Federal Budget 2023: Tax items relevant to small business owners and farmers - Feds release Notice of Ways and Means Motion including clarifications to “Bill C-208” rules

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

The new tax rules introduced in 2021 as “Bill C-208”, which, to the consternation of the government, became law through Canada’s parliamentary process, introduced long-awaited tax law changes that simply put family business and farm succession scenarios on an equal footing, tax-wise, with arm’s length sales.

Before the new rules

Prior to the new rules, selling your business or farm corporation to your son or daughter’s corporation was treated like an attempted abuse of the rules. You either weren’t allowed to use your capital gains exemption (CGE), or your child was not allowed to use tax-efficient corporate dollars to repay the debt. You were forced into a win-lose situation: If you used your CGE, your child had to pay with high-tax personal dollars. If your child bought you out through their corporation, you couldn’t use your CGE and most likely had to pay tax on a dividend. Meanwhile, unrelated buyers and sellers could use the “win-win” option - the seller would get the CGE, and the buyer could buy with low-tax corporate dollars. The new rules have fixed that, as explained in more detail here.

2023 Federal Budget announces changes to the rules

In today’s 2023 Federal Budget, the government announced in a Notice of Ways and Means Motion with intended legislative changes to the new rules to address some potential gaps or loopholes. According to the Feds’ Tax Measures Supplementary Information:

“To ensure that only genuine intergenerational share transfers are excluded from the application of section 84.1, additional conditions are proposed to be added. To provide flexibility, it is proposed that taxpayers who wish to undertake a genuine intergenerational share transfer may choose to rely on one of two transfer options:

• an immediate intergenerational business transfer (three-year test) based on arm’s length sale terms; or

• a gradual intergenerational business transfer (five-to-ten-year test) based on traditional estate freeze characteristics (an estate freeze typically involves a parent crystalizing the value of their economic interest in a corporation to allow future growth to accrue to their children while the parent’s fixed economic interest is then gradually diminished by the corporation repurchasing the parent’s interest).

“The immediate transfer rule would provide finality earlier in the process, though with more stringent conditions. In recognition of the fact that not all business transfers are immediate, the gradual transfer rule would provide additional flexibility for those who choose that approach. Both the immediate and gradual business transfer options would reflect the hallmarks of a genuine intergenerational business transfer.”

The new rules - paraphrased:

Child’s corporation buys parent’s shares

For context, recall that these rules apply where a parent is selling shares of their corporation to a corporation that is controlled by their adult child, as long as the shares are “qualified small business corporation shares” or “shares of a family farm corporation”. The rules now allow the parent to sell their shares and realize capital gains, and claim their available lifetime capital gains exemption without a set of tax rules known as “84.1” re-characterizing the tax results.

The main updates tighten up the new rules as follows.

These updated rules will apply to dispositions of shares that occur on or after January 1, 2024. Some aspects of these rules will need to be clarified, but for now, here are some main points.

Joint tax election by parent and child

The parent and the child (or each child) must jointly elect in prescribed form for the new rules to apply in respect of the sale, choosing either the “immediate sale” option or the “gradual sale” option.

Control before and after the sale

There is a requirement that, immediately before the sale, the parent, either alone or in combination with their spouse, is in a position of control of the corporation being sold, and no other person or group of persons controls, directly or indirectly in any manner whatever, the corporation being sold.  

After the sale, the parent must not, either alone or together with their spouse, control the purchased corporation or the purchaser corporation. However, in the case of a “Gradual Business Transfer”, while the parents must transfer legal control they may retain factual control, meaning economic and other influence that allows for effective control of the corporation.

Ownership after the sale

At all times after the sale, the parent, or the parent and his/her spouse together, must be left owning less than 50% of the shares of any class after the initial purchase, unless the shares are shares of a “specified class” (special freeze shares with a fixed prescribed dividend rate) in which case retaining greater than 50% is acceptable.

Within 36 months of the sale and at all times thereafter, the parent or the parent and his/her spouse together must not own any shares other than non-voting preferred shares.

In the case of an “immediate sale”

From the time of the sale until 36 months after the sale:

• the child (or children) must control the purchased corporation and the purchaser corporation; and

• the child (or at least one of them) must be actively engaged in the active business of the purchased corporation.

Within 36 months of the sale (or a greater period of time if reasonable) the parent must take reasonable steps to:

• transfer management to the child or children, and

• permanently cease to manage the business.

In the case of a “gradual sale”

Within 10 years after the sale and at all times after, the parent and his or her spouse must not own:

• in the case of a family farm corporation, interests (including debt or equity) in the purchased corporation or the purchaser corporation exceeding 50% of the fair market value of the interests owned before the sale, or

• in the case of a qualified small business corporation, interests (including debt or equity) in the purchased corporation or the purchaser corporation exceeding 30% of the fair market value of the interests owned before the sale.

From the time of the sale until the later of 60 months after the sale and the “final sale time” (this needs clarification; also, this is subject to certain provisions that appear to allow a sale by the child to an arm’s length purchaser within this time frame),

• the child (or children) must control the purchased corporation and the purchaser corporation, and

• the child, or at least one of them, must be actively engaged in the active business of the purchased corporation.

Within 60 months of the sale or a greater time if reasonable (this is subject to certain provisions that appear to allow a sale by the child to an arm’s length purchaser within this time frame), the parent must take reasonable steps to:

• transfer management of the business to the child or children, and

• permanently cease to manage the business.

Other aspects

A 10-year capital gains reserve may be claimed on a sale of shares to a corporation where it is a sale to a corporation controlled by the parent’s child under these new rules.

There is an extended definition of “child” which includes the definition applicable to farm tax rules (essentially meaning child, grandchild or great-grandchild), plus a niece or a nephew, a spouse of a niece or a nephew, plus a child of such a niece or nephew.

As noted, there are some new rules that appear to allow for situations where the child or children, after purchasing their parents’ shares, sell the shares to an unrelated purchaser.

© 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.