A change just made to the Income Tax Act ("ITA") will likely save families significant taxes when transferring their family businesses to the next generation.
Many families want to pass their business to the next generation. However, currently, section 55 and 84.1 of the Income Tax Act often apply to prevent tax-efficient intergenerational transfers. It's been a long-time complaint of those holding qualified small business corporations, farming corporations and fishing corporations that this was unfair — that a transfer to a third party had better tax results than an intergenerational transfer within the family.
Bill C-208 ("the Bill") aims to change that. The Bill recently passed its third reading in the Senate and is expected to receive Royal Assent shortly. It provides exceptions to section 55 and section 84.1.
For background, section 55 deals with "butterfly" reorganizations. This is when shareholders of a corporation seek to divide the corporation's assets between their respective holding corporations. By utilizing a share redemption in the reorganization, the transfer of assets could effectively be treated as a tax-free intercorporate dividend under section 112. The anti-avoidance rule in section 55 applies to most unrelated party transactions and will convert the tax-free intercorporate dividend into a capital gain instead.1 Section 55(5)(e) also deems siblings to be unrelated persons, therefore making it difficult for parents to divide the family corporate business between their children's (siblings) respective corporations.
Section 84.1 is an anti-avoidance rule related to the lifetime capital gains exemption ("CGE").2 An individual/taxpayer disposing of qualified small business corporation shares or shares in a qualified farming or fishing corporation to a purchaser corporation can shield the resulting capital gains tax with their CGE. The CGE is indexed each year, being $892,218 currently. Those who operate qualified farming or fishing corporations have a bumped-up CGE of $1,000,000. However, section 84.1 will deem the transfer to non-arm's length purchaser corporation to be a dividend instead of a capital gain, effectively preventing the application of the CGE for transfers to a family member's corporation.
In the Bill, section 55(5)(e) is amended to deem siblings to be unrelated and dealing at arm's length if the dividend was "received or paid, as part of a transaction or event or a series of transactions or events, by a corporation of which a share of the capital stock is a qualified small business corporation share or a share of the capital stock of a family farm or fishing corporation". This allows siblings to do an unrelated party butterfly of a qualified small business corporation or qualified farming or fishing corporation.
Section 84.1(2) is also amended deem the purchaser corporation to be arm's length if the purchaser corporation is controlled by the taxpayer's adult children or grandchildren and the purchaser corporation does not dispose of the shares for at least 60 months. This would exclude it from the application of section 84.1 and the capital gains from the transfer could then be eligible for the CGE, assuming it met all other criteria.3
While there are still lots of questions regarding how this legislation will be applied and anticipation of some future amendments, this Bill offers long-awaited relief for our clients with family business corporations.
Footnotes
1. The anti-avoidance rule applies to most unrelated party butterflies because, unlike related party butterflies, an unrelated party butterfly must meet several difficult criteria to be excluded from the rule.
2. Section 110.6.
3. For example, the shares disposed were in the capital of a qualified small business corporation or qualified farming or fishing corporation. See section 110.6 for other discrete criteria.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
