Overview of Intergenerational Transfers
When transferring a business to the next generation, the most commonly used tax strategy is to implement an estate freeze. An estate freeze will allow the business owner to transfer the business without triggering income taxes. Alternatively, business owners may choose to sell their business to their children or other family members to utilize their lifetime capital gains exemption (“LCGE”) – approximately $892K in tax-free capital gains. Care must be taken in selling a business to family members as the Income Tax Act contains “surplus stripping” rules which prevents the selling parties from extracting cash on such sales.
Passing of Bill C-208
Prior to Bill C-208 being passed, there were two key tax hurdles as it relates to inter-generational transfers:
- Sale of business – on the sale of a one’s business to non-arm’s length corporation (i.e. holding company owned by children or grandchildren), capital gains may be converted into taxable dividends, resulting in a higher tax rate and the inability to use the LCGE.
- Dividing business assets between siblings – dividing business assets or divisions between siblings was previously much more difficult to achieve on a tax-free basis.
Bill C-208, which passed the third reading in the Senate on June 22, 2021, addresses these concerns and provides significant flexibility moving forward to small business owners in regards to inter-generational transfers.
Intergenerational Sale of Business
In general, the proposed legislation allows for a taxpayer to sell shares of a qualified small business corporation (“QSBC”) to a corporation controlled by their children or grandchildren who are at least 18 years of age. Taxpayers that undertake these sales may now be able to benefit from lower-taxed or tax-free capital gains instead of having such sales treated as taxable dividends.
Under the proposed legislation, the above treatment is available if the following conditions are met:
- The shares sold qualify as QSBC shares, or shares of a family farm or fishing corporation;
- The purchaser corporation is controlled by one or more of the seller’s children or grandchildren, who are at least 18 years of age; and
- The purchaser corporation does not dispose of the acquired shares within 60 months of acquiring them.
It is important to note that the ability of the taxpayer to use his or her LCGE is dependent on the taxable capital of the corporation being sold. If the taxable capital exceeds $10 million, the LCGE otherwise available as a result of the above exception is reduced and fully eliminated if the taxable capital is greater than $15 million. This grind-down of the LCGE linked to the taxable capital of a corporation is similar to the current rules in place that limit the use of a small business deduction by a Canadian-controlled private corporation.
Moreover, if the new exception applies and is relied on, the taxpayer must provide the Canada Revenue Agency with an independent assessment of the fair market value of the shares sold, as well as an affidavit signed by both the taxpayer and a third party attesting to the disposal of the shares.
Business Reorganizations Among Siblings
The proposed legislation also impacts reorganizations involving siblings. Generally, a tax-free intercorporate dividend can be re-characterized as a capital gain by the recipient corporation if the dividend is paid in excess of “safe income on hand” allocated to the shares. This recharacterization rule may not be applicable for certain reorganizations if certain exceptions are met, such as a ‘related party exception’. For the purpose of these reorganization rules, siblings were deemed to not be related to each other which meant that siblings were not eligible for the ‘related party exception’.
The new proposed rules provide relief by providing an exception to the deeming rule, so that the siblings would be related and thus, eligible for the ‘related party exception’. The change will allow for more tax efficient and the simpler division of a qualified business among siblings.
These proposed rules are a welcome addition in the small business community as it allows for small business owners to transfer their family business to the next generation in a more tax efficient manner. These rules also provide much needed flexibility in being able to divide business assets between siblings.
It is not yet clear whether these rules will be adjusted further via future amendments since Finance previously expressed concern about the proposed legislation being too broad and not targeted enough to the intergenerational transfers.
Here at Grewal Guyatt LLP, our full line of services includes both tax consulting and business valuation services. Our tax specialist and business valuators work seamless with one another and can analyze the tax impact of these new proposed rules to your business along with the required business valuation for the rules to apply. For more information and assistance with intergenerational business transfers, estate planning and business divisive reorganization, please contact our tax team.