Bill C-208 is law: A welcome change for family owned businesses and farm corporations

Tax changes eliminate an unfair tax burden that has frustrated family business and farm succession plans for many years

Sean Rheubottom, B.A., LL.B., TEP

In June, 2021 a private members’ bill, Bill C-208, was passed in the House of Commons and the Senate. On June 29 it received Royal Assent and became law. Bill C-208 brings welcome changes to certain tax rules that have long stood as impediments to family business and farm succession plans.

One of the changes affects section 84.1 of the Income Tax Act . This change is particularly interesting in family succession planning, as it creates new planning opportunities and possibly opportunities to revise existing buy-outs already in progress. One aspect of section 84.1 has for many years made the transition of business ownership within families more expensive and difficult than a sale to an unrelated person, but this is now changing.

Immediately responding to the passing of the legislation into law, the federal Department of Finance voiced concerns about the potentially broad application of the rules to include tax avoidance transactions that fall outside the true intention of the new rules, which is to facilitate genuine intergenerational transfers of businesses and farms. Finance proposed to introduce legislation to clarify that these amendments would apply only at the beginning of the next taxation year, starting on January 1, 2022. Finance later clarified that Bill C-208 did become law when it received royal assent on June 29, 2021 and is currently the law. Finance announced that amendments will be brought forward and apply as of the later of either November 1, 2021, or the date draft legislation is complete.

The planning opportunity

Let’s say Dad wants to sell his business to Son, but Dad wants to sell (not redeem) shares and use Dad’s capital gains exemption ($892,218 in 2021, indexed thereafter until it reaches $1,000,000). Perhaps Dad wants to structure it this way because he wants to maximize his estate to provide for other beneficiaries under his estate plan.

For many years, the reality that Dad and Son had to face was that Son would have to buy the shares personally, not through Son Holdco. Son would have to receive personal compensation from the business, paying tax on salary or dividends, and then use his after tax funds to pay off his debt to Dad or the bank.

It would have been nice to have Son Holdco buy the shares instead. Son Holdco could receive tax-deductible dividends from the family business (if sheltered by “safe income” - an issue that will not be discussed right now), or perhaps Son Holdco would generate business income through the family business, and then the after-tax cash could be used by Son Holdco to pay Dad for the shares, or pay off the bank loan. There’s a great tax advantage in that case – only 9%[1] has been lost to tax by the corporation (compared to tax as high as 47.5% if Son is paying with his personal after-tax dollars). Even if Son were compensated with dividends, eligible or non-eligible, a very similar amount is lost by the business and Son in total.

To summarize: With the Holdco option, Son gets to pay off the debt to Dad or the bank out of 9%-taxed income rather than out of 47.5%-taxed income. The big win is the reduced cost and time to repay the debt. And Dad could still use his capital gains exemption to shelter the sale price from tax.

The tax problem: section 84.1

This is where the former section 84.1 stepped in and changed the result so that Dad would be deemed to have received a taxable dividend rather than a tax-free capital gain. (Section 84.1 can also work in other ways that are not discussed here.) Even if the shares being purchased by Son Holdco have high “adjusted cost base” (ACB) from a past use of the capital gains exemption by some other non-arm’s length person, 84.1 would treat this ACB as “soft” or non-existent and furthermore would deem the cash or note to Dad to be an immediate taxable dividend.

This is why many family succession plans have been structured as a post-freeze redemption of Dad’s shares. Dad could “freeze” to create a class of preferred shares that don’t grow in value. Then, Son works a little harder in the business to generate after tax business income to buy Dad out with taxable dividends that gradually eliminate Dad’s shares. Dad loses some tax on the dividends and doesn’t get a capital gains exemption. The dividends have to be sufficient to fund Mom and Dad’s lifestyle and estate planning objectives. The capital gains exemption could only come into play if shares were being sold to an arm’s length (unrelated) purchaser. It always seemed so unfair.

The solution

But no longer, under the new rules. Son can now use his Holdco to buy Dad’s shares as described above, and Dad can use his capital gains exemption. Just like unrelated people could always do.

We need to be cautious and see what the upcoming amendments will say, but that’s the gist of it.

Perhaps there are some existing situations in which a Parent and a Son or Daughter recently agreed that Parent needs the capital gains exemption, so Son or Daughter will just have to accept using their after-tax personal dollars to pay out Dad.  Maybe there will be opportunities here or there to revise an existing buy-out arrangement to take advantage of the new rules, using the CGE and the more efficient funding of the purchase price.

Purification

Additional planning may be needed to ensure that the capital gains exemption is available. Such planning may include “purification” to ensure that the shares meet the definition of shares of a “small business corporation” at the time they are sold. This basically means that 90% or more of the corporation’s assets, by value, must be assets used in the active business. Furthermore, a 50% active asset test must have been met for a period of up to two years prior to the sale. In a tiered Holdco-Opco structure, the 50% test is more stringent and may require one or the other of the corporations to meet a 90% test at all times.

 If the 50% test has been satisfied, it may be possible to purify to the 90% level and immediately qualify for the capital gains exemption. There may be some situations in which the capital gains exemption has never been considered, and maybe creditor protection was not considered either, resulting in a lot of non-business assets (investments, vacation properties, condos, etc.) in the corporate structure.

Purification transactions often involve the use of intercorporate dividends to move assets, so other complex “anti-stripping” rules need to be carefully considered.

[1] (9% in SK in 2021, increasing to 11% over the next couple of years)

© Heritage Private Wealth Law

General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.