Does a corporately owned contract affect the small business share test?

How it works

regulated as insurance, in every province

Why this is not an investment

1. 01It is a contract that pays a benefit on death
2. 02It is regulated as insurance under provincial law
3. 03Contractual value and dividends are insurance features
4. 04Presenting it as an investment misdescribes what it is

The definition sits at ITA s.110.6(1) and it is a proportion test. It asks what share of the company's value is tied up in the active business, and it asks the question at more than one point in time and not once.

A share qualifies as a qualified small business corporation share only if, throughout a specified holding period, substantially all of the fair market value of the corporation's assets was used principally in an active business carried on primarily in Canada, and the test also looks back at a moment two years before any determination point. A life insurance contract's cash surrender value sits on the balance sheet as an asset, and unless the insurer's policy is being used in a way that ties directly to the active business, such as securing a loan actually used in that business, it is generally counted among the assets that are not active business assets for this purpose. A company can therefore satisfy the test comfortably in one year and drift offside in another simply because the value inside a contract grew while the active business's own assets did not grow at the same pace.

The look back adds a second layer most owners do not expect. Even a company that is comfortably onside on the day of a sale can fail the test if it was not onside at the earlier reference point the provision uses, which means a temporary buildup of value inside a contract years before a sale is even contemplated can still matter on the day the shares change hands. This is one of the reasons the test rewards a habit of checking and not a single check performed once, close to a transaction.

The cost or the catch

the cost that never appears on a statement

Opportunity cost, and why it stays invisible

1. The value of the alternative you gave up
2. The one real cost that never appears on a statement
3. A comparison is incomplete until the alternative is named
4. Every decision about capital carries one

The problem is discovered on the eve of a sale, With that settled, the next question follows. which is the one moment nothing can be done about it. Fixing composition takes time, and a company that has accumulated quietly for a decade cannot undo that in the month before an offer closes.

The exemption at stake is not a small one to lose. It shelters a defined lifetime amount of capital gain on qualifying shares from tax, and a company found offside on the relevant testing dates can see that shelter denied entirely for the shareholder relying on it, turning what would have been a sheltered gain into one taxed in full. That outcome is not something a lawyer can negotiate away after the fact with the Canada Revenue Agency. The test is applied to the facts as they existed, and by the time a sale is signed those facts are already fixed. A buyer's own counsel typically reviews this question independently as part of due diligence, which means a seller who has not already confirmed the answer is negotiating from a position of not knowing something the other side is actively checking.

Asking your accountant for an annual check of this proportion, and not a check made only as a planned sale approaches, leaves time to correct the asset mix before the window closes. The contract values that check depends on come from whoever currently services the file, and who services my contract now, and how do I have somebody else appointed explains how to find that person. A statement from the insurer showing the contract's current cash surrender value, requested annually and not only when a sale is being discussed, is the single piece of information the accountant needs most to keep this check current.

What varies

The question of whether a given contract's cash value is treated as an active business asset or not can depend on how the contract is used, not only on the fact that a corporation owns it. A contract pledged as collateral for a loan the business genuinely uses in its operations is treated differently from one sitting untouched building value with no connection to any operating activity, and the line between the two is a question of fact your accountant applies to your company's specific arrangement and not a label attached automatically to any corporately owned contract. Should the corporation or the shareholder own the policy covers the broader ownership question this one sits inside, since the share test is only one of several consequences that follow from where a contract sits.

The size of the company relative to the contract also matters enormously. A large operating company with a modest contract may never come close to the threshold that puts the exemption at risk, while a smaller company or a holding structure where value has concentrated inside a contract over many years can find the same contract represents a much larger share of total assets. There is no single dollar figure at which a contract becomes a problem, since the test is always a proportion of that specific company's own balance sheet. A group of associated corporations under common control adds a further layer, since the way assets are distributed among related companies can itself affect the answer, which is a structural question specific enough that it belongs to your accountant rather than to any general description.

Who this matters to most

planning one leaves the other open

Two halves of an owner's retirement

1. 01No pension and no employer match
2. 02Most of the wealth sits in one illiquid asset
3. 03Building assets outside the business
4. 04Arranging an exit that turns the business into money
5. 05Planning only one half leaves the harder one open

This matters most to a shareholder who expects to sell shares, rather than assets, and who is counting on the capital gains exemption to shelter a meaningful part of the proceeds, since that shareholder is the one who loses the shelter if the company is found offside. It matters far less to a company with no realistic prospect of a share sale, where shares will instead pass by will or simply be wound up, since the exemption in question applies specifically to a disposition of qualifying shares.

It also matters more to a company nearing the end of a founder's active involvement, where a sale to a third party or a transition to a family member structured as a share sale is a realistic possibility within a few years, than to one where ownership is expected to remain fixed indefinitely. A company in the first category benefits from treating this check as part of its regular annual accounting cycle, while one in the second can reasonably treat it as a lower priority until circumstances change.

What this page will not tell you

This page does not tell you whether your own company currently qualifies, since that requires a review of your company's actual balance sheet, its history of asset composition and the specific testing dates that would apply to a contemplated transaction. It also does not tell you how to restructure ownership to correct a problem once found, since that is a legal and accounting exercise specific to your corporation's facts.

A CPA who reviews corporate financial statements is the professional positioned to run this test properly and to flag a drift before it becomes irreversible, and a lawyer is the one to involve once a correction to share structure or ownership is being considered. This page describes the mechanism the test applies. It does not replace that review, and it does not advise on whether a corporation should hold the contract at all, own it jointly with an individual shareholder, or restructure ownership in anticipation of a future sale, since those are decisions that turn on facts specific to your company and your family that a general answer cannot see. Nobody can answer this one for you.