Investment Tax Tip: Capital Gains Reserves

Evelyn Jacks

Did you or your clients sell capital property last year?  Did they help finance the purchase?  In that case, it’s important to review how to complete Form T2017 Summary of Reserves on Dispositions of Capital Property, because tax on these capital gains can be deferred for up to 10 years.   Further, if there is a gradual transfer of property under the new intergenerational business transfer rules that begin in 2024, the capital gains reserve provisions will come into play. Here’s a synopsis of the rules, with excerpts from Knowledge Bureau’s Evergreen Explanatory Notes.

Definitions.  A capital gain realized on the disposition of property must be reported by the taxpayer in the year in which the property is sold. This can cause problems in situations where the taxpayer does not receive the full proceeds from the sale in that year. In other words, the taxpayer may not have received all the cash, but is still liable to pay tax on the entire capital gain.

To address this potentially punitive situation, there are specific rules available for claiming a reserve for the amounts not yet due. S. 40(1) provides that reserve may be claimed where an asset is disposed of in one taxation year, but the total proceeds from the disposition are not received until a subsequent taxation year. The reserve is calculated on Form T2017 Summary of Reserves on Dispositions of Capital Property.

However, note that no reserve for uncollected proceeds is permitted in calculating the amount of recapture of capital cost allowance or the amount of income to be recognized on the sale of eligible capital property.

The Reserve Calculation.  The basic calculation is as follows:

Claim a 10 year reserve.  For small business corporation shares, family farm property and family fishing property (for dispositions on or after May 2, 2006), the maximum reserve is for a period of 10 years. The maximum percentage of the gain that may be claimed as a reserve is 90% in the first year, decreasing by 10% each year so that in the tenth year, no reserve may be taken.

Gifts of non-qualifying security (other than an excepted gift) to a qualified done.  It is also possible to claim a reserve for any tax year ending within 60 months after the time a gift of a non-qualifying security is made to a qualified donee. This occurs when a shareholder is not at arm's length with the issuer of the security, such as in the case of the donation of a private company share. In this case a reserve cannot be claimed in the year the donee disposes of the securities, or where the security ceases to be a non-qualifying security.  Also, the reserve cannot be greater than the eligible amount of the gift.

Claim a 5 year reserve.  Other than the above, the maximum reserve is limited to five years for all properties other than small business corporation shares, family farm property and family fishing property (for dispositions on or after May 2, 2006). The maximum percentage of the gain that may be claimed as a reserve is 80% in the first year, 60% in the second, 40% in the third, 20% in the fourth, and in the fifth year, no reserve may be claimed.

Reserves in the year of death.  Normally, no reserve may be claimed in the year of death.  However, if a reserve could have been claimed had the taxpayer not died, and the right to receive the outstanding proceeds is transferred to a surviving spouse or common-law partner (or spouse trust), then an election can be made by filing Form T2069 Election in Respect of Amounts Not Deductible as Reserves for the Year of Death. 

The surviving spouse (or trust) would include the outstanding proceeds in income in the year.  This amount is deemed to be proceeds of disposition of a capital property in that year and the taxpayer may claim a reserve following the normal rules.

What’s New for 2024.  Review newly released Form T2017 Summary of Reserves on Dispositions of Capital Property. Note that new subsection 40(1.2), as proposed in Finance Canada’s explanatory notes to legislation on August 4, 2023, provides a capital gains reserve for intergenerational business transfers for up to 10 years in order to satisfy the conditions of subsection (2.31) or (2.32) of Section 84.1, which is an anti-avoidance rule that prevents an individual from avoiding tax by removing a corporate surplus through a non-arm’s length transfer of shares, instead of reporting a taxable dividend.

Subparagraph 40(1)(a)(iii) provides that the gain otherwise determined on the disposition of a capital property in the tax year may be reduced by a reasonable reserve for proceeds of disposition that are not due until after the end of the year.  That reasonable reserve is calculated at 1/5 or the gain to be included in income each year over a maximum reserve period of five-years. For farmers, a 10 year reserve period is possible.

New subsection 40(1.2) provides an exception to this general rule so that a reserve can be claimed over up to a ten-year period if the conditions in subsections 84.1(2.31) or (2.32), with regard to immediate or gradual intergenerational transfers, are satisfied. These amendments come into force on January 1, 2024.

Make a Big Difference.  From a planning perspective, these rules should be considered in anticipation of capital dispositions under the new calculations for Alternative Minimum Tax (AMT) as well; specifically under Section 127.52 which for AMT purposes increases the capital gains inclusion rate.