Mortgage Blog

A capital gains surplus strip is a tax planning strategy often used by Canadian private business owners to extract corporate surplus (retained earnings) from a corporation at a lower tax rate by converting what would typically be considered dividend income into a capital gain. Since capital gains are taxed at a lower rate than dividends, this can result in significant tax savings.

How It Works:

Corporation with Retained Earnings:

The corporation has accumulated retained earnings that the owner wishes to withdraw.

1. Sale of Shares:

   The business owner (or a related party) sells shares of the corporation, often to a related entity, such as a holding company or a family trust.

2. Capital Gain Realization:

   The transaction is structured so that the proceeds from the sale are treated as a capital gain for tax purposes instead of a taxable dividend.

3. Return of Surplus:

   The purchasing entity may subsequently withdraw funds from the corporation (e.g., by repaying intercorporate debt created during the process) to make the transaction tax-efficient.

4. Accessing Capital Gains Exemptions (if applicable):

5. In some cases, the strategy may be combined with the Lifetime Capital Gains Exemption (LCGE) for qualifying small business shares, which allows individuals to exempt up to a certain amount of capital gains from tax.

Why Use This Strategy?

The primary benefit is to take advantage of the preferential tax treatment of capital gains over dividends:

• Capital Gains: Only 50% of the gain is taxable at the individual's marginal rate.
• Dividends: Dividends are fully taxable, with an adjusted tax credit depending on whether they are eligible or non-eligible dividends.

Risks and Considerations:

1. General Anti-Avoidance Rule (GAAR):

   The Canada Revenue Agency (CRA) closely monitors surplus strip transactions and may challenge them under GAAR if the primary purpose is tax avoidance without a valid commercial purpose.

2. Proper Structuring Required:

   The transaction must be carefully structured to comply with tax laws and avoid unintended consequences like double taxation.

3. Professional Advice Needed:

   Due to its complexity and the potential for CRA scrutiny, professional tax and legal advice are essential when considering a surplus strip.

4. Legislative Changes:

   Tax laws are subject to change, and recent amendments may affect the viability of certain surplus strip strategies.

This strategy is often part of broader succession planning or corporate reorganization and should be implemented only after a thorough consultation with tax professionals.