This article appears in the June 2023 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
Business owners who want to keep their enterprise in the family have an incentive to accelerate succession planning as the window closes on a permissive period for the capital gains treatment of intergenerational business transfers.
As part of the 2023 budget, the federal government proposed several amendments to the rules introduced in Bill C-208, a private member’s bill that was passed into law in 2021. Those amendments are designed to address gaps in the original legislation that could allow business owners to convert dividends to capital gains without completing a genuine property transfer to family members, also known as “surplus stripping.”
The changes are scheduled to take effect on Jan. 1, 2024, giving taxpayers a limited opportunity to take advantage of the looser C-208 rules.
“If you have a genuine intergenerational transfer and the circumstances are right, you should definitely try to execute before the new rules come into play,” said Kenneth Keung, director of Canadian tax advisory with Moodys Tax in Calgary.
Kurt Oelschlagel, national agriculture tax leader with BDO Canada LLP in Hanover, Ont., also is urging clients considering an intergenerational transfer to bring forward their discussions, even if they ultimately decide not to complete a transaction before the end of 2023.
“We’re telling them to look at this option while it is still there,” Oelschlagel said. “We won’t know what makes the most sense until we’ve had a close look at an individual client’s situation, but there are a lot of conditions attached to the options available next year. Under the current rules, things generally move faster, and the parties get more finality.”
Parents selling shares in a small business, family farm or fishing corporation to their children traditionally have received a raw deal compared with those selling to an unrelated third party, thanks to provisions in Section 84.1 of the Income Tax Act (ITA) that prevent vendors from claiming the lifetime capital gains exemption on transfers to non-arm’s length corporations.
Reforms to put sales to family on an equal footing with sales to strangers have long been a topic of discussion among Canadian tax professionals, said Keung, who explained that the lack of accompanying legislative action may have been due to the difficulty of judging which intergenerational transfers are genuine.
The federal government’s hand was forced in June 2021 by the surprise passage of C-208, which the government felt allowed vendors to claim technical compliance via sales of shares to an adult child with superficial involvement in the business.
Following C-208’s passage, the Department of Finance promised to address the loopholes with its own amendments, which arrived almost two years later as part of the 2023 budget.
Determining how much surplus stripping has gone on since Bill C-208 came into force is difficult, Oelschlagel said, but many advisory firms — including his — have declined to support transactions that appeared to not be genuine intergenerational transfers.
“C-208 certainly could be abused, and I’m sure some people were,” he said.
More aggressive tax planners may have been deterred by the ITA’s general anti-avoidance rule (GAAR), which grants the Canada Revenue Agency (CRA) broad reassessment powers over taxpayers determined to have engaged in an “avoidance transaction,” said MaryAnne Loney, partner with McLennan Ross LLP in Edmonton.
“There are questions as to how GAAR actually applies, but it probably limited how much surplus stripping was done,” she said. “If GAAR wasn’t in play, we would have seen a lot more.”
Following the budget updates, parties to an intergenerational transfer of business must jump through extra hoops to qualify for the exception to Sec. 84.1 created by C-208.
Ahead of a transfer, the new rules require a parent to control the business, either alone or with a spouse. Meanwhile, the acquiring company must be controlled by at least one of their “children” — a definition newly expanded to include nieces, nephews, grandnieces and grandnephews, in addition to children, stepchildren, children-in-law and grandchildren.
In the initial transaction, the parents’ company must transfer a majority of voting shares, as well as at least half of the common growth shares. The remaining shares must follow within three years of the sale.
Further requirements depend on whether the parties opt for an “immediate” or “gradual” transfer of the business.
Under the immediate transfer option, parents cannot hold legal or factual control of the business after the sale has occurred. They then have 36 months to transfer management to their children, who must remain actively involved for the full three years.
By contrast, the gradual transfer option requires parents to only give up legal control at the time of the transaction, allowing them to exercise factual or economic influence over the business after the sale.
Still, within 10 years of the transaction, parents opting for a gradual transfer must reduce their debt and equity interests to, at most, 30% of the value of their interest on the date of the initial sale (50% for fishing and farming corporations). Meanwhile, the deadline to transfer management and the minimum time during which at least one child must remain actively involved are each extended to 60 months.
“These are very workable rules,” Loney said, adding the proposed amendments cleared up much of the confusion associated with the original private member’s bill.
“C-208 was not written by the Department of Finance, and you could tell,” she said.
Oelschlagel, however, has concerns with the rules proposed in the 2023 budget. For example, many businesses will need to reorganize to ensure parents have legal control immediately before the sale.
He said business owners who have executed a partial estate freeze or who own their business with a larger group of family members may fall short of legal control, adding that people in this situation are prime candidates for an early transaction under the current C-208 rules.
“I’m also a little concerned that the government feels it has to tell parents they must transfer management,” Oelschlagel said, suggesting this could have a chilling effect on the level of mentoring and advice that older family members are willing to provide to the younger generation.
“I’m not sure how they’re going to audit that or what criteria they will use to judge whether management has been transferred,” Oelschlagel said.
Keung attributes these kinds of issues to the federal government’s attempt in the new rules to reconcile the differences between intergenerational and arm’s-length transfers.
“They have put in these tests to try to require that a sale to children looks more like a sale to a third party,” he said. “What it really forces business owners to do is to think carefully about whether they’re ready to transition the business to the next generation. Both options require the older generation to step off, but if you’re ready to truly do that, then [the new] rules can work for you.”
Loney anticipates most of her clients will choose the immediate transfer option because the CRA can dig back an additional 10 years into the tax returns of those who select the gradual option.
“I don’t think it’s going to be worth the additional onerousness just to get the advantage of an extra couple of years of parental involvement in the business,” she said.
As of press time, legislation to implement the C-208 proposals in the 2023 federal budget had not yet been tabled.