With thousands of baby boomers due to retire over the next few years, many private companies will need to prepare for their succession. To facilitate business transfers, two new tax measures were incorporated into the Income Tax Act (“ITA”) effective January 1, 2024.
Making intergenerational transfers easier
The first measure aims to make transferring a business to the next generation easier and as tax-efficient as selling to a third party. Historically, it was often less advantageous and more complicated for a shareholder to sell their business to their children than to a third party due to rules set out in section 84.1 ITA. In particular, this anti-avoidance rule recharacterizes as a dividend the capital gains that would otherwise have been realized on the share sale to a corporation not dealing at arm’s length with the vendor, barring a capital gains deduction and access to the advantageous capital gains tax rate.[1]
This rule was initially intended to prevent surplus-stripping transactions, but it also applied to share sales within the same family, making intergenerational transfers more complicated. The tax community has long called for amendments to simplify these transfers.
These amendments, effective January 1, 2024, streamline the transfer of an actively operated business from a parent to one or more of their children, all the while upholding the anti-avoidance rules for surplus-stripping transactions.
There are two different types of transfers:
1. Immediate– akin to a sale to a third party
At the time of the sale, the transferor-parent must transfer to the child or group of children de jure control (i.e., more than 50% of the voting shares) as well as de facto control of the corporation—and any corporation that contributes to the value of the shares sold, and management of each relevant business—in the 36 months following the sale. During this period, the child or children must also retain control of the purchaser corporation and play an active role in business activities.
2. Progressive– akin to a sale in an estate freeze
At the time of the sale, the transferor-parent must transfer to the child or group of children de jure control of the corporation and any relevant corporation, but may retain de facto control. Within 10 years of the sale, the value of the parent’s residual interest (e.g., sale price balance or non-voting preferred shares) must be reduced to 30% (or 50% for family farm or fishing corporations). Management must be transferred to the child or children within 60 months. During this period, the child or children must retain control of the purchaser corporation and play an active role in business activities.
For both types of transfers, the following general conditions must also be met:
- The parent is an individual and not a trust (to avoid multiplying the capital gains deduction)
- The child takes control of the corporation after the sale
- The shares are qualified small business corporation shares or shares of the capital stock of a family farm or fishing corporation
- The parent does not directly or indirectly own 50% or more of a class of shares of the corporation or any relevant corporation after the sale, except for non-voting preferred shares that meet certain criteria (e.g., freeze shares)
- Participating and voting shares are fully transferred to the child or group of children within 36 months, except for non-voting preferred shares
- The parent and the child or group of children make a joint election, in prescribed form
If all conditions are met, the sale of the shares will not be considered to have been made to a corporation not dealing at arm’s length with the parent, thereby avoiding the capital gain being recharacterized as a dividend. This allows the parent to benefit from the capital gains deduction, under certain conditions. Additionally, the period for which the parent can claim a capital gains reserve is extended to 10 years.
This measure provides adult children with the opportunity to structure the acquisition so that part of the sale price is financed by the corporation’s business activities. This was difficult to achieve prior to these new rules.
Simplifying business transfers to employees
The second measure, also in effect January 1, 2024, makes it easier for employees to acquire a business without having to pay for the shares directly when they use an employee ownership trust. While this measure will probably be less widely used than intergenerational business transfers, it certainly presents an attractive option in some industries where continuity and employee engagement are essential.
An employee ownership trust holds the shares of the business for the benefit of employees. It must meet a few criteria for the share sale to constitute a qualifying transfer and benefit from the tax incentives, including:
- The trust is resident in Canada and exists exclusively for the benefit of current or former employees
- The beneficiaries’ equity and income interest is determined equitably, based on hours worked or compensation, with certain limits
- The trustees may not exercise any discretion to act in the interest of a beneficiary or a group of beneficiaries
- At least one-third of the trustees are employees
- All or substantially all of the value of the trust’s property is attributable to the shares of the corporation
For the vendor, the new rules provide a significant tax benefit: a capital gains deduction of up to $10 million for sales of qualifying shares to an employee ownership trust completed between January 1, 2024 and December 31, 2026.
In addition:
- The capital gains reserve period available to the vendor is extended to 10 years to allow an employee ownership trust to pay the proceeds of the share sale over a longer period and support more flexible financing terms.
- A shareholder of a corporation that receives a loan from the corporation is normally required to include the amount of the loan in their taxable income if the loan is not repaid during the year. The repayment period for a loan made to an employee ownership trust is extended to 15 years before the trust is required to include the amount in its taxable income.
- An employee ownership trust is not subject to the deemed disposition rule for all of its assets on its 21stanniversary as long as it continues to qualify as such.
By opting for a transfer to an employee ownership trust, entrepreneurs can ensure a smooth business transfer and boost employee loyalty and engagement, while providing for a tax-efficient transaction.
Advantageous solutions for business successions
These recent tax amendments provide vital solutions for business successions in Canada, simplifying the process and making it more advantageous for both families and employees. They offer entrepreneurs attractive alternatives to selling to competitors or investment funds. This preserves Canadian capital and encourages business stability. It also enables entrepreneurs to plan their succession strategically while providing new buyers with favourable conditions to successfully take over the helm.
This article is intended to provide an overview of these new rules, whose application remains complex. For assistance in analyzing your potential options and planning the purchase or sale of your business, reach out to our tax team specialists.
[1] The capital gains inclusion rate was increased from 1/2 to 2/3 on June 25, 2024.
