The "GIST" Of Genuine Intergenerational Share Transfers: Important Proposed Legislative Changes

Business owners planning to transition their business to the next generation will need to consider further changes proposed to the rules for intergenerational business transfers in the 2023 Federal Budget. These changes were expected and much anticipated following the enactment of Bill C-208, a private member's bill that received Royal Assent on June 29, 2021 and became law as of that date.¹ Bill C-208 amended the Income Tax Act (Canada) (the "Act") with the main aim of creating fairness in Canada's tax system by placing genuine intergenerational share transfers on equal footing with arm's length share sales. This was welcome news to many business owners who intended to cede their business to their children or grandchildren.

Prior to Bill C-208, the transfer by an individual of shares of a Canadian corporation to a corporation controlled by that individual's adult child or grandchild resulted in the proceeds of the sale being treated as a deemed dividend, whereas a similar sale to a corporation controlled by an arm's length third party was treated as a capital gain. This difference in treatment was a significant disadvantage for intergenerational business transfers as a result of the loss of the 50% inclusion rate for capital gains and the loss of the ability to claim the lifetime capital gains exemption ("LCGE") in specific circumstances.

While the changes implemented by Bill C-208 were welcomed overall, the Department of Finance expressed concerns with the breadth of Bill C-208 and, in particular, certain gaps that could allow an individual to engage in surplus stripping through disingenuous intergenerational share transfers.² To address these concerns, further amendments have been proposed in the 2023 Federal Budget to ensure the spirit of Bill C-208 is honoured by only allowing for genuine intergenerational share transfers.

The GIST – A Brief Summary for Business Owners

A business owner that wishes to transition their business to the next generation (as opposed to selling to an arm's length third party) while maintaining capital gains treatment and ultimate access to the LCGE has a few options available to them. As was always the case, a business owner can sell the shares they personally own in a corporation (that either operates the business or directly/indirectly owns the shares of a corporation that operates the business) directly to the desired individuals of the next generation (i.e., adult child, grandchild, niece, nephew, etc.) in their personal capacities. Further, thanks to Bill C-208, a business owner's adult child(ren)/grandchild(ren) now has additional flexibility to use a corporation controlled by them to finance and facilitate the purchase of the shares from the business owner, while maintaining the seller's preferable tax treatment.

With the proposed changes in the 2023 Federal Budget, there will be two possible streams when using a corporation to facilitate the purchase: (1) an "immediate" intergenerational business transfer; and (2) a "gradual" intergenerational business transfer. Under both transfer streams, the shares being sold must qualify as a "qualified small business corporation share" or a "share of the capital stock of a family farm or fishing corporation" (as those terms are defined in the Act), and the shares must be owned by the business owner (either alone or together with their spouse) in their personal capacity. Further, under both transfer streams, the purchasing corporation must be controlled by one or more of certain specified individuals, which can include the business owner's (or their spouse's) children, grandchildren, great-grandchildren, nieces, nephews, grandnieces, grandnephews, or the spouse of any of the foregoing. There are then additional and differing conditions to be met for each transfer stream.

Under an "immediate" transfer, the following conditions must be satisfied:

1. the business owner must immediately (and permanently) transfer both legal and factual control of the corporation and a majority of all classes of shares (other than certain fixed-value preferred shares);
2. within 36 months of the initial transfer the business owner must transfer the balance of all classes of shares (other than certain fixed-value preferred shares);
3. the children (or other specified individuals) of the business owner must control the purchasing corporation for a period of 36 months after the initial transfer and at least one child (or other specified individual) must be actively engaged in the business (and the business must be carried on as an active business) during such period; and
4. within 36 months after the initial transfer (or a greater period of time if reasonable given the circumstances), the management of the business must be transferred to the child or children (or other specified individual(s)).

Under a "gradual" transfer, the following conditions must be satisfied:

1. the business owner must immediately (and permanently) transfer only legal control of the corporation and a majority of all classes of shares (other than certain fixed-value preferred shares);
2. within 36 months of the initial transfer the business owner must transfer the balance of all classes of shares (other than certain fixed-value preferred shares);
3. within 10 years of the initial transfer the business owner must reduce their debt and equity interest to a fair market value of not greater than 50% (in the case of a sale of a "share of the capital stock of a family farm or fishing corporation") or 30% (in the case of a sale of a "qualified small business corporation share") of the fair market value of their total interest owned immediately prior to the initial transfer;
4. the children (or other specified individuals) of the business owner must control the purchasing corporation for a period of 60 months after the date of the transfer of the debt and equity interest to the specified levels noted in the previous condition and at least one child (or other specified individual) must be actively engaged in the business (and the business must be carried on as an active business) during such period; and
5. within 60 months after the initial transfer (or a greater period of time if reasonable given the circumstances), the management of the business must be transferred to the child or children (or other specified individual(s)).

The GIST – A Deeper Dive

i. Current Status of Bill C-208

Bill C-208 amended Sections 55 and 84.1 of the Act, which are anti-avoidance rules designed to prevent capital gains stripping and taxable capital surplus stripping, respectively.

Section 55

When dividends are received by a shareholder that is a corporation (i.e., an intercorporate dividend), the recipient generally has an income inclusion and an offsetting deduction, resulting in a tax-free intercorporate dividend. Subsection 55(2) has the effect of recharacterizing those dividends, which would otherwise be tax-free, as a capital gain unless certain exceptions are met. One important exception is the "related party butterfly" exception in paragraph 55(3)(a), which allows for certain distributions and reorganizations among related parties without the application of subsection 55(2). Prior to Bill C-208, siblings were deemed not to be related to each other for the purposes of section 55 of the Act. This was a significant limitation for a family business jointly owned by, or business transitions among or involving, siblings. Bill C-208 amended subparagraph 55(5)(e)(i) to provide that siblings would not be deemed to be related to each other where the dividend was received or paid by a corporation of which a share of its capital stock is a "qualified small business corporation share" ("QSBC Share") or a "share of the capital stock of a family farm or fishing corporation" ("FFC Share"), as those terms are defined in subsection 110.6(1) of the Act. This amendment may help facilitate intergenerational transfers to two or more children/grandchildren and may also open the door to other tax planning opportunities in situations involving siblings by allowing siblings that jointly own a corporation to reorganize their affairs in reliance on the "related party butterfly" exception under paragraph 55(3)(a). There were no further revisions to section 55 proposed in the 2023 Federal Budget.

Section 84.1

Section 84.1 is an anti-surplus stripping provision that is designed to prevent the extraction of property from a corporation on a tax-free basis through non-arm's length sales or transfers. Section 84.1 applies when: (i) a taxpayer (other than a corporation) resident in Canada (the "Seller") disposes of shares (the "Subject Shares") of a corporation resident in Canada (the "Target Corporation") to another corporation (the "Purchaser Corporation"); (ii) the Subject Shares are capital property to the Seller; (iii) the Seller does not deal at arm's length with the Purchaser Corporation; and (iv) immediately after the disposition, the Purchaser Corporation and the Target Corporation are connected. When subsection 84.1(1) applies:

• if shares of the Purchaser Corporation are issued to the Seller as consideration for the purchase of the Subject Shares, paragraph 84.1(1)(a) will generally require the paid-up capital of such shares received by the Seller to be reduced to an amount equal to the Seller's modified adjusted cost base ("ACB") of the Subject Shares immediately before the disposition; and
• if the Seller receives non-share consideration (i.e., cash or a promissory note) from the Purchaser Corporation for the Subject Shares, paragraph 84.1(1)(b) will generally deem a dividend to have been received by the Seller equal to the amount that the value of such non-share consideration exceeds the Seller's modified ACB of the Subject Shares immediately before the disposition.

Prior to Bill C-208, where the Purchaser Corporation was controlled by the Seller's child(ren)/grandchild(ren), section 84.1 would deem the proceeds received by the Seller to be a dividend, as opposed to a capital gain. This meant that the Seller would have to include the full amount of the deemed dividend as taxable income, as opposed to receiving the benefit of the 50% capital gains inclusion rate, and would not be permitted to claim the LCGE on the sale that would otherwise allow them to receive up to $971,190 tax free on dispositions of a QSBC Share and up to $1 million tax free on dispositions of a FFC Share. This treatment has a significantly disadvantageous tax result when compared to the capital gains treatment afforded to a Seller that sold the Subject Shares to an arm's length Purchaser Corporation.

As noted above in the brief summary for business owners, a Seller could maintain access to capital gains treatment and the LCGE by simply selling the Subject Shares directly to the Seller's child(ren)/grandchild(ren) in their personal capacity (as opposed to selling to a corporation owned by them). However, while structuring a sale in such a manner would allow the Seller to transition their business to their child(ren)/grandchild(ren) and receive a similar tax treatment as a sale to an arm's length Purchaser Corporation, section 84.1 placed unnecessary restrictions on the ability of a business owner's child(ren)/grandchild(ren) to use a corporation to finance and facilitate the purchase.

Bill C-208, in an attempt to eliminate this disadvantageous tax result, added paragraph 84.1(2)(e). This amendment excludes a disposition of Subject Shares by a Seller to a Purchaser Corporation controlled by the Seller's adult child(ren)/grandchild(ren) from the application of the anti-surplus stripping rules of subsection 84.1(1) where:

• the Subject Shares qualify as a QSBC Share or FFC Share;
• the Purchaser Corporation does not dispose of the Subject Shares within 60 months of their purchase; and
• the Seller provides the Minister with an independent assessment of fair market value ("FMV") of the Subject Shares and an affidavit signed by the Seller and a third party attesting to the disposal of the Subject Shares.

Further, Bill C-208 added subsection 84.1(2.3), which, among other things, purported to reduce on a sliding scale basis the available LCGE in circumstances where the combined taxable capital of the Target Corporation and its associated corporations exceeds $10 million, with the available LCGE being completely eliminated once the combined taxable capital reaches $15 million. This amendment purported to limit access of the Seller to the LCGE on a sale of a QSBC Share or FFC Share to a Purchaser Corporation controlled by the Seller's adult child(ren)/grandchild(ren) where the Target Corporation is a larger corporation or a particularly capital-intensive corporation (such as one with large real estate holdings). However, there are technical issues with the way that subsection 84.1(2.3) was drafted and it is debatable whether it operates at all to accomplish the intended effect. There is no similar limitation based on taxable capital applicable to a sale to an arm's length Purchaser Corporation.

ii. Budget 2023 Proposed Amendments

The breadth of the exception contained in Bill C-208 left significant gaps and provided insufficient safeguards, ultimately permitting transactions that amount to surplus stripping in a non-arm's length context in circumstances where there is not a genuine succession of the business to a Seller's child(ren)/grandchild(ren). As such, there have been further revisions to section 84.1 proposed in the 2023 Federal Budget to address the concerns expressed and to ensure that the exceptions to the application of subsection 84.1(1) only apply for genuine intergenerational share transfers.

In the proposed amendments, paragraph 84.1(2)(e) is still the operative exception to the application of the anti-surplus stripping rules of subsection 84.1(1). However, paragraph 84.1(2)(e) is proposed to be revised to create further conditions for its application, which are contained in new subsections 84.1(2.31) or (2.32). Subsection 84.1(2.31) relates to "immediate" intergenerational business transfers (subject to a three-year test) based on arm's length sale terms, while subsection 84.1(2.32) relates to "gradual" intergenerational business transfers (subject to a five-to-ten-year test) based on traditional estate freeze characteristics. The proposed amendments maintain the following conditions:

• the Seller must still be an individual, though the amendments would prevent the Seller from being a trust and would require that the Seller, either alone or together with a spouse or common-law partner, control the Target Corporation immediately prior to the disposition of the Subject Shares;
• the Purchaser Corporation must still be controlled by one or more adult children of the Seller, though the amendments would adopt a much more expansive definition of children to include: (i) a natural or adoptive child, grandchild or great-grandchild of the Seller or the Seller's spouse/common-law partner; (ii) a spouse or common-law partner of a natural or adoptive child, grandchild or great-grandchild of the Seller or the Seller's spouse/common-law partner; (iii) a niece or nephew of the Seller or the Seller's spouse/common-law partner; (iv) a spouse of a niece or nephew of the Seller or the Seller's spouse/common-law partner; and (v) a child of a niece or nephew of the Seller or the Seller's spouse/common-law partner; and
• the Subject Shares must still qualify as either a QSBC Share or FFC Share.

In addition to the conditions noted above, there will be a number of additional conditions (which vary depending on which transfer option is selected), as follows:

1. Transfer of Control of the Business

• Immediate Transfer – At all times after the time of disposition of the Subject Shares (the "Disposition Time") the Seller (either alone or together with a spouse/common-law partner) must not control, directly or indirectly in any manner whatever, the Target Corporation, the Purchaser Corporation, or any other person or partnership (a "Relevant Group Entity", and together with the Target Corporation and the Purchaser Corporation, the "Group Entities") that carries on an active business relevant to determining whether the Subject Shares qualify as a QSBC Share or FFC Share. Notably, an immediate transfer requires the immediate transfer of both legal and factual control.
• Gradual Transfer – At all times after the Disposition Time, the Seller (either alone or together with a spouse/common-law partner) must not control any of the Group Entities.

Unlike with an immediate transfer, a gradual transfer only requires transfer of legal control, which creates more flexibility for the Seller to maintain factual control over any of the Group Entities (e.g., through a unanimous shareholder agreement). The ability to maintain factual control after the Disposition Time may provide some security to the Seller if the Seller still maintains any financial interest (whether through debt or equity) in any of the Group Entities.

2. Transfer of Economic Interests in the Business

• Immediate Transfer/Gradual Transfer – The same condition with respect to the transfer of economic interests is applicable to both immediate transfers and gradual transfers. At all times after the Disposition Time the Seller (either alone or together with a spouse/common-law partner) must not own, directly or indirectly, 50% or more of any class of shares of the Target Corporation or the Purchaser Corporation or of any class of equity interest of any Relevant Group Entity, other than certain classes of fixed value shares ("Specified Shares").

Specified Shares are shares that: (i) are not convertible or exchangeable; (ii) are non-voting; (iii) only have dividends calculated as a fixed amount or by reference to a fixed percentage of their FMV, such annual dividend rate not to exceed the prescribed rate of interest at the time the shares were issued; and (iv) limit the amount the holder can receive on redemption, cancellation or acquisition of the shares by the corporation to their FMV plus any declared but unpaid dividends.

3. Subsequent Transfer of Share Interest in the Business

• Immediate Transfer – Within 36 months of the Disposition Time and at all times thereafter, the Seller (and the Seller's spouse/common-law partner) must not own, directly or indirectly, any shares of the Target Corporation or the Purchaser Corporation or any equity interest in any Relevant Group Entity, other than Specified Shares.
• Gradual Transfer – The same 36-month condition (described above) applies to gradual transfers but in addition, within 10 years after the Disposition Time (the "Final Sale Time") and at all times thereafter, the Seller (and the Seller's spouse/common-law partner) must not own, directly or indirectly, where the Subject Shares were:

• FFC Shares, debt or equity interests in any of the Group Entities with a FMV that exceeds 50% of the FMV of all the interests that were owned, directly or indirectly, by the Seller (and the Seller's spouse/common-law partner) immediately before the disposition; or
• QSBC Shares, debt or equity interests in any of the Group Entities with a FMV that exceeds 30% of the FMV of all the interests that were owned, directly or indirectly, by the Seller (and the Seller's spouse/common-law partner) immediately before the disposition.

It is not readily apparent why this later condition is being proposed to apply to the gradual transfer and not the immediate transfer and it may serve as a significant factor in the determination of whether to proceed with an immediate or gradual transfer. If proceeding with a gradual transfer, this condition could pose a risk for future cash-flow issues in the efforts to pay out sufficient amounts to the Seller to reduce their interests in the Group Entities to the applicable threshold prior to the Final Sale Time. However, under an immediate transfer the Seller could presumably retain an interest in the Group Entities in excess of the above-noted values for an indefinite period of time, which could alleviate risk for future cash-flow issues by simply deferring payments beyond the Final Sale Time if necessary.

4. Control and Operation of the Business

• Immediate Transfer – From the Disposition Time until 36 months after, (i) the child or group of children, as the case may be, must control the Target Corporation and the Purchaser Corporation; (ii) the child, or at least one member of the group of children, as the case may be, must be actively engaged on a regular, continuous and substantial basis (i.e., at least an average of 20 hours per week) in a relevant business of the Target Corporation or a Relevant Group Entity; and (iii) each relevant business of the Target Corporation and any Relevant Group Entity must be carried on as an active business.
• Gradual Transfer – From the Disposition Time until the later of 60 months after and the Final Sale Time, (i) the child or group of children, as the case may be, must control the Target Corporation and the Purchaser Corporation; (ii) the child, or at least one member of the group of children, as the case may be, must be actively engaged on a regular, continuous and substantial basis (i.e., at least an average of 20 hours per week) in a relevant business of the Target Corporation or a Relevant Group Entity; and (iii) each relevant business of the Target Corporation and any Relevant Group Entity must be carried on as an active business.

5. Transfer of Management of the Business

• Immediate Transfer – Within 36 months of the Disposition Time or such greater period of time as is reasonable in the circumstances, the Seller and the Seller's spouse/common-law partner must take reasonable steps to transfer management of each relevant business of the Target Corporation and any Relevant Group Entity to the child or children, and to permanently cease managing the business.
• Gradual Transfer – Within 60 months of the Disposition Time or such greater period of time as is reasonable in the circumstances, the Seller and the Seller's spouse/common-law partner must take reasonable steps to transfer management of each relevant business of the Target Corporation and any Relevant Group Entity to the child or children, and to permanently cease managing the business.

Under both the immediate and gradual transfer rules, there is ambiguity as to what is meant by "management" of the business or under what circumstances it would be reasonable to take longer than 36 or 60 months, as applicable, to transfer the management of the business.

In either case, the Seller and the Seller's child (or each member of the group of children, as the case may be) must jointly elect in prescribed form for the immediate transfer or gradual transfer rules to apply and must file the election with the Minister on or before the taxpayer's filing-due date for the taxation year in which the disposition occurred.

Finally, there are also a number of other ancillary amendments proposed to facilitate the new rules, including:

• Subsection 40(1.2) is proposed to increase the capital gains reserve from 5 years to 10 years for genuine intergenerational transfers that satisfy the above conditions. This will permit the Seller to defer the recognition of the capital gain over a period of 10 years, being a minimum of 10% of the capital gain each year.
• Paragraphs 84.1(2.3)(c) and (d) are proposed to relieve the Seller and the child or children of the Seller from the conditions of 4 (Control and Operation of the Business) and 5 (Transfer of Management of the Business) noted above where one or more children have disposed of all of the shares of the Target Corporation, the Purchaser Corporation, or all Relevant Group Entities to an arm's length person, or where a child has died or is suffering from a severe and prolonged impairment in physical or mental functions.
• Paragraph 152(4)(b.8) is proposed to extend the period of time in which the Minister can make an assessment, reassessment or additional assessment of tax, interest or penalties to (i) three years after the taxpayer's normal reassessment period in respect of an immediate intergenerational business transfer and (ii) ten years after the taxpayer's normal reassessment period in respect of a gradual intergenerational business transfer.
• Subsection 160(1.5) is proposed to provide that, where an election is made to have the immediate or gradual intergenerational business transfer rules apply, the child or children of the Seller will be jointly and severally liable with the Seller for any tax payable by the Seller resulting from a failure to meet the conditions prescribed for a genuine intergenerational business transfer. This proposed change recognizes the fact that the children of the Seller could take actions post-transfer outside of the control of the Seller that place the parties offside of the rules.

It is also notable that the provisions contained in Bill C-208 that purported to reduce, on a sliding scale basis, the available LCGE in circumstances where the combined taxable capital of the Target Corporation and its associated corporations exceeds $10 million have been removed. This is a positive change to ensure intergenerational share transfers receive the same tax treatment as an arm's length sale.

iii. Implementation

The legislative amendments implementing the above changes will take effect on January 1, 2024.

Footnotes

1. While Bill C-208 was passed without providing for a commencement date or a date for coming into force, it effectively became law on the date assented to pursuant to subsections 5(2) and 6(2) of the Interpretation Act (Canada).

2."Government of Canada clarifies taxation for intergenerational transfers of small business shares" (July 19, 2021) online: https://www.canada.ca/en/department-finance/news/2021/07/government-of-canada-clarifies-taxation-for-intergenerational-transfers-of-small-business-shares.html

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.