Intergenerational business transfers
New tax developments in motion
On June 29, 2021, the Senate approved Bill C-208, which attempts to correct “unfair” income tax impacts that can arise when shares of private businesses are transferred to family members.
Prior to Bill C-208, individuals would generally have been financially incentivized to sell the shares of their business to an arm’s length party rather than to the next generation.
Application of Bill C-208
Bill C-208, a private Member’s bill, makes amendments to the federal Income Tax Act with the intention of neutralizing the income tax impact to a taxpayer of transferring an incorporated business, whether to a related party or to an arm’s length party. Bill C-208 also includes amendments to better facilitate tax-deferred reorganizations of corporations between siblings. Bill C-208 applies to certain transfers of shares of “qualified small business corporations” and “family farm or fishing corporations.”
Comparative example - Prior to Bill C-208
An individual has an incorporated business, the shares of which are considered qualified small business corporation shares. An unrelated third party has offered to purchase the shares from the individual. Alternatively, the individual’s child has expressed interest in purchasing the shares through their holding company. The child’s holding company will issue a promissory note to the individual as consideration and will repay the note over time using future income from the business.
If the shares are sold to the unrelated party
The individual would realize a capital gain. The individual could then use their lifetime capital gains exemption against the capital gain, which would significantly reduce the income tax cost of the sale. For 2021, the lifetime capital gains exemption is $892,218 for qualified small business corporation shares (indexed annually to inflation) and $1,000,000 for qualified farm or fishing corporation shares (not indexed annually to inflation).
If the shares are sold to the child’s holding company
Existing tax rules would deem the individual to receive a taxable dividend rather than a capital gain. This can materially increase the income tax cost of the sale to the individual for two reasons:
- Dividends are generally taxed at higher rates than capital gains. Differences in tax rates will depend on the province or territory; for example, the top personal income tax rate in 2021 on a non-eligible dividend in British Columbia is over 22% higher than the top rate on a capital gain.
- The individual is precluded from claiming the lifetime capital gains exemption because the sale is taxed as a dividend rather than a capital gain.
The example illustrates that families are discouraged from transferring their businesses to the next generation from an income tax perspective, even if the next generation genuinely intends on continuing the business.
Tax relief under Bill C-208
Bill C-208 facilitates intergenerational transfers by excluding the application of the punitive deemed dividend rules on transfers of a qualified small business, family farm, or fishing corporation to a related party, provided that the purchasing corporation is controlled by one or more children or grandchildren over the age of 18, and the purchasing corporation does not dispose of the acquired corporation within 60 months of the transfer.
Using the same example, the Bill C-208 amendments suggest that the individual could now transfer the shares of the business to the child’s holding company and have it taxed as a capital gain rather than being deemed a dividend. The capital gain could then be reduced by the individual’s lifetime capital gains exemption. This effectively achieves the same financial result as a sale to an unrelated third party.
Note that Quebec already has similar provincial tax relief in place for intergenerational transfers; however, the conditions are more stringent than Bill C-208 and generally require the vendors to decrease their activities in the business after the transfer and the purchasers to play an active role in the business going forward.
Proceed with caution
While Bill C-208 is considered law, the Department of Finance announced on July 19, 2021 that it proposes to introduce additional amendments to Bill C-208 in order to prevent abuse of the new tax relief available. They have expressed concern that Bill C-208 may inappropriately facilitate tax-motivated business transfers within families, where there is no intention of having the business carried on by the next generation. Therefore, their amendments will look to address matters not outlined in Bill C-208, such as:
- The requirement to transfer legal and factual control of the corporation from the parent to the children or grandchildren;
- The level of ownership in the corporation that the parent can maintain after the transfer; and
- The requirements and timeline of the transition of the business of the corporation from the parent to the children and grandchildren, and the level of involvement of such children or grandchildren in the business after the transfer.
The Department of Finance has confirmed that any additional amendments would apply as of the later of either November 1, 2021, or the date of publication of the final legislation. This suggests that individuals may still be able to initiate intergenerational business transfers under the less stringent criteria of current Bill C-208 until at least November 1, 2021.
In light of the Department of Finance’s announcement, individuals who are looking to undergo tax planning under Bill C-208 are cautioned to seek professional tax and legal advice and to monitor developments from the Department of Finance before taking any action.
While the tax relief from Bill C-208 can provide an incentive to explore the restructuring of existing business structures, it is important to recognize that business succession is an art and a process. Successful transitions of businesses, whether inside or outside of the family, require purposeful planning beyond just tax minimization. Contact us to discuss and plan for a future transition of your business.