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Family business succession planning

Florence Marino, B.A., LL.B, TEP 

Head of Tax, Retirement and Estate Planning, Individual Insurance, Canada 

Florence Marino, Head of Tax, Retirement and Estate Planning Services, 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. 

Details on how the current rules will be modified.

In 2021, amendments to the Income Tax Act (ITA) were made that facilitated family business succession. The amendments, which you can read about here, were made by a private member’s bill (Bill C-208). It was widely recognized that Bill C-208 was too broad and allowed for transfers that were not genuine intergenerational business transfers. In essence, the rules allowed for the monetization of the available lifetime capital gains exemption and stripping out that amount to a parent or grandparent on the sale of shares in the business to a corporation controlled by a child or grandchild. 

The 2023 Federal Budget proposes more robust rules for family business succession to prescribe the conditions for a genuine intergenerational transfer. The benefit of falling within these rules is that these transfers will be carved out from the anti-avoidance rule (section 84.1) which would recharacterize a capital gain of the seller into a dividend when the sale of shares is to a corporation of the seller’s child. At a high level the new rules prescribe:

  • the requirement to transfer legal and factual control of the corporation carrying on the business from the seller to their child;
  • the level of ownership in the corporation carrying on the business that the seller can maintain for a reasonable time after the transfer;
  • the requirements and timeline for the seller to transition their involvement in the business to the next generation; and,
  • the level of involvement of the child in the business after the transfer.

The proposed amendments are to be effective for transfers initiated on or after January 1, 2024. So, the existing rules with all their holes can still be used with the caution that they would still be subject to review under the general anti-avoidance rule (GAAR), which itself is to be strengthened by proposals made in the 2023 Federal Budget.

An overview of the proposals

Very little of the existing requirements from Bill C-208 will be part of the go-forward rules. Two existing conditions remain: the shares that are sold must be qualified small business corporation (QSBC) shares or shares of a family farm or fishing corporation (QFFC shares), and the seller of the shares must be an individual (other than a trust). 

Two transfer options replace the existing regime: immediate transfer and a gradual transfer. The requirements of these options are discussed below. Where the requirements are met, section 84.1 will not apply to the sale of the shares by the seller and a 10-year capital gains reserve will be allowed so the seller can slowly bring any capital gain into income. 

The proposals also expand those of the next-generation that are eligible to participate in a transfer beyond children and grandchildren to reference the definition of child under subsection 70(10), which would include: great-grandchildren, stepchildren/grandchildren, and children/grandchildren-in-law. Also, the measures specifically include nieces/nephews of the taxpayer, nieces/nephews of a spouse or common law partner, spouses or common-law partners of these nieces/nephews, and grandnieces/nephews. For the remainder of this article, we’ll just use the term ‘child’. 

Transfer the corporation immediately

The immediate transfer option requires that the seller and their spouse/common-law partner (hereafter referred to as spouse) give up legal and factual control over the business immediately after the sale of shares to the Purchaser Corporation. The seller and spouse cannot retain more than 50 per cent of any classes of shares of the Subject Corporation, Purchaser Corporation, or any corporations down the chain from the Subject Corporation. There is an exception for non-voting preferred shares (akin to freeze shares) that are redeemable for no more than the fair market value of the consideration for which they were issued and having a dividend rate that is limited to the prescribed rate at the time of issuance. This option requires that within 36 months, the seller and spouse must not hold any shares other than such non-voting preferred shares in any of the corporations. The seller and spouse are also permitted to retain debt, like shareholder loan receivables.

From the time of the sale and for the next 36 months, the child or group of children must have legal control of the Subject Corporation and the Purchaser Corporation. At least one child must be actively engaged on a regular, continuous and substantial basis in a relevant business of the Subject Corporation or a corporation down the chain from the Subject Corporation during this period. This is the same test that must be met in the context of the tax on split income (TOSI) rules. Each relevant business of the Subject Corporation and any corporations down the chain must be carried on as an active business during this period. 

Within 36 months (or a greater amount of time if reasonable in the circumstances), reasonable steps must be taken by the seller and spouse to transfer management of the business to the active children and permanently cease to manage any relevant business of the Subject Corporation or corporation down the chain.

A relieving provision deems an active child to meet these tests in the event of their death or severe mental or physical impairment. Also, if a child subsequently sells all of the shares of the Purchaser Corporation, the Subject Corporation and all relevant corporations down the chain to an arm’s length purchaser, these tests will also be viewed to be satisfied. In essence, a child may sell to an arm’s length purchaser as long as all shares in all relevant businesses are part of the subsequent disposition. This is different from the Bill C-208 requirement that prevented a sale to a third party by the child within 60 months.

A gradual transition of the business

The requirements for a gradual transfer resemble the requirements for an immediate transfer with some modifications. The gradual option allows for the seller and spouse to retain factual control after the sale, and they have up to 60 months (rather than 36 months) to transition the management of the business to the active child or children. However, with the gradual transfer option, there is a requirement that within 10 years of the sale, the seller and spouse reduce the economic value of debt or equity to a 30 per cent for QSBC shares and 50 per cent for QFFC shares threshold of the fair market value of their interest in the business immediately before the sale. During the latter of 60 months and the time at which the value threshold is met, all of the businesses must be active businesses, at least one child must be actively engaged in one of the businesses per the TOSI test and the children must have legal control. The same relieving provision for an arm’s length sale or death or disability applies in the gradual transfer context. 

For either of the options, a joint election is made by the seller and all children. There is also joint and several liability for taxes payable by the seller if the requirements are not met for these transfer options and section 84.1 applies. The normal reassessment period is also extended by 3 years for immediate transfers and 10 years for gradual transfers. 

Where does life insurance planning fit in?

How does this framework fit with other available options for family business succession? And what does this framework mean for life insurance planning? 

The immediate transfer option allows the seller to continue to hold debt and non-voting freeze shares (so long as the share conditions are as described) indefinitely (with no time limitation for divestiture as with the gradual option). Life insurance to fund the capital gains tax liability in respect of freeze shares or to carry out a redemption of remaining freeze shares, is and always was a source of liquidity on death. The main difference is that in a full freeze, there is no sale of shares to a corporation controlled by the next generation along with other factors discussed above including the transfer of legal and factual control. Rather the freeze shares represent the entire fair market value of the business with new common shares issued to the next generation or a trust for the benefit of the next generation. Often these freeze shares have super-voting rights so that control remains with the founder. 

It is possible that these new intergenerational transfer options may be considered in conjunction with a conventional freeze. However, unlike a conventional freeze, the share attributes under such an intergenerational transfer could not allow the founder to retain control. As a result, where control is important, a traditional freeze can be deployed and where control is not important, there may be an opportunity to integrate these intergenerational transfer options with a traditional freeze. 

These transfer options will allow for monetization of the freezor’s entire value as capital gains (not just the portion representing the lifetime capital gains exemption that can be crystallized on a freeze) as opposed to dividends (as is traditionally the case with wasting freezes). But these options come with specific requirements regarding control and, in the case of a gradual transfer, limitations on the amount of retained value by the seller. 

Where these options are utilized, there is still a need for life insurance to fund any deferred tax liabilities on death of the seller or estate equalization of non-involved children in the succession transaction, and, ultimately in respect of the next generation taking over the business. Understanding the method of family business succession being deployed will assist insurance advisors in understanding the coverage needed, where to hold the insurance, and possibly using sale proceeds to pay premiums.

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