An article by PPI’s Planning Services team, a group of lawyers, accountants and actuaries who provide tax and estate planning support to Advisors affiliated with PPI.
The taxation of intergenerational transfers in Canada has been in the news over the last several years. A private members’ Bill, Bill C-208, proposed changes to section 84.1 of the Income Tax Act to exempt certain intergenerational transfers from this anti-avoidance provision (the anti-avoidance rule is intended to prevent stripping surplus out of a corporation as a tax-free return of capital rather than a taxable dividend). The changes proposed in Bill C-208 became law in June 2021 but the Department of Finance had concerns that the rules were too broad and might result in abuse. The Department of Finance announced revisions to the rules in the 2023 Federal Budget, which are more restrictive than the original proposals in Bill C-208 and are contained in the draft legislation of August 4, 2023. The revised rules come into effect on January 1, 2024, so there is a shrinking planning window for those cases in which it may make sense to apply the existing rules.*
Before we discuss the planning options in this changing landscape, let’s review why Bill C-208 was considered necessary.
Bill C-208 – Why did it come about?
The anti-avoidance rules in section 84.1 of the Income Tax Act convert a taxable capital gain into a taxable dividend in non-arm’s length situations if certain conditions are satisfied. Generally, section 84.1 will apply when a taxpayer resident in Canada (that is not a corporation) transfers shares of a Canadian corporation to another corporation on a non-arm’s length basis. These rules are punitive since current dividend tax rates are higher than capital gain rates. In addition, the qualified small business corporation exemption and the qualified farm and fishing corporation exemption would not be available (the exemptions for 2023 are $971,190 and $1,000,000 respectively). This provision therefore hindered the transfer of family businesses to the next generation when the business was sold to a child’s corporation and made it more favorable from a tax perspective to sell to an arm’s length third party corporation.
The revisions announced in the 2023 Federal Budget are meant to address the concern that the exemption from section 84.1 should only apply when there is a “genuine” intergenerational transfer. The rules retain the original requirements that the shares must be that of a qualified small business corporation or a qualified farm and fishing corporation and the purchaser corporation be controlled by one or more children of the transferor. The revisions deal with the concerns that the Department of Finance raised regarding the transfer of control, management, and economic interests to the next generation within certain time frames. When considering this planning, keep in mind that there is an expanded definition of ‘child’ (e.g., can include grandchildren) that should be reviewed before undertaking the planning.
Family Business transfer options proposed in the 2023 Federal Budget
There are two proposed transfer options: immediate and gradual. As the name implies, the gradual transfer option allows more time to transfer the control and management of the business to the next generation.
For the immediate transfer option, the parent must transfer both legal and factual control to the adult child immediately, and the balance of the voting and growth shares must be transferred within 36 months. In addition, the adult child must take over management of the business within 36 months and must retain legal control and work in the business for 36 months following the share transfer.
On the other hand, the gradual transfer option only requires that legal control be transferred immediately with the balance of the voting and growth shares required to be transferred within 36 months. There is an additional requirement under the gradual option that within 10 years of the transfer, the parent must reduce the value of their debt and equity interests in the business to 30 per cent of the value of all their interests at the time of sale (50 per cent of the value for a family farm or fishing corporation). The adult child must take over management of the business within 36 months and must retain legal control and work in the business for 60 months following the transfer.
Under either option, the reassessment period is extended. For the immediate transfer, the reassessment period is extended by 3 years while for the gradual transfer it is extended 10 years. The extension of the period in which CRA can make a reassessment should be considered carefully. There are other aspects of the rules that need to be reviewed before any planning is completed.
Family Business transfer choices: use the existing rules (by December 31, 2023!), the new rules, or another option?
A question for family business owners who want to transfer their business to the next generation is whether they want to complete the planning under the revised rules, under the original rules (by December 31, 2023) that are less restrictive, or under other planning options. The key question to address is how soon the owner wants to give up management and control.
- Two options under the new rules (that become effective January 1, 2024)
- If the transfer of legal and factual control is not a concern for the owner, then the new immediate transfer rules provide a tax efficient succession plan.
- If the transfer of factual control is an issue, then the new gradual transfer option should be reviewed keeping in mind the reduction of debt and equity interests (preferred shares) within 10 years plus the longer reassessment period and the longer period that the child must be working in the business.
- Using the existing rules by December 31, 2023 – If the owner is not ready to give up control, then planning could be completed to fall into the less restrictive existing provisions of the original Bill C-208 which are effective until December 31, 2023. Time is running out to use this option! If this option is to be considered, keep in mind there must be a true intention to transfer the business, as Finance and CRA have stated they will look at transactions that abuse the intent of the rules.*
- Other planning options – If the owner wants to transfer the business gradually, then consider a collateral assignment of a life insurance policy so that an adult child can borrow funds to purchase the shares personally.
Life insurance alternative
Let’s look at the life insurance alternative noted above in the final bullet point. While the changes to section 84.1 make intergenerational transfers more tax efficient, the rules are complex and there may be situations where the parent might not want to transfer control entirely and might want to be involved in the business longer than the proposed revisions to section 84.1 will allow. In these situations, life insurance can be a valuable tool to fund the buyout of the parent. The strategy involves using insurance on the life of the parent(s), that is owned by the child’s holding company, as collateral for a personal loan for the child. The child would use the loan to buy a portion of the parent’s shares (maybe equal to the QSBC exemption). An estate freeze may have to be completed to facilitate this planning. The rules in section 84.1 should not apply since the purchase of the parent’s shares is made by the child personally and not by the child’s holding company, PPI has a technical strategy (TS-130 Using The Capital Gains Exemption in a Family Success Plan) that discusses this planning idea. However, the proposed revisions to the alternative minimum tax (AMT) rules should be reviewed with the child’s professional advisors since the interest paid on the loan would be a tax preference item of which 50% would have to be added back when calculating AMT.
Contact your local PPI Collaboration Centre for more information.
*This is not the case in the province of Quebec where the current rules are more restrictive, however on January 1, 2024, Quebec will harmonize its provincial rules with the new federal rules.
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