New legislation to ease intergenerational transfers also opens opportunity for tax evasion, warns expert
New legislation aimed at curing a tax-planning imbalance that’s plagued family businesses could have an unintended side effect: allowing unscrupulous business owners a new opportunity to pull the wool over the Canada Revenue Agency’s eyes.
Bill C-208, which received Royal Assent last week, has been widely hailed as a win for owners of small businesses, farms, and fishing corporations across Canada. It addresses a gap in the Income Tax Act that for many years had made it more costly for small business owners to transfer shares of their business to their children than to sell those same shares to an outside party.
But according to Allan Lanthier, a retired partner of an international accounting firm who’s been an advisor to the Department of Finance and the CRA, said the new legislation creates a massive new loophole.
“Under the new rules, an individual who sells shares to a corporation controlled by children or grandchildren who are at least 18 years of age will benefit from capital gains treatment, including the LCGE, provided the purchaser corporation keeps the transferred shares for at least 60 months,” Lanthier explained in a commentary published by the Financial Post.
To illustrate the problem, he gave the example of a female small business owner whose private corporation markets pet food. The corporation is set to earn roughly $1 million over the next half-decade; the woman has no plans to sell the corporation, but wants to access its cash to purchase a villa in France.
Realizing that taking dividends from the corporation would cost her around 48% in taxes, the woman’s accountant hatches a scheme. As Lanthier explained, it starts with the creation of a new company that the woman and her daughter each invest $100 in; the woman gets 100 common shares, while her daughter receives preferred shares that give her voting control.
The mother then sells shares of her pet food-marketing company to the new corporation, in exchange for a promissory note to the effect that the new corporation will pay her $1 million over the next five years.
The woman sees a capital gain from the transaction but, because of her lifetime capital gains exemption, is able to limit the tax hit to less than $30,000. The pet food-marketing corporation pays the new corporation cash dividends totalling $1 million over the next five years from, which is then paid to the woman pursuant to the promissory note. All the while, the woman is still operating the business, while her daughter is not likely to participate in the business as she’s pursuing a medical degree.
“There is only one test for access to the new rules: [the daughter] must control Newco,” Lanthier said. “[She] does, and so her mother’s tax avoidance scheme will almost certainly succeed.”
Bill C-208 could have been stronger, he said, had it followed the example in Quebec. Under a similar provision already in place in the province, various tests must be satisfied to prevent taxpayers from abusing the rules with bogus business transfers.
“The bill has handed tax avoiders a new scheme on a silver platter,” he said. “The Department of Finance says this is a government issue. But … with an election on the horizon and small business votes important, we should not hold our collective breaths waiting for a remedial government announcement.”