By Ted McIntyre, with MNP’s Melissa Aveiro
Succession planning within the family gets a boost
It seemed like an obvious inequity—that you got taxed more harshly if you tried to sell the family business to children or grandchildren than if you conducted a third-party sale. But that was precisely the case—for years—until Bill C-208 came into law late this summer.
As noted by MNP, a leading national accounting, tax and business consulting firm in Canada, “Previously, a longstanding anti-avoidance rule in the Income Tax Act (ITA) treated intergenerational transfers of a business as a dividend rather than a capital gain when the lifetime capital gains exemption (LCGE) was used. Bill C-208 changes that rule to effectively allow access to the LCGE (equal to approximately $225,000 – $250,000 of tax savings per taxpayer) and provide for positive changes around the division of a family business amongst siblings.”
It’s welcome news for the residential construction industry, where the vast majority of companies are family-owned—and intend on keeping it that way for generations to come.
MNP’s Melissa Aveiro, Regional Lead Partner, Tax and Real Estate and Construction, was a presenter at the CHBA’s Tax Changes to Succession Planning for Businesses webinar in September.
OHB: Can you provide an example of the financial impact of C-208?
Melissa Aveiro: “Under the previous legislation, a parent selling shares of their company to their child’s holding company were faced with adverse tax consequences when using their LCGE. The amount of the purchase price received in excess of the cost base of the shares is a capital gain. In a third-party sale, the LCGE could be used to shelter this gain up to the annual capital gains limit, which in 2021 is $892,218. But in the context of the sale from parent to child, this capital gain would be deemed to be a dividend instead and thus taxed at a higher rate than if the parent sold to a third party. With the changes, if certain requirements are met, parents selling shares to corporations controlled by their adult children can now report capital gains and utilize their available LCGE in the same way.
“For example, consider parents residing in Ontario who own a company worth $1.785 million, $892,500 each for mom and dad. Their daughter wants to purchase the shares of the business using her own holding company to facilitate financing of the transaction. Assume both parents have their full LCGE available ($892,218 for 2021) and the cost base of the shares is $100 to each parent from incorporation. Under the old rules, assuming each parent claimed their full LCGE on the sale, they would each have to report a deemed dividend of $892,218 (full amount of capital gains exemption used) and a capital gain of $182 ($892,500 less $100 less $892,218), resulting in total tax owing of approximately $850,000, assuming the dividend is taxed at the highest marginal tax rate of 47.74%.
“Under the new rules, each parent would have a capital gain of $892,400 ($892,500 minus $100), but would be able to shelter this almost fully with their LCGE. In this scenario, there would essentially be no taxes payable, as the gain is almost fully sheltered by the exemption, save for just $182 for each of mom and dad (this does not consider an alternative minimum tax).
“So the ability to use the LCGE when selling to a child facilitates the decision-making process and potentially motivates the business to remain in the family.”
OHB: to leverage the LCGE, shares must be held for at least 24 months prior to sale. But what if you just bought the company and want to transition it?
“That depends on who the shares were acquired from. The ITA provides that the shares must have been owned throughout the immediately preceding 24 months by the selling individual, or a person or partnership related to them. Therefore, if the shares were purchased/acquired from a related person or partnership, they are still eligible for this treatment. Otherwise, the 24-month holding period must be met to meet the tests of the new rules.”
Under the new guidelines, at the time of sale, 90% of the assets must be used in the active business?
“Throughout the 24-month period before a sale, more than 50% of the fair market value of the corporation’s assets must have been attributable to ‘active’ assets. To be an active asset, it must have been used principally in an active business carried on primarily in Canada by the corporation or a related corporation. ‘Principally’ and ‘primarily’ are both generally understood to mean more than 50%. Therefore, an asset must be used by the corporation or a related corporation more than 50% of the time in an active business and that business must be carried on more than 50% of the time in Canada. Then, at the time of sale, the threshold increases to all or substantially all (generally understood to be 90% or more). This means at the time of the sale, 90% or more of the fair market value of the corporation’s assets must be ‘active’ assets.
“If a corporation has met the 50% threshold over the preceding 24 months, but does not meet the 90% threshold, transactions may be undertaken to ‘purify’ it. This entails removing the ‘inactive’ assets prior to sale. For example, excess cash can be used to purchase active assets or prepay business expenses; dividends can be paid to individual shareholders; liabilities can be paid down. There are multiple possibilities and solutions.”
There are still some c-208 clarifications coming?
“Currently it is legislated. However, the Department of Finance announced that it intends to introduce amendments that honour the spirit of Bill C-208 while safeguarding against any unintended tax avoidance loopholes that may have been created by Bill C-208. These amendments could have come as early as Nov. 1. We’re concerned that any changes may result in restrictive legislation that will be difficult to utilize in a family business transition. For example, there are tax rules that apply to just Quebec. These rules have narrow application and many clients are not able to meet the conditions.”
What happens if the parent changes their mind after the fact?
“While the legislation is unclear, the intent of the provisions appear to be that capital gains treatment and the corresponding capital gains exemption will be denied, and instead a ‘deemed dividend’ treatment will be imposed.”
The new legislation pertains to Canadian-controlled private corps, so there needs to be shares involved. But What are a few of the mistakes you see prior to any type of succession planning?
“A couple of points come to mind:
• Assuming that the next generation wants to own and operate the business in the future and not having a conversation with the kids about it. Mom and Dad just assume that their children will want what they wanted.
• Not involving the kids and/or management in the process of succession planning soon enough and then losing these key people.
• Not involving management in the process and also assuming that management will not want to buy the business because the shareholders assume that the employees cannot afford it. There are a number of financial institutions that are willing to finance management buyouts. With proper modelling, management buyouts are a viable option.
• Assuming fair is the same as equal, and then dividing up the business ownership between the children equally. That can be a big issue when some of the children work in the business and others do not.
• And finally, not having a plan B for who the successors are.”
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