What is the 90% rule for capital gains exemption?

What is the 90% rule for capital gains exemption?

Plain-English definition

The “90% rule” is part of Canada’s Lifetime Capital Gains Exemption (LCGE) for Qualified Small Business Corporation (QSBC) shares. To pass this test at the time you sell your shares, 90% or more of the fair market value (FMV) of the company’s assets must be used in an active business carried on primarily in Canada. In practice, that means passive investments, excess non-operating cash, and non-business-use assets generally need to be minimized or removed before closing.

Why it matters now

• Capital gains inclusion rules have increased in recent years, making the LCGE even more valuable if you qualify.

• If you’re 12–24 months away from selling your Canadian business, you need to plan early so you can clean up balance sheets, document usage of assets, and comfortably pass the 90% active-asset test on closing day.

“As of December 2024, small businesses made up 98.2% of all employer businesses in Canada.” – Source

Who should care

• Founders of Canadian incorporated operating companies (OpCos)

• Professionals using professional corporations (PCs)

• Families using family trusts or holdcos that own OpCo shares and plan to sell

Quick snapshot of the LCGE framework

• 24-month ownership test: Shares must be owned by you (or related parties/partnership) for at least 24 months before the sale.

• 50% active-asset test (over the prior 24 months): Throughout the 24 months before closing, more than 50% of the FMV of the corporation’s assets must have been used in an active business carried on primarily in Canada.

• 90% active-asset test (at sale): At the time of disposition, 90%+ of asset FMV must be used in an active business in Canada.

• If you pass, the LCGE may allow you to shelter a large amount of your gain on QSBC shares from tax.

What this guide covers (and how to use it)

• A step-by-step walkthrough of the 90% test and how it’s applied at closing

• Asset classification: what’s “active” vs. “passive” (and what to do with excess cash)

• Purification moves to get above 90% without tripping anti-avoidance rules

• Timing, crystallization strategies, and coordinating with the 50%/24-month test

• Special cases (holdcos, family trusts, working capital, intercompany items)

• Clear examples and a practical pre-sale checklist you can use with your tax advisor

Ready to turn your proceeds into assets that work harder? If you’re in India, build inflation-resistant savings with 24K digital gold and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

LCGE and QSBC tests: the 90% active-asset rule in context

The three QSBC requirements (how they fit together)

• 24-month ownership test: Shares must be owned by the individual (or related persons/partnership) throughout the 24 months before sale.

• 50% active-asset test: During those 24 months, more than 50% of the FMV of corporate assets must be used in an active business carried on primarily in Canada.

• 90% active-asset test at sale: At the exact moment of disposition, at least 90% of the FMV of assets must be used in an active business in Canada.

What counts as “active business” (high level)

• Operating assets: Inventory, accounts receivable from operations, equipment and machinery, IP used to generate revenue, and operating cash genuinely needed for day-to-day working capital.

• Excluded/passive: Portfolio investments, excess/surplus cash beyond reasonable business needs, loans to shareholders, and investment real estate not used in the active business.

Timing matters

• The 90% test is applied at the instant of closing. A last-minute spike in passive assets (e.g., a large cash receipt parked in treasury bills) can sink eligibility.

• The 50% test applies continuously over the preceding 24 months, so historical balance sheets and usage documentation matter.

Look-through considerations (subsidiaries and related corps)

• If your corporation holds shares or debt of a subsidiary/related corporation, you often “look through” to classify the underlying assets of that entity as active or passive.

• Intercompany receivables/payables and connected-corporation shares need careful review to avoid inadvertently breaching the thresholds.

Practical takeaway

• Start planning 12–18 months ahead. If you’re tracking at 70–85% active assets, you likely need a purification plan (reduce surplus cash, move or eliminate passive investments, settle shareholder loans) to get to ≥90% by closing.

“Shares of a small business corporation generally qualify if, at the time of disposition, 90% or more of the FMV of the corporation’s assets are used principally in an active business carried on primarily in Canada, and the additional 24‑month tests are met.” – Source

– What the 90% test measures: The proportion of asset FMV used in an active business in Canada at the moment of sale. – Why timing matters: The test is applied at closing, while the 50% test runs continuously for 24 months – both must be satisfied. – Common passive-asset traps: Surplus cash, marketable securities, shareholder loans, and investment real estate not used in operations.

Turn your hard‑won sale proceeds into assets that work every day. If you’re in India, start stacking 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

How to measure the 90% test: asset classification and step-by-step audit

Step 1: Map the balance sheet (FMV, not book value)

• Revalue major assets to FMV near closing: real estate, equipment, IP, goodwill, investments, cash.

Step 2: Classify assets: active vs ineligible

• Active: inventory, AR from operations, op cash (reasonable working capital), equipment, software/IP used in production, owner‑occupied real estate.

• Ineligible/passive: marketable securities, excess treasury cash, shareholder/related‑party loans, investment real estate not used by the business.

Step 3: Handle grey areas

• Cash: document a working capital analysis (seasonality, payroll cycles, supplier terms). Excess beyond reasonable needs trends passive.

• Real property: prorate FMV if partially used for the business vs leased out.

• Intercompany holdings: look‑through to underlying assets where applicable.

Step 4: Calculate the percentage

• Active FMV / Total FMV ≥ 90% at the time of sale.

• Re-test immediately pre‑closing (post‑dividends, debt repayments, or asset transfers).

Step 5: Evidence pack for auditors/buyers

• Appraisals, AR/AP aging, cash forecast, board minutes for payouts/transfers, tax opinions where needed.

Common pitfalls that break the 90% test

• Late‑stage treasury buildup after a big contract, personal loans to shareholders, investment portfolios inside OpCo, and properties largely leased to third parties.

“The Lifetime Capital Gains Exemption (LCGE) limit for QSBC shares was increased to $1.25 million for dispositions occurring on or after June 25, 2024, with indexation set to resume in 2026.” – Source

Active vs Ineligible Assets – how to classify and prove it

Asset category	Usually active or ineligible?	Examples	Evidence to keep (FMV/appraisals, working capital memo, usage logs)	Notes (proration/look‑through)
Operating cash	Active (to reasonable needs)	Cash to cover payroll, rent, vendor cycles	13‑week cash flow, working capital memo, board approvals	Excess above needs trends passive
Excess cash/treasury	Ineligible	Term deposits, T‑bills not tied to ops	Treasury statements, purpose memo	Consider dividend or pre‑close payout
Accounts receivable (AR)	Active	Customer invoices from core ops	AR aging, contracts, revenue linkage	Exclude non‑operating/related-party AR
Inventory	Active	Raw materials, WIP, finished goods	Inventory counts, SKU reports	Remove obsolete/consignment items
Equipment	Active	Machinery, servers, tooling	Appraisals, asset register, maintenance logs	Exclude idle/non-business equipment
IP/goodwill	Active (if used)	Patents, software, brand used to earn income	Valuation report, usage documentation	Separate unused/held-for-sale IP
Owner‑occupied real estate	Active (to business use %)	Plant/office used by OpCo	Appraisal, floor plans, utility bills	Prorate by square footage/usage
Investment/leased‑out real estate	Ineligible (unless minor use)	Third‑party leased property	Lease agreements, rent rolls	Prorate if partially owner‑used
Marketable securities	Ineligible	Equity/debt portfolios	Broker statements	Typically passive unless treasury for ops (rare)
Loans to shareholders	Ineligible	Due from shareholder/related party	Loan agreements, ledgers	Repay or settle pre‑close
Shares of subsidiaries (look‑through)	Depends (look‑through)	Shares of OpCo/related corps	Subco balance sheet, asset classification	Classify based on underlying assets’ mix

Turn your hard‑won sale into long-term wealth. If you’re in India, start stacking 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

Purification: moving from 72% active to 90%+ before closing

Goal

• Convert or remove passive assets so that ≥90% of FMV is active at closing – without jeopardizing the 24‑month 50% test.

High‑impact moves (with sequencing)

• Pay down operating debt and trade payables from excess cash.

• Prepay taxes, insurance, or vendor retainers legitimately tied to operations.

• Declare and pay dividends of surplus cash or portfolio investments (mind safe‑income/withholding where applicable).

• Transfer passive investments to a holding company via a tax‑deferred rollover (e.g., s.85 election) where appropriate.

• Sell non‑core investment real estate or convert it to active use (e.g., owner‑occupy or allocate to operations with documentation).

Timing and documentation

• Execute moves well before LOI/closing; retain minutes, appraisals, working capital memos, and tax elections.

Cautions

• Anti‑avoidance/GAAR concerns if steps lack commercial purpose.

• Don’t inadvertently dip below the 50% active‑asset test during the 24 months pre‑sale.

• Related‑party loans and circular funds flows draw scrutiny.

Buyer communication

• Provide a clean, dated balance sheet showing ≥90% active; align with reps & warranties.

Maximize the value of your exit and put your proceeds to work. If you’re in India, start building wealth with 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

Timing tactics and crystallization: locking in LCGE safely

When crystallization is considered

• You currently qualify as QSBC but a future sale could miss the tests (asset mix drifting passive, corporate restructuring ahead, or regulatory changes).

Common crystallization methods (at a glance)

• Trigger a capital gain on a reorganization and claim LCGE to step up ACB, while retaining control (e.g., share exchange/freeze with a holding company; consult counsel).

Key guardrails

• Substantive commercial purpose, avoid value shifting that triggers attribution, confirm AMT exposure, and ensure you don’t taint future eligibility.

Alternatives to crystallization

• Estate freeze, partial secondary sale now, or staged asset deployment to keep ≥90% active.

Professional support

• Always coordinate with a Canadian tax advisor for elections, valuations, and filing (e.g., T657).

Exit tactics compared

Strategy	When to use	Pros	Cons/risks (AMT/GAAR/complexity)	Effect on QSBC tests	Filing/evidence needed
Crystallization	QSBC-qualified today but risk of failing future 50%/90% tests; long runway before exit	Locks in LCGE now; steps up ACB; preserves control	AMT exposure; GAAR if no commercial purpose; valuation/legal costs; may affect future eligibility if structure gets “tainted”	Must qualify at crystallization; future sales still need QSBC tests for any additional LCGE; maintain active-asset mix post-freeze	Valuation report; reorg agreements; board minutes; s.85 election (T2057) if rollover used; T1 Schedule 3; Form T657
Straight sale	Confident of meeting QSBC tests at closing; clean, single transaction	Simpler; immediate liquidity; fewer moving parts	Last‑minute passive buildup risk; no step‑up if fail; heavy diligence	Must meet 24‑month 50% test and 90% test at disposition	Purchase agreement; appraisals; working capital memo; T1 Schedule 3; Form T657
Estate freeze	Succession/wealth transfer; cap founder value and shift growth	Enables LCGE multiplication across family/trust beneficiaries; planning flexibility	Complex; attribution rules; valuation scrutiny; possible AMT on redemptions	Can preserve QSBC if OpCo remains active; track ownership/24‑month periods for successors	Freeze/share terms; valuations; trust documents; s.85 elections as needed; board minutes
Partial secondary	De‑risk by selling a slice now; retain upside for later	Liquidity + diversification; incremental LCGE use; price discovery	Control dilution; each tranche must qualify; AMT possible if gains large	Each closing must meet 90%; maintain >50% active over the whole period; monitor passive drift	SPA(s) per tranche; appraisals; T1 Schedule 3 and T657 each year of sale
Management buyout (MBO)	Transition to team; vendor financing/earn‑outs common	Continuity and cultural fit; flexible structures	Complex financing; VTB notes/earn‑outs; potential passive‑asset complications	Keep OpCo ≥90% active at each tranche; keep vendor notes outside OpCo where possible	MBO agreements; financing docs; valuation; T1 Schedule 3; T657; board minutes
Holdco reorg	Purify OpCo; move passive assets; pre‑sale structuring	Helps OpCo reach ≥90%; asset protection; dividend flow control	GAAR/surplus‑stripping risk if poorly structured; step‑transaction concerns; added complexity	If selling OpCo shares: improves 90% by relocating passive to Holdco; if selling Holdco shares: apply look‑through to connected OpCo assets	s.85 election (T2057); intercompany agreements; updated minute book; valuations; legal opinions

Secure your exit. Grow your wealth. If you’re in India, start stacking 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

Ownership structures, farms/fishing, and holdcos: special rules to know

Holding companies and look‑through

• OpCo–HoldCo structures can still qualify for LCGE if the underlying assets of connected corporations are predominantly active. Apply a look‑through: classify the sub’s assets as if they were held directly by OpCo, document business use, and maintain working‑capital memos.

• Track safe‑income and surplus balances if paying pre‑sale dividends to purify. Poorly structured dividends or redemptions can invite surplus stripping/GAAR scrutiny.

Family trusts and splitting the LCGE

• A properly drafted family trust can allocate capital gains to multiple resident beneficiaries, allowing each to claim their own LCGE (subject to their available limit).

• Watch attribution rules, ensure beneficiaries are Canadian residents in the year of the claim, and maintain 24‑month ownership history for the trust or related parties.

Real‑asset‑heavy businesses

• Separate operating real estate (owner‑occupied, used to earn active income) from investment real estate (leased to third parties). Use proration (e.g., square footage or FMV allocation) where only part of a property is actively used.

• Sale‑leaseback arrangements can accidentally flip an asset from active to investment – structure and document usage carefully.

Farms and fishing businesses

• Parallel LCGE rules historically provided higher lifetime limits for qualifying farm/fishing property. Ensure the property is used principally in a farming or fishing business carried on in Canada and that the 24‑month and active‑use tests are satisfied.

• Ownership structures (family transfers, partnerships, and holdcos) need careful tracing to confirm qualifying use.

Interaction with broader capital gains rules

• Recent inclusion‑rate changes and transitional rules can affect whether you crystallize now or sell later. Model both after‑tax outcomes, especially if part of your gain exceeds the individual annual threshold or involves a corporation/trust.

“Effective June 25, 2024, Canada increased the capital gains inclusion rate to two‑thirds for corporations and most trusts, and for individuals on annual gains above $250,000 – while LCGE‑sheltered gains remain deductible (LCGE limit raised to $1.25 million for qualifying shares).” – Source

Turn your exit into lasting wealth. If you’re in India, start building with 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

Worked examples: do you pass the 90% test?

Example 1 – SaaS company (passes)

• FMV mix: Operating cash justified by 3‑month burn and deferred revenue, core IP used to generate subscription revenue, AR from customers, minimal passive holdings.

• Result: Active FMV / Total FMV = 93% at closing.

Example 2 – Dental practice (borderline)

• Issue: Significant retained earnings parked in passive GICs suppress active ratio to 84%.

• Fix: Repay equipment loans, prepay key vendors/insurance, and dividend out surplus investments.

• Result: Active FMV / Total FMV rises to 91% before closing.

Example 3 – Manufacturing with investment property (fails, then fixed)

• Issue: Plant is 60% owner‑occupied, 40% rented to third parties; brokerage portfolio inside OpCo.

• Fix: Prorate real estate FMV; spin out the 40% investment portion to HoldCo and dividend out brokerage account.

• Result: Active FMV / Total FMV improves from 78% to 90.5% at closing.

What buyers and lenders want to see

• A dated pre‑closing calculation, FMV appraisals, AR/AP aging, working capital memo, and board approvals for any purification steps.

Selling soon? Line up your ducks early. If you’re in India, turn proceeds into 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

Checklist, timeline, and documents you’ll need

12–18 months before sale

• Run a QSBC diagnostic, model active% quarterly, and draft a purification plan.

6–12 months

• Execute asset moves (dividends, debt repayment, rollovers), gather appraisals, maintain working‑capital memo.

0–3 months (pre‑closing)

• Re‑test the 90% ratio, finalize minutes/elections, prepare disclosure for buyer reps & warranties.

Filing after the sale

• Personal return (T1), Schedule 3 for capital gains, Form T657 for the capital gains deduction (LCGE). Retain all support.

Documents to retain

• Valuation/appraisal reports, AR/AP aging, cash forecasts, board minutes, tax elections, legal opinions, and closing balance sheet.

For Indian readers & NRIs

• If you are an India‑based investor or an NRI reinvesting proceeds, diversify into inflation‑resilient assets. Digital gold lets you start small and stay liquid while you decide your long‑term allocations.

Put your proceeds to work the modern way. Start with 24K digital gold from just ₹1 and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

FAQs on the 90% rule and LCGE

1) Does cash ever count as active?

• Yes – cash that’s demonstrably needed for day‑to‑day operations (payroll, supplier terms, taxes, seasonality buffers). Keep a working‑capital memo. Surplus cash beyond reasonable needs trends passive.

2) Can investment real estate ever be active?

• Only the portion directly used in the business (owner‑occupied or operational). Prorate FMV if a property is partly leased to third parties; the leased portion is typically passive.

3) If I’m at 88% active on signing, can I fix this before closing?

• Often yes. Use purification: repay operating debt/payables, prepay bona fide expenses, dividend out surplus cash or portfolio securities, or move passive assets to a HoldCo via a qualified rollover. Re‑test immediately pre‑closing and watch the 24‑month 50% test.

4) Do intercompany loans hurt?

• Frequently yes – they’re often treated as passive unless tightly linked to operations (short‑term working capital, documented business purpose). Clean up or properly document before closing.

5) Do subsidiaries count as active?

• Apply look‑through. Classify the sub’s underlying assets as if held directly. Connected‑corporation shares and intercompany balances require careful analysis.

6) Can each family member claim LCGE?

• Potentially, yes – if each is an eligible shareholder realizing a qualifying gain. Family trusts can help allocate gains to beneficiaries (mind residency, attribution, and 24‑month ownership history).

7) Can I partially sell and still qualify?

• Yes. Each disposition must meet the tests at that exact time. Maintain ≥90% active at closing for every tranche and ensure the 24‑month/50% test holds across the period.

8) What forms do I file to claim LCGE?

• T1 personal return with Schedule 3 for capital gains and Form T657 for the capital gains deduction. Keep appraisals, working‑capital analysis, board minutes, and tax opinions as support.

9) Is this relevant if I’m based in India?

• The 90% rule and LCGE are Canadian. Indian readers with Canadian corporations (or NRIs exiting Canadian businesses) may benefit. For India‑only investing, follow Indian tax rules and keep proceeds liquid and diversified while planning long‑term allocations.

Make your proceeds work harder from day one. Start with 24K digital gold from just ₹1 – and earn free Bitcoin on every purchase. Download the OroPocket app: https://oropocket.com/app

Conclusion: Use OroPocket to turn sale proceeds into inflation-resilient wealth

You now know how the 90% active‑asset rule fits into LCGE eligibility and how to plan purification, timing, and documentation to protect your exit gains. Post‑exit, keep your money working. With OroPocket, you can micro‑invest in 24K digital gold and silver from just ₹1 via UPI – while earning free Bitcoin (Satoshis) as cashback on every purchase. It’s the stability of gold plus the upside of Bitcoin, without the friction.

Why OroPocket today:

• ₹1 entry point and instant UPI payments

• Free Bitcoin on every gold/silver buy

• Gamified rewards (daily streaks, spin‑to‑win, referrals)

• 24K pure gold, 100% insured, RBI‑compliant vault partners

Take charge of your post‑exit plan in minutes. Download the OroPocket app now: https://oropocket.com/app