New tax amendments that supports family business succession.
Florence Marino, B.A., LL.B, TEP
Head of Tax, Retirement and Estate Planning, Individual Insurance, Canada
Florence Marino is the Head of Tax, Retirement and Estate Planning Services, and she provides tax, retirement, estate and insurance planning support and consultation to advisors regarding complex cases in the affluent and business markets. She leads a team of professionals providing this type of support and consultation across the country.
Amendments to the Income Tax Act (ITA) effective June 29, 2021 aim to facilitate family business succession. These amendments were made by a private member’s bill (Bill C-208), but there are some flaws in the drafting of this bill, which the Department of Finance (“Finance”) intends to correct effective November 1, 2021 or the date of publication of final draft legislation, if later.
This article describes the problem that Bill C-208 addresses, outlines the concerns of Finance and discusses the insurance opportunities arising from a more permissive set of rules for family business transfers. You can also watch this video to learn more.
The problem: Pre-existing anti-avoidance rules in the ITA prevented family business transfers from being on the same footing as arm’s length transfers
Generally, a sale of shares to a third party is taxed as a capital gain and, if the shares qualify, the vendor can claim the capital gains exemption. An anti-avoidance rule, section 84.1, applies where an individual sells shares of a Canadian corporation to another corporation that is related to the individual. Where it applies, the seller is deemed to receive a dividend instead of a capital gain.
Section 84.1 would apply when a parent sells the shares of a family business corporation to their child’s corporation. The parent’s capital gain on the sale is converted to a dividend and the parent is prevented from claiming the capital gains exemption. If the parent were to sell the shares directly to their child, they would be able to utilize their capital gains exemption to shelter the gain from tax. However, where the child later sold these shares to a related corporation, for cash or cash equivalents, a promissory note or high paid-up capital shares, in the related corporation, the child would face the same dividend tax treatment, to the extent of the parent’s gain.
Financing a buy-out by a child in a tax-effective manner by using the corporation’s retained earnings to satisfy the purchase price was punitive due to the operation of this rule. It effectively penalized families where a child uses a corporation to finance the transaction even where the child is paying what a third party would pay for the shares.
On the other hand, if the parent sold the shares to an arm’s length third party in the same manner as described above, the parent would be taxed at capital gains rates and they could claim the capital gains exemption. It was more tax efficient to sell the family business to a third-party than to sell it within the family, even if on the same terms and using the same structure.
The recent amendments enacted by Bill C-208 carve out intergenerational transfers from the scope of 84.1 by deeming that the vendor taxpayer deals at arm’s length with the purchaser corporation when:
- the corporation is controlled by one or more of the taxpayer’s children or grandchildren
- the children or grandchildren are 18 years of age or older, and
- provided that the purchaser corporation does not dispose of the subject shares within 60 months of their purchase.
What is Finance concerned about and what can we expect to see addressed?
Finance wants to see more robust rules that will identify and prescribe the conditions for a “genuine” intergenerational transfers that will continue to be carved out from the anti-avoidance rule. While still staying within the spirit of the amendments brought in by Bill C-208, these will include:
- The requirement to transfer legal and factual control of the corporation carrying on the business from the parent to their child or grandchild;
- The level of ownership in the corporation carrying on the business that the parent can maintain for a reasonable time after the transfer;
- The requirements and timeline for the parent to transition their involvement in the business to the next generation; and
- The level of involvement of the child or grandchild in the business after the transfer.
Quebec already has a carve-out rule for genuine intergenerational business transfers that is prescriptive. The main criticism of the Quebec rule is that it is too restrictive which effectively means the problem is not solved. There is still a disincentive for intergenerational business transfers.
Insurance opportunities arising from more permissive family business transfer rules
Although there will be changes to the rules governing family business transfers, wherever the rules land, alerting your clients that there may be ways that they can structure the sale of their business and keep it in their family, will involve you in the solution.
Life insurance can be an important part of planning for family business succession. There continues to be a role for life insurance especially where the value of the business exceeds the capital gains exemption or there are other appreciated assets. The sale of a portion of the shares to a holding company can leave the vendor with deferred tax liabilities for any capital gains not covered by the capital gains exemption. Life insurance can fund these deferred tax liabilities and sale proceeds can be used to pay premiums.
Also, where there is existing corporate-owned life insurance and the business can be sold within the family instead of to third parties, the existing insurance does not have to be transferred out of the corporation prior to the sale. This means that there is less chance of ugly tax consequences arising on transfer of a policy if it doesn’t have to move.
And let’s not forget the next generation – the children or grandchildren buying the business. Life insurance on the children can assure that the purchase of the parent’s shares that is financed with debt from the child’s corporation can be completed should the child die prematurely.