THE FAMILY BUSINESS AND THE CAPITAL GAINS EXEMPTION
People wishing to pass on a family business to the next generation have, up until recently, been met with a tax problem – the availability (or more accurately non-availability) of the lifetime capital gains exemption.
The lifetime capital gains exemption currently allows for up to $971,190 per person of capital gains arising from the sale of certain shares to be realized tax-free. (This is the amount for 2023; it is automatically increased annually for inflation.)
However, although the sale of eligible shares to non-relatives may benefit from this tax exemption, sales to "related" persons (immediate family members, grandchildren, etc.), until recently, could not.
This was recognized as unfair, and in some cases a barrier to keeping a business in the family.
For example, on the sale of a business in Ontario, if qualifying for the capital gains exemption, up to around $260,000 in tax may be saved per shareholder through the use of the exemption.
This tax saving, which was not available if the business was kept in the family, may have influenced a decision to sell when a parent decided to step back from the business.
To address this unfortunate situation, a Private Member’s Bill was introduced in Parliament in 2021 — known as Bill C-208 – which sought to allow the sale of certain businesses to adult children to finally qualify for the capital gains exemption.
The intention was to place genuine business sales to the next generation on the same tax-savings footing as sales to third parties.
As part of this levelling of the playing field, it was intended that the parent would have to sell most, if not all of their shares. They would also have to give up control of the business, like in a third-party sale.
Bill C-208 was passed by Parliament against the wishes of the Department of Finance and the (minority) governing Liberals. Although Bill C-208 was well-intentioned, its wording was not as precise as required, which created what many people described as a “loophole” in the rules.
Instead of applying only to outright business sales, the rules allowed parents to transfer just some of their shares to their children, and to claim their capital gains exemption. In addition, the parent did not have to give up control of the business.
This allowed the parent to sell enough shares to take advantage of the capital gains exemption and no more.
Therefore, where a family business was owned by a combination of mom and dad, almost $2M of growth in the business could be withdrawn tax-free without mom or dad having to sell the business or give up control of it.
Budget 2023 announced that the rules would be amended to fix this. Mom and dad would still be able to claim their capital gains exemption on the sale of family business shares to their children; however outright control would have to be given over to the child. The child would also have to be actively involved in the business from the time of sale (which is not required under the current rules).
The revised rules provide the option of two time periods for the parent to give up control — a three-year period and a five-to-ten-year period.
In both cases, the parent is required to transfer the majority of their voting shares (and therefore give up control of the business) to the child at the time of sale.
The remainder of the shares and the management of the business (subject to some exceptions) must be given up by the parent within 3 years or 5 years, depending on the time period selected.
Although this is more restrictive than the current rules, the scope of related people who can buy the business is being widened at the same time to include nieces and nephews (as well as grandnieces and grandnephews). This adds increased flexibility in passing the business down through the family.
The rules around which business sales are eligible for the capital gains exemption, both before and after the revised rules take effect, are complex.
The shares must be shares of a “qualified small business corporation”. This definition itself contains specific requirements.
The majority of the assets held by the business must be used in the business itself (rather than being, for example, excess cash or unrelated investments). The parent must also hold the shares for two years before selling.
Some businesses may not immediately meet these requirements, meaning that parents may have to wait for up to two years before the business can be passed down. In some circumstances, it may be possible to undertake pre-sale planning to ensure some of the tests are met, if they are not met currently.
There are also strict requirements regarding elections that must be made to claim the capital gains exemption, and the length of time the child must hold the shares and be actively involved in the business after the sale.
For example, after purchasing the shares, the child cannot immediately sell the shares to another person; otherwise the parent’s capital gains exemption would be denied, and the parent would pay tax on the full gain they previously realized.
To enforce some of these requirements, the revised rules extend the period of time that the Canada Revenue Agency (CRA) can reassess the parent’s tax year in which the sale to the child takes place.
Normally, the CRA has three years from the date that they issue a notice of assessment for a tax year. However, this period is to be increased by a further three years if the three-year transfer period is used, and by a further ten years if the five-to-ten transfer period is used.
This allows the CRA to monitor the child’s involvement in the business after the sale, and to retroactively deny the tax-free capital gains treatment to the parent if the child does not continue to control the company, or stay active in its management.
The revised rules are scheduled to take effect on January 1, 2024. The current rules remain in effect until the end of this year.
Although the current rules do not operate as originally intended, this does not mean that they are invalid. Until the revised rules take effect, the current rules can be used to pass value in the family business to an adult child (the extension to nieces and nephews is not yet in effect).
Also, the current rules do not require parents to give up business control. All that is required is that the parent’s shares be sold to an adult child (more accurately, a corporation controlled by the adult child), and that those shares be held by the child for at least 60 months.
For example, if the family business is worth at least $1 million, the parent could sell non-voting shares to the child and retain the voting shares (therefore retaining business control). It may be possible to plan the sale in a way that allows the child to purchase the shares without having the immediate cash necessary for the purchase.
As you may suspect, this type of sale falls under the category of “complex” tax planning!
Under both the current and revised rules, there are several requirements to meet to successfully claim the capital gains exemption. Failing to comply with any one of these requirements could result in a denial of the exemption, making the sale fully taxable.
For advice on passing on your business to the next generation in a way that lets you claim your capital gains exemption, speak with an experienced tax advisor or tax lawyer.