Section 84.1 of the 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, when their parents wanted to claim the lifetime capital gains exemption on the sale of shares. Parents selling the shares to an arm's length (unrelated) corporation were able to use the capital gains exemption to reduce the income tax on the resulting capital gain on the transaction. However, if the shares were sold to a non-arm's length (related) corporation, such as a corporation owned by the parent's children, for cash or a promissory note, the parents would not have a capital gain and could not use the capital gains exemption. This could result in significant income tax consequences.
The new rules attempt to level the playing field and to alleviate this problem by allowing a sale to non-arm's length purchasers of the shares to result in a capital gain and the ability to use the capital gains exemption to reduce the income tax.
The new rules will require that the purchaser corporation is controlled by one or more children or grandchildren, aged 18 or older, of the vendor and the purchaser corporation does not dispose of the purchased shares within 60 months of the purchase. An independent assessment of the fair market value of the shares must be provided to the Canada Revenue Agency, together with an affidavit signed by the vendor and a third party attesting to the disposal of the shares.
The changes also include a rule intended to reduce the vendor's ability to claim the lifetime capital gains exemption on the sale of shares if the company being sold has taxable capital employed in Canada exceeding $10 million, calculated on an associated group basis (with the ability to claim the capital gains exemption being completely eliminated once taxable capital exceeds $15 million). This is an attempt to ensure the relief only applies to small businesses. However, the reduction to the capital gains exemption may not be effective due to concerns with the language used in the legislation.