The only thing more rewarding than building a successful business is passing it on to the next generation.
The Canadian Federation of Independent Business recently found that 3 out of 4 Canadian small business owners expect to exit their company sometime over the next decade.
To address this impending succession crisis, Budget 2023 introduced two new tax measures for owners transferring their businesses. For family business transfers, the budget put forth a new set of rules with additional conditions that will replace those of Bill C-208. For the transfer of a business to one or more employees, the budget introduced Employee Ownership Trusts (EOTs) for the first time in Canada.
Part One of our Success in Succession series focuses on family business transfers. Keep reading as we discuss the changes proposed in Budget 2023, why they were needed, and how they will affect you and your family. For more on Employee Ownership Trusts, head over to Part Two.
The Problem With the Previous Tax Rules
Until recently, Canada’s tax rules for intergenerational business transfers (IBTs) were complex and often unfair. If you sold your shares of a qualified small business corporation (QSBC) or qualified farm or fishing property (QFFP) to an arm’s-length buyer, such as another company, you could generally claim the lifetime capital gains exemption (LCGE) of up to $892,218 (for 2023) on the gain.
However, if you sold your shares to a non-arm’s-length buyer, such as a corporation owned by your children, you faced a different tax treatment. Instead of a capital gain eligible for the LCGE, the sale would trigger a deemed dividend under section 84.1 of the Income Tax Act (ITA). This meant paying tax at the dividend rate, which is higher than the capital gains rate. Moreover, you were not able to use your LCGE to reduce your tax bill.
In order for the sale to be treated as a capital gain to which the LCGE could be applied, the non-arm’s-length buyer had to purchase the shares personally (not through a corporation). This meant that instead of using after-tax corporate income to finance the purchase, the buyer was forced to use their personal, after-tax cash.
These unfair rules created a tax disadvantage for families wanting to pass their business on to the next generation. The significant inequity between arm’s-length and non-arm’s-length sales discouraged owners from intergenerational business transfers, incentivizing them to sell their businesses to outsiders rather than their children.
Bill C-208: A Partial Solution
To address these issues, a private member’s bill called Bill C-208 was enacted on June 29, 2021. This bill amended the ITA, allowing owners to claim the LCGE when selling their QSBC shares to a non-arm’s-length corporation, provided certain conditions were met.
Bill C-208 was intended to level the playing field between family and non-family business transfers. However, the Department of Finance Canada raised concerns that certain flaws and ambiguities in the bill could lead to surplus stripping.
For example, some owners could use Bill C-208 to sell their business to their children at an artificially low price, claim the LCGE, and then have their children sell the business at a higher price to an arm’s-length buyer shortly after, leading to erosion of the tax base. Other potential pitfalls included:
- Not requiring the seller to transfer legal or factual control of the corporation to the buyer within a reasonable time
- Not requiring the buyer to retain legal control of the corporation for a minimum period or to be actively engaged in the management of the business(es) of the corporation
- Not preventing the seller from retaining an interest in or right to acquire shares of the corporation after the transfer
To combat these issues, Finance committed to amending the rules put forth in Bill C-208, with the goal of improving tax fairness and facilitating intergenerational business transfers, while at the same time eliminating the potential for tax avoidance.
Budget 2023: A Clearer Framework
The Department of Finance’s amendments were recently proposed as part of Budget 2023, ensuring that the tax treatments established in Bill C-208 would apply only “where a genuine intergenerational business transfer takes place”. From Jan 1, 2024, onwards, to qualify as genuine, intergenerational business transfers must meet the following requirements:
- The seller must be an individual resident in Canada who is at least 18 years old
- The seller, either alone or with their spouse, must control the corporation, with no other persons or groups having legal or factual control
- The seller has not already sought an exemption from the application of a deemed dividend
The shares sold must be qualified small business corporation (QSBC) shares, qualified farm or fishing property (QFFP) shares, or a combination of both - The buyer must be a corporation resident in Canada that is controlled by one or more children or grandchildren (or a niece/nephew or a grandniece/grandnephew from 2024 onwards) of the seller who is at least 18 years old
To provide greater flexibility, two distinct transfer options were also put forward, an Immediate IBT (3 year test) and a Gradual IBT (5-10 year test). As well as the requirements listed above, additional conditions were proposed for each of these transfer options:
The new rules are designed to provide more certainty and consistency for taxpayers who want to transfer their businesses to their families while preventing transactions that are not bona fide intergenerational transfers. They also align more closely with international best practices and recommendations from various stakeholders.
Final Thoughts
The 2023 budget introduced significant changes to the tax rules for intergenerational business transfers. These new measures are welcome news for many Canadian entrepreneurs who want to keep their businesses in the family.
By amending and strengthening the tax treatments set forth in Bill C-208, Finance has made it easier and fairer for families to pass their business on to the next generation, with greater flexibility and clearer guidelines. From 2024 onwards, families will have more succession options available to them including the ability to transfer their business to nieces/nephews and grandnieces/grandnephews. The new rules have also helped shut the door on the potential for surplus stripping through tax avoidance and abuse.
If you are considering transferring ownership of your business, you should be aware of these new tax measures and how they will affect you and your family. You should also consult with a qualified tax advisor to help you navigate these complex rules to ensure optimal use and compliance.
Our Advisory team works with corporations of all sizes at every stage of their business transfer. Through tailor-made solutions, we create comprehensive strategies to ensure a successful succession for you, your business, and the generations to come.
