A tax-planning win for Canadian family businesses

KPMG Canada’s Dino Infanti explains how newly passed Bill C-208 lifts a longstanding impediment to intergenerational transfers

A tax-planning win for Canadian family businesses

After being passed in the Senate last week following a third reading, Bill C-208 has officially received Royal Assent. The news has been enthusiastically received by different corners of Canada’s small and independent business community – and for good reason.

The bill is designed to address a tax-policy quirk that has held back many owners of farms, fisheries, and other qualified small business corporations from handing their business down to the next generation.

Specifically, individuals who own a Canadian farm, fishery, or small-business corporation and choose to transfer their shares to a corporation controlled by their children or grandchildren – who must be at least 18 years old – have long been exposed to a higher tax bill compared to if they had sold those shares to an arm’s-length third party.

A tilted tax policy

Prior to Bill C-208, intercorporate transfers of shares of a qualified small business from an exiting owner to a corporation controlled by their adult children or grandchildren were liable to trigger certain provisions under section 84.1 of the Income Tax Act.

“These rules have been in place for many years,” Dino Infanti, partner and national leader with KPMG’s Enterprise Tax practice in Canada, told Wealth Professional.  “Because of the disparity in tax treatment between dividends and capital gains, the pre-existing rules have been very painful for many business owners.”

Through the lens of those rules, the CRA essentially viewed intercorporate business share transfers between a taxpayer and a corporation controlled by their adult child or grandchild as a dividend payment to the original elder owner of the shares. But if the shares of the business had gone to an unrelated third party instead, it would have counted as a capital gain.

Since such transfers were regarded as dividends rather than capital gains, many business owners transferring their shares to their descendants were unable to invoke the lifetime capital gains exemption. In 2021, the LCGE amounts to $892,218 for dispositions of qualified small businesses, and is topped up to $1 million for qualified shares of farms and fishing corporations.

Dividends are also taxed at a higher rate than capital gains. Depending on different factors, including whether they’re eligible or non-eligible dividends, the tax rate on them can be up to 22% higher than the rate for capital gains.

“In our experience, families considering these transfers have to address various matters when the owner is exiting the business and think about what the business means to them,” Infanti said. “After-tax income has been a major consideration simply because of how the Income Tax Act viewed intercorporate transfers within families.”

In a tax update covering Bill C-208, KPMG Canada gave the example of an individual living in Ontario who owns a small business, and holds shares of that business in a qualified corporation. The individual wants to retire and transfer their stake in the business to one of their adult children. Unable to buy the business outright, the child wants to acquire the shares using a wholly owned corporation in consideration of a promissory note for the business’s fair market value, which will be repaid in time with the business’s future earnings.

Assuming that the adjusted cost base and paid-up capital both amount to zero, and the parent is subject to the top marginal tax rate, the pre-existing income tax rules would result in their realizing a deemed dividend equal to the FMV that would be subject to a 47.74% tax rate or, for an eligible dividend, a 39.34% tax rate. If the parent had sold the shares to an arm’s length party instead, they would have realized a capital gain that’s subject to a lower 26.76% tax rate, with the potential for further reductions under the LCGE.

Leveling the playing field

“In 2017, the current government started socializing the idea of leveling the playing field for these types of transfers,” Infanti said. “Since then, there have been ongoing discussions on the appropriate legislation to address that imbalance.”

Those conversations led to the development of Bill C-208. As explained KPMG’s tax update, the bill specifies that the transfer of shares from the owner of a qualified small business corporation to a corporation controlled by their adult child or grandchildren should be counted as an arm’s-length transaction, preventing it from getting sideswiped by Section 84.1.

“With Bill C-208, an individual entitled to claim the full lifetime capital gains exemption can sell shares of a qualified corporation and pay no regular income tax; however, alternative minimum tax may apply,” Infanti said. “Compared to the current rules, the difference in tax impact on the family could be north of $400,000, assuming the individual vendor is at the top tax bracket.”

Crucially, the purchaser corporation must hold the subject shares for at least 60 months after it acquires them. If it disposes or sells the purchased shares to a third party within the 60-month window, the CRA will take it as if the original corporate owner of the shares had sold them to the third party who acquired them, and the new relief provision is deemed to have never applied. Of course, Bill C-208 makes an exception for situations where a death forces the premature disposal of the shares.

The bill also leaves open other exceptional cases and potential pitfalls for family businesses. One example, highlighted in KPMG Canada’s tax update relating to the bill, considers the amalgamation of the purchaser corporation belonging to the child or grandchild and the original business owner’s corporation. If that were to happen before the 60-month window expires, it might result in the deemed disposition rules under Section 84.1 being applied.

During deliberations in the Senate, the Finance department also raised concerns that the bill as drafted may be too broad and could let slip some transactions masked as intergenerational transfers. Although certain amendments may follow at some point in the future, the bill received Royal Assent on June 29 and is now law.

“This is very welcome news,” Infanti said. “With the introduction of Bill C-208, business owners will be better able to understand and plan for their retirement, without necessarily having differences in after-tax income affecting their decision to pass the business on to the next generation.”