On April 16, 2024, the Federal Government released its 2024 Budget. Among the significant changes, a proposed increase in the capital gains inclusion rate to 2/3 (two-thirds) beginning June 25, 2024 was announced, which we covered in a previous article.
This article highlights noteworthy announcements in the Budget and the implementation legislation we anticipate may impact our clients.
Increase in the capital gains inclusion rate
This change has now passed and is law. As a result, we now have more information regarding the actual implementation.
Key items to note are:
- The first $250,000 for individuals, graduated rate estates and qualified disability trusts will still be taxed at the 1/2 inclusion rate. This full amount will be available for capital gains received after June 24, 2024, for the 2024 tax year.
- Employee stock option deduction will also be reduced to match the new capital gains inclusion rates.
- Capital losses carried back or forward will be adjusted to reflect the rate of the relevant period they are being used to offset, such that capital losses realized in a year will still fully offset the equivalent capital gains realized in another year where a different inclusion rate applies.
- The deductible portion of allowable business investment losses ("ABIL") will increase to 2/3.
- Capital gains reserves which are brought into income for a taxation year than begins before June 25, 2024, will be subject to the 1/2 inclusion rate. Capital gains reserves that are brought into income in tax years starting June 25, 2024, and later will be subject to the 2/3 inclusion rate. This may be a reason to consider bringing in all outstanding capital gains reserves from prior to June 25, 2024 this year.
- Trusts allocating capital gains to beneficiaries will need to disclose if those capital gains were incurred prior to June 25, 2024, in order for the beneficiary to be able to take advantage of the 1/2 inclusion rate, otherwise, it will be taxed at the 2/3 inclusion rate.
Canadian Entrepreneurs' Incentive ("CEI")
To offset the increase in the capital gains inclusion rate for some entrepreneurs, the Government has proposed the CEI. This proposed incentive would apply to reduce the capital gains inclusion rate applicable to dispositions of qualifying corporate shares to 1/2 of the capital gains rate applicable at that time. Therefore, under the new capital gain inclusion rate of 2/3, the CEI would reduce the capital gains rate to 1/3 for the qualifying disposition. The CEI will be limited to a lifetime maximum of $2 million, which will be phased-in with increments of $200,000 per year starting January 1, 2025. It will reach $2 million by January 1, 2034.
The main limitation to the CEI is its long list of excluded types of corporations (discussed below). However, if a taxpayer is able to use the CEI, the good news is that they can apply the CEI in addition to the capital gains exemption.
To qualify for the CEI, the following criteria must all be satisfied:
- The shares were obtained for fair market value consideration;
- At the time of disposition, the shares must be in the capital of a "small business corporation" and must be owned directly by the taxpayer;1
- Throughout the 24 months immediately before the disposition, the shares are in corporation that is a Canadian-controlled Private Corporation and more than 50% of the fair market of the assets of the corporation were:
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- used principally in an active business carried on primarily in Canada by the corporation, or by a related corporation,
- certain shares or debts of connected corporations, or
- a combination of these two types of assets;
- The taxpayer was a founding investor at the time the corporation was initially capitalized and held the share for a minimum of 5 years prior to disposition;
- At all times since the initial share subscription until the disposition, the taxpayer directly owned shares that represented more than 10% of the fair market value of the issued and outstanding capital stock of the corporation and more than 10% of the voting power of the corporation;
- Throughout the 5 years immediately before the disposition, the taxpayer must have been actively engaged on a regular, continuous, and substantial basis in the activities of the business;
- The shares do not represent a direct or indirect interest (1) in a professional corporation, or (2) in a corporation whose principal asset is the reputation or skill of the employee(s), or (3) in a corporation in any of the following business sectors:
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- financial,
- insurance,
- real estate,
- food and accommodation,
- arts,
- recreation,
- entertainment,
- consulting services, or
- personal services.
Overall, the CEI can be a great incentive for entrepreneurs in certain industries, but the extensive excluded businesses and restrictions mean very few Canadians will ever benefit.
Employee Ownership Trust Exemption ("EOTE")
As discussed in our previous Budget article, the EOTE would exempt the first $10 million of capital gains realized on qualifying dispositions of businesses to an Employee Ownership Trust ("EOT"). If there are multiple individuals claiming the EOTE on the disposition of the business to an EOT, the maximum applicable to the disposition cannot exceed $10 million and they must decide amongst themselves on how to allocate the exemption.
In addition to the EOTE, the 2023 Budget proposed the following additional benefits for EOTs:
- Extending the capital gains reserve for qualifying dispositions to EOTs from 5 years to 10 years, which allows a significant deferral on any capital gains tax not exempted under the EOTE.
- Under the usual shareholder loan rules, if a shareholder borrows funds from the business to buy the business, the shareholder must repay the loan within 1 year otherwise the loan will be included in the shareholder's income. In contrast, an EOT that borrows funds from the business in order to purchase it in a qualifying disposition will instead of 15 years to repay the loan instead of the 1 year.
- EOTs would be exempt from the 21-year rule that deems trusts to have disposed of its assets every 21 years to trigger capital gains. Instead, the EOT will only realize capital gains when it actually disposes of its assets or if it ceases to be an EOT.
Please see here for our article on EOTs.
To qualify for the $10 million EOTE, there are a few "point in time" criteria that must be satisfied, as set out below:
- The individual, or a personal trust which the individual is a beneficiary, or a partnership in which the individual is a member, disposes of shares of a corporation (other than a professional corporation) (the "Subject Corporation") to an EOT or to a Canadian-controlled private corporation controlled and wholly owned by an EOT (the "Purchaser Corporation");
- At any time before the disposition, the seller, their spouse or their common-law partner must have been actively engaged in the Subject Corporation's business on a regular and continuous basis for at least 24 months (but does not need to be the 24 months immediately before the disposition);
- For the 24 months immediately prior to the disposition:
-
- For the 24 months prior to the disposition, the shares must have been exclusively owned by the seller, a related person, or a partnership in which the seller was a member;
- For the 24 months prior to the disposition, over 50% of the fair market value of the Subject Corporation's assets were principally in an active business;
- Immediately before the disposition:
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- all or substantially all of the fair market value of the assets of the Subject Corporation are used principally in an active business carried on by the Subject Corporation or a wholly owned and controlled subsidiary;2
- At the time of the disposition:
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- the seller deals at arm's length with the EOT or the Purchaser Corporation;
- the EOT acquires control of the Subject Corporation;
- the EOT's beneficiaries are employed in the business of the Subject Corporation;
- After the disposition:
-
- the seller deals at arm's length with the Subject Corporation and the EOT (or Purchaser Corporation, as the case may be);
- the seller does not retain any rights or influence that would allow them (whether alone or together with any person or partnership affiliated with the seller) to control, directly or indirectly, the Subject Corporation or EOT (or Purchaser Corporation, as the case may be);
- at least 90% of the beneficiaries of the EOT must be resident of Canada for tax purposes.
It should be noted that in order for the EOTE to apply, the seller and the EOT must elect to be jointly and severally liable OR one must elect to sole liable for any taxes payable by the seller if the EOTE is later denied due to a "disqualifying event". A disqualifying event means if, within 36 months after the qualifying disposition, the EOT ceases to be an EOT or if less than 50% of the EOT's fair market value of the Subject Corporation's shares is attributable to assets used principally in an active business at the beginning of two consecutive tax years of the Subject Corporation.
Practically, this does not reflect how Canadian business owners have historically transitioned their businesses. That being said, if an owner would like to consider passing their business to its employees, this may now be an option.
Changes to GAAR
Changes to the general anti-avoidance rule ("GAAR") became retroactively effective back to January 1, 2024, with penalties becoming applicable once the Bill received Royal Assent on June 20, 2024. These changes will significantly broaden the circumstances in which GAAR can apply and introduces a new penalty.
Firstly, the definition of an "avoidance transaction" has been amended. The previous GAAR stated that a transaction would not be an avoidance transaction is it may be reasonably considered to have been undertaken primarily for a bona fide purpose. The new GAAR will now consider any transaction where it can reasonably consider that one of the main purposes was to obtain a tax benefit to be an "avoidance transaction". This broadens the applicability of GAAR substantially because it can apply to transactions so long as one of the purposes is for a tax benefit, regardless of if the primary purpose was a bona fide purpose.
Secondly, in determining whether an avoidance transaction is a misuse or abuse of the relevant provision(s) of the Income Tax Act, they will now consider whether the transaction is "significantly lacking economic substance". This legislative change will require Courts to consider economic substance in determining whether GAAR should apply. To determine whether there has been a significant lack of economic substance, the following factors are considered:
- the opportunity for gain or risk of loss is unchanged for the taxpayer and the non-arm's length parties to the taxpayer;
- the expected value of the tax benefit exceeds the expected non-tax economic return;
- the entire, or almost entire, purpose of the transaction was to obtain a tax benefit.
Thirdly, the new GAAR will now have a 25% penalty equal to the total increase in tax payable that results from GAAR applying (including adjusting for loss of any refundable tax credits because of GAAR applying). This penalty is reduced by any gross negligence penalties that also apply to prevent duplication of penalties. This is a large shift from the previous GAAR penalty, which was only to deny the tax benefit plus any interest on the overdue tax.
However, the new penalty will not apply if the transaction was previously disclosed as a reportable or notifiable transaction (mandatory or voluntarily) or if it is reasonably to conclude that GAAR would not apply because it was identical or almost identical to circumstances in case law or CRA administrative guidance stating that GAAR would not apply.
Lastly, the normal reassessment period for GAAR assessments are now expanded by 3 years unless the transaction was previously disclosed to the CRA.
Proposed Change: CRA Information Requests
The Budget also proposed a new type of notice called a "notice of non-compliance", which could be issued to a person that the CRA believes has not complied with a requirement or notice to provide assistance or information to the CRA. If a notice of non-compliance has been issued, the normal reassessment period that the notice relates to will be extended for the duration of that the notice remains outstanding. Additionally, the Budget proposes a steep penalty of $50 per day that the notice remains outstanding, up to $25,000.
The CRA also appears to have a fair amount of discretion on when to issue and when to vacate such penalties.
This proposal is concerning since, in our experience the CRA can make extremely onerous audit requests with unrealistic deadlines. Historically, there was nothing an auditor could do other than issue a notice of reassessment which the taxpayer could then appeal. However, this proposal could lead to significant penalties even when a taxpayer owes no tax. Practically, this will likely hurt small business owners who have difficulty complying with audit requests on the tight timelines demanded by the CRA.
Conclusion
Overall, the changes brought by the Budget provide some new potential tax breaks for owners of Canadian-controlled private corporations looking to sell which do not offset the new capital gains inclusion rate. It also significantly expands the CRA's information gathering and anti-avoidance powers which will make CRA audits even more stressful than they already are.
Footnotes
1. Income Tax Act, ss 248(1), definition of "small business corporation"
2. The term "all or substantially all" generally means 90% or more. The term "principally" generally means more than 50%.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.