Excess cash, excess tax – what’s on your balance sheet?

Canadian federal income tax law provides numerous benefits to companies that engage in an “active business”. Whether a particular endeavour undertaken is an “active business” is, of course, a question of fact and depends on individual circumstances. Some scenarios are clearly those of an “active business”, such as the case of manufacturing and production, retail, mining, sales and shipping and receiving. Others are clearly more of a passive nature, such as merely owning real estate and collecting rent on the property, without any substantive management. Many could be considered somewhere in between.

When a company is in fact engaged in an “active business” and all or substantially all of its assets (generally meaning 90% or more) are principally used in that business, the Income Tax Act allows the sale of the shares by an individual shareholder to be free of capital gains tax, up to the individual sellers amount of their lifetime capital gains exemption (provided certain other criteria are met). The Act also allows investment in the shares of said company by registered plans, such as RRSPs, RESPs and RRIFs, providing another means to raise capital. The business may also be eligible to claim the small business deduction and thereby pay tax at a considerably lower combined federal and provincial tax rate.

In order to meet the “all of substantially all” test, however, 90% or more of the assets in the business must be used principally in the active business. This can be an issue when it comes to cash and near-cash instruments, such as short-term deposits and investments in securities. After all, unlike the property, plant and equipment of a company, which are much easier demonstrated to be used to carry on the active business, the cash held by a company may not do anything more than sit untouched and earn interest income.

The courts have generally determined that the question to ask is whether the cash, as any other asset, is actually employed in the business, such that it is put at risk and the withdrawal of such may destabilize the business. Cash to provide working capital and pay for running expenses is an example of this. Merely sitting untouched, however, with a remote possibility that it may have to be drawn upon (as in the case of a need to pay back a long-term loan or advance) will not suffice. If faced with the latter, the cash may have to be withdrawn, with potential tax consequences.

Accordingly, numerous taxpayers have been caught off-guard when they seek to take advantage of the aforementioned benefits, but are denied such on the basis of the asset mix on their balance sheet. While strategies are available to reduce this risk, they are best employed early on, and your balance sheet should be kept a close eye on.

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