New Tax Rules for Family Business Owners In Place…But More Changes Coming
There has been a great deal of confusion coming from Parliament Hill over a Bill intended to reduce the tax bill when a family business is transferred to the next generation. As it stands now, Bill C-208 is law. But the government has announced that it intends to amend the Bill in the coming months in order to avoid unintended consequences. It is important to note however, that the government has already stated that the forthcoming changes would not be retroactive.
Bill C-208 was a private members Bill that corrected an anomaly in the tax code that resulted in business owners paying more tax when selling a company to a family member than when selling to an independent third party. This has created issues for years in cases where parents wanted to transfer the family business to their adult children. When a business is sold to a third party, the seller is able to realize the capital gains on the sale of the shares and potentially apply their Lifetime Capital Gains Exemption (LCGE) (thereby allowing tax-free capital gains), which is currently limited to $892,218. Capital gains are currently taxed at a lower rate than dividends or employment income.
Prior to Bill C-208, when a business was sold or transferred to a family member, section 84.1 of the Income Tax Act treated the transfer as a dividend and did not allow for capital gains to be realized, or for the LCGE to be claimed. This has long been a frustration of business owners when transitioning the business to the next generation. Finance has commented in the past that this resulted in unfair treatment and they would look to correct it.
When Bill C-208 was passed in Parliament in June and received Royal Assent, it changed this section of the Income Tax Act so that the seller and buyer in an intergenerational sale are now considered at arm’s length, so long as the purchasing company is controlled by one or more of the seller’s adult children or grandchildren. On a large transaction the tax savings will be significant. To prevent abuse of this change to the tax code, the purchasing family member(s) must retain ownership of the shares for five years, to ensure the transaction is a bona fide business transfer. There are other restrictions that must be currently met as well, such as the need for an independent assessment of value of the shares and having a signed affidavit related to the sale of shares. If that sounds strange, it is as other sections of the Income Tax Act do not require such an affidavit.
The day after the Bill was passed in Parliament, the Government announced that it would repeal the Bill and that the repeal would be retroactive to July 1st. Thankfully, on July 19th, the Government then issued another statement retracting this proposed course of action. In its place, they confirmed that Bill C-208 is indeed now law (as is normally the case when a Bill receives Royal Assent) and that they intend to amend the law later this year to ensure that the new rules are used solely for a “genuine intergenerational share transfer” of a family business.
Of particular concern to the Government with the current legislation is the potential for “surplus stripping” which involves converting dividends to capital gains without any actual transfer of ownership or control of the business occurring. To close this loophole, the Government intends to address the following elements in the forthcoming draft legislation:
- 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 the transfer.
The draft legislation to amend the Bill will be brought forward for consultation. Importantly, the Government has also indicated that the amendments will NOT be retroactive to July 1st. Instead, the amendments will come into effect on November 1st or the date the final legislation is published, whichever is later. Therefore, the rules as they stand now will be law until that time.
Bill C-208 also amended another anomaly in the tax code which had been adversely affecting siblings who own a business together. In instances where business owners wish to divide the company into separate entities, section 55 of the tax code allowed this transfer to happen on a tax-free basis if the business owners are related. Until Bill C-208 passed, siblings were not considered related in the eyes of Canada Revenue Agency.
There are still many unanswered questions at this point related to what the future draft legislation will look like and what will and will not be allowed. One such question relates to the expansion of which related parties will qualify for enhanced treatment. The current legislation only allows for a sale to an adult child or grandchild, but surely, other related parties should be included as well.
Family business owners planning a transfer of the business to the next generation and related parties should still review the planned structure of the sale to ensure they will benefit from the current and planned changes to the tax code. While the Bill is now law, taxpayers should exercise caution and work with their advisors on any potential such sales to ensure all tests are met and the intergenerational share sale is a genuine business transfer.