For Canadian family business owners, many factors go into deciding how to pass the business on to the next generation. When the time comes to retire or exit the business, tax can be a key factor in determining how best to structure the sale.
Previously, under Canada’s Income Tax Act, those who sold the shares of their business to a company owned by their children or grandchildren were taxed at a significantly higher tax rate than if they had sold their business to a purchaser at arm’s length. The result essentially amounted to a tax penalty for keeping the family business in the family.
Now, new legislation to address this long-standing is in effect.
Bill C-208, which received Royal Assent on June 29, levels the tax playing field on the sale of shares of a small business, farm or fishing corporation to a company controlled by the next generation.
In a June 30 statement, senior Department of Finance officials said the federal government proposed to introduce legislation to make the ruling effective January 1, 2022. But on July 19, Finance Minister Chrystia Freeland overruled that decision, ruling that Bill C-208 is now in effect. "The law is the law," she said in a statement.
Prior to the passage of the bill, when small business owners and owners of family farms or fishing corporations sold shares of their incorporated business to a non-family member, the sale was generally considered a capital gain, which may have been eligible for the lifetime capital gains exemption. This option was not available when the sale of shares was to a corporation controlled by a family member.
For example, if the husband and wife who own a successful auto repair company sold shares of their business to a third party, the increase in the value of the company was considered a capital gain for tax purposes. If the shares qualified for the lifetime capital gains exemption, the owner might not be required to pay any regular income tax on the sale.
In contrast, if the parents sold those same shares to a corporation controlled by a daughter or son, they could have been hit with a steep tax bill when they retired or exited the business. Canadian tax law treated the difference between the sale price of the shares and the cost to the owner of those shares as a dividend, rather than a capital gain.
As a result, the business owners would lose out on the capital gain tax treatment and, if they qualified, the lifetime capital gains exemption, and be taxed at the higher dividend rate. Depending on the province they live in, the type of dividend and their overall income, they could have been taxed at a rate of 49 per cent. For example, on a $900,000 sale, the parents’ tax bill would have been a whopping $441,000 more to keep the business in family hands.
Bill C-208 addresses this by amending a section of the Income Tax Act to essentially treat a business owner’s child or grandchild as being at arm’s length from them. Specifically, this amendment considers the business owner and the purchaser of the shares as dealing at arm’s length if:
The company buying the business is controlled by one or more of the seller’s children or grandchildren who are 18 or older; and
The shares must be of a “qualified small business corporation, family farm or fishing corporation.”
There were some concerns expressed that the bill, as drafted, may be too broad and may lack the safeguards needed to ensure it only applies to genuine intergenerational transfers. While the legislation may not be perfect, it was welcome news for many family business owners across Canada.
Now, they can better plan for their retirement, without necessarily having differences in after-tax income affect their decision to pass the business on to the next generation.
– Dino Infanti is partner, national leader, enterprise tax for KPMG LLP in Canada. He is also a member of the family office leadership team at KPMG.
