous rules, including:

• an ordering rule that provides that a taxpayer is deemed to have disposed of the shares that are identical properties in the order in which they were acquired;
• rules regarding personal trusts and partnerships which state that the period of time during which subject shares were held by a personal trust of which the individual was a beneficiary or a partnership of which the taxpayer was a member (along with certain other related persons) will be included in determining whether the holding period requirement for the subject shares set out in the definition of qualifying CEI property have been met;
• a rule regarding holding corporations which states that a holding corporation is deemed to be related to any of its shareholders from whom it acquired shares in another corporation in respect of the acquired shares where all or substantially all of the consideration received by a shareholder from the corporation in respect of the acquisition was common shares of the corporation (this ensures that shareholders who held shares that are qualifying CEI property will not disentitle themselves to the capital gains deduction by reason only of the interposition of a holding company between themselves and the qualifying CEI property); and
• a rule that requires a 24-month holding period in respect of newly issued shares, unless: (i) such shares were issued as consideration for other shares; (ii) such shares were issued as part of a transaction or series of transactions in which the person or partnership disposed of all or substantially all of the assets used in an active business carried on by that person or the members of the partnership or disposed of an interest in a partnership where all or substantially all of the partnership's assets were used in an active business carried on by the members of that partnership, or (iii) such shares were issued by the corporation as payment of a stock dividend.

Reporting and anti-avoidance

Individuals who fail to report a disposition of qualifying CEI property in their tax return or fail to file a return for that taxation year within one year following the taxpayer’s filing-due-date will be denied the CEI deduction.

Anti-avoidance rules will apply to prevent the conversion of taxable gains of corporations into exempt capital gains of individuals and the conversion of dividend income into partially exempt capital gains.

Conclusion

The CEI potentially offers significant tax savings for certain entrepreneurs planning to sell their businesses, enabling them to reduce their tax burden and retain more of their capital gains. Proper planning and documentation are essential to ensure full utilization of the CEI and to avoid missing out on substantial tax savings. In particular, similar to the conditions for the LCGE, there are requirements that must be met for a 2year period prior to the date of the sale. Accordingly, it would be prudent to start planning at least 30 months prior to a proposed sale as there may be steps that a taxpayer can take to support the position that  the relevant shares qualify for both the LCGE and the CEI.

About the authors

Kevin Yip is a partner at Fasken. He has a broad income tax practice with expertise in all aspects of domestic and international tax planning, corporate reorganizations, and mergers and acquisitions. Kevin also regularly assists clients in transfer pricing, real estate transactions, corporate financing, and executive compensation plans.
 
Katerina Ignatova is a tax associate at Fasken. Katerina assists clients with a wide variety of tax matters, including income tax.
 
Dongwoo Kim is an articling student at Fasken.

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