TaxMatters@EY: Family Wealth Edition – February 2024

Amit Kalsi and Matthew Mammola, Toronto

In recent years, there has been significant discussion around the transfer of small businesses from owners to family members. On June 29, 2021, a private member’s bill, Bill C‑208, amended Canada’s Income Tax Act with the intention of facilitating intergenerational share transfers between family members.¹

Bill C-208 provided exceptions to existing rules, known as the anti-surplus stripping rules, in the context of transfers of certain shares in a small business or family farm or fishing corporation.

This issue came to light again in the 2023 federal budget, which proposed new amendments to the changes made by Bill C-208, to apply to transactions that occur on or after January 1, 2024. These new amendments were recently included in Bill C-59, which received first reading in the House of Commons on November 30, 2023.²

Let’s take a look at the proposed amendments included in Bill C‑59 and what they mean if you’re looking to transfer your business to the next generation.

Background

The anti-surplus stripping rules are designed to prevent a shareholder, other than a corporation, from using a non-arm’s-length transfer of shares to extract corporate surplus as a capital gain.³

These rules often apply when there is an intergenerational transfer of shares of a corporation. If parents or grandparents transfer shares of a corporation carrying on the family business to a corporation owned by one or more of their children or grandchildren, the anti-surplus stripping rules would apply and could deem the parents or grandparents to have received dividends rather than capital gains.

In the absence of any exceptions, not only would the amounts received by the parents or grandparents be taxed at higher rates because dividends are subject to higher rates than capital gains, but they would also not be eligible for the lifetime capital gains exemption for gains realized on the disposition of qualified small business corporation (QSBC) shares or shares of the capital stock of a family farm or fishing corporation (FFFC).⁴

As a result, until recently, there was a significant advantage to selling shares to an arm's-length buyer rather than to a corporation owned by an individual's children or grandchildren, in that capital gains treatment and potential access to the capital gains exemption were preserved with an arm’s-length sale.

To level the playing field, the federal government introduced special rules in Bill C‑208, effective June 29, 2021, that may in certain circumstances allow an individual to transfer certain shares to a corporation controlled by their adult children or grandchildren without triggering the anti-surplus stripping rules.

This exception operates by deeming the individual transferor to deal at arm’s length with the purchaser corporation and applies only if the subject shares are QSBC shares or shares of the capital stock of an FFFC.⁵ Under this version of the rules, the purchaser corporation had to retain ownership of the shares for a minimum of five years.

On July 19, 2021, the Department of Finance announced plans to introduce further amendments with respect to Bill C‑208 while safeguarding against unintended tax avoidance loopholes Bill C‑208 may have created, such as surplus stripping where dividends are converted to capital gains to take advantage of lower income tax rates without a genuine transfer of the business.

The Department of Finance also provided an illustrative list of issues the proposed amendments would address:

• The requirement for the parent to transfer both legal and factual control of the subjectcorporation to their child or grandchild
• The level of ownership the parent is permitted to maintain in the subject corporation for a reasonable period of time after the transfer of the business
• The timeline for the transfer of the parent’s management of the subject corporation to their child or grandchild
• The required level of involvement of the child or grandchild after the transfer

What are the proposed amendments?

The proposed amendments introduced in the 2023 budget and contained in Bill C‑59 introduce new conditions that must be met both before and after the transfer. These latest changes are largely focused on both legal and factual control — future ownership of the subject corporation, management of the subject corporation, and the level of the children’s control and involvement.

Under the proposed amendments, two approaches can be taken to achieve an intergenerational transfer of the business that involves qualifying shares.

The first option is through an immediate intergenerational transfer, which must be completed within three years of the transaction date.

The second option is through a gradual intergenerational transfer, which can be completed within a period of up to 10 years.

An additional proposed amendment extends the definition of a child for the purposes of an intergenerational transfer. The amended definition includes a niece or nephew of either the taxpayer or their spouse or common-law partner, the spouse or common-law partner of the niece or nephew, or any children of the respective niece or nephew.

Other amendments that have been introduced:

• A transferor is no longer required to give the Minister of National Revenue an independent assessment of the fair market value of the transferred shares or a signed affidavit attesting to the share disposal.
• The grind in the availability of the lifetime capital gains exemption on a qualifying transfer where the subject corporation’s taxable capital employed in Canada exceeds $10 million has been eliminated.

Immediate vs. gradual transfer

Under the proposed amendments, certain conditions must be met on and after the transfer. The rules are complex and the information below is intended only to provide a brief summary of the key requirements of each transfer method.

For each transfer method, the transferor must be an individual, the purchaser corporation must be controlled by one or more of the individual’s adult children, and the subject corporation’s shares must be QSBC shares or FFFC shares. Further, the transferor must not have made use of the exception for a previous disposition of shares in respect of the same business, except if the previous use was made before January 1, 2024.

Control of the business

Under the immediate transfer rules, the parent, together with a spouse or common-law partner, must not have legal or factual control of the subject corporation at any time after the transfer. In addition, the adult children must generally retain legal control of the purchaser corporation for 36 months.

The gradual transfer rules require the parent to transfer legal control immediately, but the parent and their spouse or common-law partner may still retain some factual control until the close of the transaction, which for a gradual transfer may be up to 10 years. The adult children must generally retain legal control of the purchaser corporation for a 60‑month period.

Ownership of the business

Under both the immediate and gradual transfer methods, after the transfer, the parent and their spouse or common-law partner must not own, directly or indirectly, more than 50% of any class of the voting common shares in the subject corporation, the purchasing corporation, or any person or partnership, referred to as a relevant group entity, that carries on an active business at the disposition time that is relevant to the characterization of the subject shares as QSBC shares or FFFC shares. This requirement does not apply to any non-voting, fixed-value preferred shares, meaning that the parent may continue to hold these types of shares indefinitely.

Remaining ownership in the business

Under both an immediate transfer and a gradual transfer, the parent and their spouse or common-law partner must not own, directly or indirectly, any shares of the subject corporation, the purchasing corporation or a relevant group entity after 36 months from the date of the initial transfer. As noted above, non-voting, fixed-value preferred shares are not subject to this requirement.

The gradual transfer may take up to 10 years to complete. Within that period, if the shares of the subject corporation are QSBC shares, the parent’s debt and equity interests in the subject corporation, the purchasing corporation and any relevant group entity must be reduced to a maximum of 30% of the fair market value of the interests they owned at the time of the original sale. This limit is increased to 50% if the subject corporation’s shares are FFFC shares.

Management of the business

Under an immediate transfer, the transfer of management of the subject corporation’s business from parent to child must generally be completed within 36 months of the transfer date. This period is extended to the later of 60 months and the final sale date for a gradual transfer. In this context, management means directing or supervising business activities rather than simply providing advice.

During the transitional period before management of the business has been transferred to the child or a group of children, the child or at least one member of the group must be actively involved in the business on a regular, continuous and substantial basis. For this purpose, active involvement would include a minimum of 20 hours per week of work.

Elections, reassessments and reserves

Under the amended intergenerational business transfer rules, the parent and child or children must sign a joint tax election. This is due on or before the seller’s tax-return filing due date for the taxation year in which the initial disposition occurred.

Under the proposed amendments, the transferor’s normal reassessment period is increased in respect of any intergenerational transfers. For an immediate transfer, the extension is three years, in the case of a gradual transfer, 10 years.

The vendor of the subject corporation may be eligible to claim a capital gains reserve on the transfer of the subject corporation shares. The capital gains reserve has been extended from 5 years to up to 10 years where all conditions of either an immediate or gradual transfer have been met.

Conclusion

The proposed amendments add a layer of complexity when navigating the intergenerational transfer of a business. But they also introduce opportunities for tax efficiency on such a transaction. The amendments are meant to ensure that tax advantages apply only to genuine intergenerational transfers of businesses.

There are two options for taxpayers to apply, each with their own strict rules that must be followed. The optimal choice for your family may not be the same as another’s.

The immediate transfer provides earlier closure to the transaction process, while the gradual transfer allows more time for a parent or grandparent to remain engaged in the business and for the next generation to prepare to take over.

Each option also has a meaningful impact on the normal reassessment period applicable to the transferor.

The amended rules will apply to transactions occurring on or after January 1, 2024.

At EY, we understand how important it is for you to successfully transition your business to the next generation. If you are considering an intergenerational business transfer or would like to understand the potential implications of the proposed amendments in greater detail, please reach out to your EY or EY Law advisor.  

1. Private member’s Bill C-208, An Act to amend the Income Tax Act (transfer of small business or family farm or fishing corporation).
2. Bill C-59, Fall Economic Statement Implementation Act, 2023. For more information on the measures included in this bill, see EY Tax Alert 2023 Issue No. 44.
3. Surplus stripping involves extracting accumulated earnings from a corporation in a manner that does not involve the payment of a dividend to reduce the tax payable on the accumulated earnings.
4. For 2024, the lifetime capital gains exemption limit is $1,016,836.
5. Determining whether shares meet the conditions to be QSBC or FFFC shares involves detailed consideration of the statutory conditions and the facts of the particular situation. Discussion of the definitions is beyond the scope of this article.