In the 2023 Federal Budget, the federal government proposed changes to the tax rules that provide tax relief to families who wish to transfer shares of small businesses or family farms and fishing corporations to the next generation.
The proposed changes introduce conditions that must be met for the owners of these corporations to be able to sell their shares to a non-arm’s length corporation, such as a corporation owned by the owner’s children, and be able to realize a capital gain on this disposition and benefit from the use of their capital gains exemption to reduce tax on the capital gain.
Challenges under previous tax rules
For years, provisions in the Income Tax Act (ITA) made it difficult for children to use a corporation to buy shares of a small business, family farm or fishing corporation from their parents.
Parents selling their shares to an arm’s length (unrelated corporation) were able to use the capital gains exemption to reduce tax on the resulting capital gain on the transaction. However, if the shares were sold to a non-arm’s length corporation for cash or a promissory note, the parents would not have a capital gain and could not use the capital gains exemption, resulting in significant income tax consequences.
Introduction of Bill C-208
In 2021, a private member’s bill, Bill C-208, was passed into law. It introduced changes to the ITA that partially addressed these concerns to facilitate tax-efficient intergenerational transfers of closely held small businesses, like farming and fishing, to children or grandchildren of the owners.
The main benefit of these changes is the ability of an individual to sell shares to a non-arm's length (related) corporation, such as a corporation owned by the taxpayer’s children, for cash or a promissory note. It also allows individuals to claim a capital gain on the transfer and reduce the gain using the lifetime capital gains exemption where applicable. In other words, when shares qualified under these new rules, it leveled the playing field with the same tax rules applying to non-arm’s length and arm’s length sales.
Key conditions addressed in the revised rules
The new rules were inadequately drafted and raised many questions and uncertainty on how they applied. The Department of Finance stated in July 2021, shortly after Bill C-208 passed into law, that they would be introducing revised rules to address the conditions that must be met to benefit from the changes introduced in Bill C-208, including the following:
- 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
- The level of involvement of the child or grandchild in the business after the transfer
It is proposed that these new rules will be effective for dispositions of shares that occur on or after January 1, 2024. This means that transactions can be carried out under existing rules for the remainder of 2023.
Proposals in the 2023 Budget
As with the current law, the proposals apply only to dispositions by an individual of a qualified small business corporation shares (QSBCs) or shares of a qualifying family farming or fishing corporation (FFFC).
However, the 2023 proposals include additional restrictions to ensure a bona fide transfer of the business occurs, including a transfer of both economic and voting control of the corporation being sold (Opco). Additionally, the purchaser must be a corporation controlled by a family member who will retain economic and voting control of the subject corporation for a minimum period.
This can be achieved by meeting one of two tests – immediate intergenerational or gradual intergenerational business transfer. The chart below summarizes the major elements of the new legislation and these two tests.
Some key points to take note of when referring to the charts:
- The proposed rules expand the qualifying recipients of the businesses to include grandchildren, stepchildren, children-in-law, nieces, nephews, spouses of nieces and nephews, grandnieces, and grandnephews. All of them are referred to as children in the charts below. They all must be at least 18 years old.
- A reference to a spouse in this article includes a reference to a common-law partner.
- In general, reference to specified shares means non-voting, non-convertible preferred shares.
- For simplicity, these charts assume Opco and a purchaser corporation (Purchaseco) but no other business holdings. Other business holdings, such as a subsidiary corporation or partnership interest, could affect the characterization of the Opco shares as QSBC or FFFC shares – they are subject to the same restrictions on control as Opco.
- Although the ITA refers to the transferor of the shares of Opco and their spouse, these taxpayers are referred to as parents in the charts below.
| Prior to the sale | Immediately prior to the sale, parents must control Opco |
|---|---|
| At the time of the sale | At the time of the sale, Purchaseco must be controlled by one or more children of the parents. |
| Immediately after the sale | After the sale, the parents must not control Opco or Purchaseco and must own less than 50% of any class of shares in Opco or Purchaseco (excluding specified shares). |
| Within 36 months of the sale | Within 36 months of the sale and thereafter, the parents cannot own any shares in Opco or Purchaseco (excluding specified shares). |
| Joint election | To obtain capital gains treatment on the disposition of Opco shares, both the parents and the child or group of children who control Purchaseco must sign a joint election for the tax year of the sale. This election makes all parties to the election liable for taxes resulting from the election when the share transfer does not meet future conditions. |
| Subsequent sale of Opco or Purchaseco | Where all the shares of Opco or Purchaseco held by the child or group of children who control Opco and Purchaseco have been disposed of by such child or children, the holding periods of 36 months or 60 months are deemed to be met at the time of such subsequent disposition. |
| Death or disability of active child(ren) | Where the child, or each of the children, who are the active children in the business, have died or have suffered physical or mental impairment, the holding period is deemed to be met at the time of such death or impairment. |
| Capital gains reserve | Where some of the proceeds of the disposition are to be received over time, a capital gains reserve can be claimed. It is possible to spread the gain over up to 10 years, provided the proceeds are received over at least 10 years. |
| Immediate Transfer This is an immediate transfer of voting and economic control. | Gradual Transfer This is an immediate transfer of voting control, and a gradual transfer of economic control. | |
|---|---|---|
| Transfer of control | >After the sale, the parents must not have voting or factual economic control of Opco or Purchaseco. | After the sale, the parents must not have voting control of Opco or Purchaseco. |
| Transfer of economic interest | Within 36 months years of sale, parents cannot own any shares other than specified shares in Opco or Purchaseco. | Within 36 months years of sale, the parents cannot own any shares other than specified shares in Opco or Purchaseco. Within 10 years of sale, in the case of a sale of shares of a QSBC, the fair market value of all interests of the parents in Opco or Purchaseco must be 30% less than such interests at the time of sale. Within 10 years of sale, in the case of a sale of shares of a FFFC, the fair market value of all interests of parents in Opco or Purchaseco must be 50% less than such interest at the time of sale. |
| Transfer of management control to active children | Within 36 months, or such greater time as is reasonable in the circumstances. As yet, no guidance has been provided as to what would be a reasonable time. | Within 60 months, or such greater time as is reasonable in the circumstances. As yet, no guidance has been provided as to what would be a reasonable time. |
| Control retained by purchasing children/group of children | Child or group of children that controlled Purchaseco at the time of sale continue to have voting control over Purchaseco and Opco for at least 36 months after the sale. | Child or group of children that controlled Purchaseco at the time of sale continue to have voting control over Purchaseco and Opco for at least 60 months after the sale. |
| Continuation as an active business | Business(es) of Opco must be carried on for at least 36 months. | Business(es) of Opco must be carried on for at least 60 months. |
| Purchasing children/group of children work in the business | At least one child must be actively engaged on a regular, continuous, and substantial basis for at least 36 months. | At least one child must be actively engaged on a regular, continuous, and substantial basis for at least 60 months. |
How BDO Can Help
For ease of illustration and comprehension, the rules have been presented in a simplified manner in this article. If you are contemplating transferring your business to your children or grandchildren, your BDO advisor can help you understand if these rules could help you and provide tax savings. They can also help to determine whether it is better to have a transaction in 2023 (if possible) to be under the current rules or wait until the new rules are in effect in 2024.