When purchasing a business, a common acquisition structure involves the purchaser using a corporation to purchase the shares of the target corporation. This strategy effectively allows the purchaser to fund the acquisition using corporate profits, rather than having to use personal funds. Given the significant difference in tax rates applicable to corporations (either 12.2% of 26.5% in Ontario) and individuals (up to 53.53% in Ontario), this provides a much more tax-efficient way of funding the acquisition, since it requires far less pre-tax funds. When dealing with the sale of a business to an unrelated party under the transaction outlined above, the vendor will generally realize a capital gain from the sale and may be able to claim the capital gains deduction in connection with the capital gain. As you may be aware, the capital gains deduction allows individuals to realize tax-free capital gains of over $892,000 in their lifetimes from the sale of certain qualifying shares of Canadian-controlled private corporations.
Under current rules, this type of planning is not available where shares are sold to related parties, including to corporations owned by children and/or grandchildren. Section 84.1 of the Income Tax Act provides that where shares are sold to a corporation with which the vendor does not deal at arm’s length, the vendor will instead be considered to have received a dividend from the purchaser corporation. The result is that rather than realizing a capital gain from the sale (a portion of which may be sheltered from tax by claiming the capital gains deduction), the vendor will be taxed on deemed dividend income at rates of up to 47%. This often creates a dilemma for families when selling a business to children – in order for the parents to realize a capital gain (and claim the capital gains deduction), the children must purchase shares personally; on the other hand, if the parents are willing to pay tax at dividend tax rates, the children may use a corporation to purchase the shares. It is not possible for the parents to realize a tax-advantaged sale and for the children to structure the purchase in a tax-efficient manner, even though both can be accomplished if the shares were instead sold to an unrelated party under the same terms.
On May 12, 2021, Bill C-208, a private-members Bill introduced by Larry Maguire (MP for Brandon-Souris), was passed by the House of Commons. Bill C-208 proposes to amend the provisions of section 84.1 of the Income Tax Act to allow individuals capital gains treatment where shares are sold to non-arms’ length corporations (including those owned by children/grandchildren). In order to ensure that business succession is done on arm’s length terms, the proposed changes require that the corporation purchasing the shares must own the acquired shares for at least 60 months after their purchase and the CRA must be provided with “an independent assessment of the fair market value” of the shares. It is unclear what is meant by an “independent assessment” of the value and whether this will require that a formal valuation of the shares be obtained. The proposed rules are also limited based on the “taxable capital” of the corporate group (basically equity and debt, less investments in, and loans to, other corporations), with partial capital gains treatment available where the corporate group’s taxable capital is in the range of $10 million – $15 million. The proposed rules would not apply where the corporate group’s taxable capital exceeds $15 million. Before becoming law, the Bill must still be passed by the Senate.
This is a welcome change, since it will finally put the succession of many family businesses to children/grandchildren on equal footing with sales of the business to unrelated parties. The status of this proposed change will be of interest to anyone considering the transition of a business to their family and may necessitate a review of any plans currently in place. Please consult your Welch LLP trusted advisor to discuss how we these changes may impact your situation.