Transition to Next Generations
Author: Vern Peters, Tax Advisory Specialist, CPA, CA, Partner
A private member’s bill, Bill C-208, received Royal Assent on June 29, 2021. It is now law in Canada. The bill contained two separate parts that provided for changes to our Income Tax Act (the Act). One change will allow a parent or grandparent (parent) to utilize the capital gains deduction on the sale of shares where the child or grandchild (child) uses a corporation to purchase the shares. The other change will allow siblings in a company to divide a company while using somewhat simpler provisions in the Act. The government has indicated that they will make changes to this legislation to “safeguard against any unintended loopholes that may have been created by Bill C-208.”
Even prior to Bill C-208, you could sell shares of a company to a company owned by and arm’s length party and claim the capital gains deduction. However, the same result could not be accomplished if a parent wanted to perform the same transaction with a child. Transitioning to the next generation was not as tax efficient. Purchasers of shares would prefer to do so in a corporation. This allows them to pay for the shares with after tax corporate dollars rather than after tax personal dollars. Currently in Saskatchewan we have a 9% corporate income tax rate for active business income up to $500,000. With a corporate share purchase, the company has after tax income of $0.91 of every dollar to use to pay for the share purchase. Individual income tax rates vary from 25.5% to 47.5%.
Prior to Bill C-208, the proceeds of disposition would be converted from a capital gain to a taxable dividend where:
- The parent sold shares to a child’s company;
- The parent claimed the capital gains deduction; and
- The parent receive cash or a loan from the child’s company.
Bill C-208 now allows a parent to sell shares to a child’s company without having the proceeds converted to a dividend provided certain conditions are met.
- The purchaser’s corporation is controlled by one or more children who are 18 years of age or older;
- The shares qualify for the capital gains deduction; and
- The shares are not resold within 60 months of purchase.
The capital gains deduction will start to be reduced if the taxable capital of the company whose shares are being sold exceeds $10 million. The capital gains deduction will not be available where taxable capital exceeds $15 million. Taxable capital includes most of the liabilities and equity of a corporation. Short-term liabilities such as accounts payable are not included. Lease obligations are also not included.
The changes made by Bill C-208 should be beneficial for succession planning for our small business clients. The lifetime capital gains deduction for each individual for qualified small business corporation shares is $892,218. This limit will be indexed annually for inflation until it reaches $1 million. Mom and dad can sell up to $1,784,436 of shares to their child’s company, utilize the capital gains deduction and pay no income tax1 on the sale.
The current version of Bill C-208 should also be beneficial for agricultural operations. Many farming operations have higher share values than small business operations. Let’s assume that a farming corporation has share value of $5 million. Mom and dad own the shares 50-50. They think they only need $2 million to retire. The capital gains deduction limit for each individual for qualified farm property is $1 million. The current legislation should allow for a freeze of $5 million of share value. The common shares would be frozen into fixed value preferred shares. Mom and dad could then sell $2 million of the preferred shares to their child’s company. They would use the capital gains deduction and pay no income tax. Again, AMT would need to be considered. Mom and dad could retain their remaining $3 million of preferred shares in case they need access to more funds in retirement. They also could decide now or later to simply gift the shares to their farming child.
The government as stated that they want to make changes to the current legislation. The changes will take effect the later of November 1, 2021 or the date of publication of the final draft changes. They provided the following illustrative list of changes:
- 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 transfer.
The government has indicated that it will bring forward draft changes for consultation. Hopefully the final changes do not affect the farming example we provided previously.
A western Canadian tax law firm has also identified problems with wording in Bill C-208. Hopefully these items are also addressed in the changes.
The other area addressed by Bill C-208 was splitting up a corporation that contained siblings. We commonly refer to these transactions as butterflies. The Act contains two provisions relating to splitting up a corporation. One provision (subsection 55(3)(a)) is for related shareholders, e.g., parent and a child. The other (subsection 55(3)(b)) is for unrelated shareholders. For purposes of 55(3)(b), siblings were previously deemed to be unrelated. Bill C-208 changed the legislation so that sibling shareholders of a company will now be subject to the provision for related shareholders if the shares of the company qualify for the capital gains deduction.
The provisions of subsection 55(3)b) were much more onerous and contained more risk. The legislation itself is not very good. Practitioners rely on interpretations by the Canada Revenue Agency. There are requirements for continuity of assets and shareholders before and after the transaction. Property needed to be distributed prorata according to three different types of property: cash and near cash, business assets and investment assets. There are times when it is unclear which classification a property should have. If the allocation is not done correctly, a significant portion of the transaction could become taxable. The Canada Revenue Agency only allows for a small margin of error. It may also not be possible to utilize price adjustment clauses where the company contains more than one type of property. This is a sampling of the extra requirements of 55(3)(b).
Subsection 55(3)(a) does not contain the onerous elements of 55(3)(b). Performing a butterfly under 55(3)(a) will still require a fair amount of work, but not as much as under 55(3)(b). It should be easier to butterfly a company that has, e.g., only two brothers or sisters as shareholders.
1 One would need to plan for alternative minimum tax (AMT). AMT is a separate calculation that applies when the capital gains deduction is used to remove capital gains from taxable income. AMT paid in one year can be recovered over the next seven years as the individual otherwise has income tax to pay.
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Vern Peters CPA, CA
Tax Advisory Specialist, Partner
Vern works closely with his team specializing in income tax. Our firm has a large agricultural focus, but we also work with many other types of businesses. We specialize in Canadian income tax consulting and implementing income tax plans for private businesses and individuals.