Two tax rules are being introduced in Budget 2023 to consider when owners transfer their businesses to their families and employees. Learn how these measures might impact business succession in 2024 and beyond.
For many years, Canada’s tax treatment of business sales and succession has been a hot topic. Business owners wanting to pass on their businesses to future generations faced tax problems that did not arise on commercial sales to non-family members. Further, unlike many other countries, Canada had no tax framework in place to help owners wishing to pass the business to their employees.
Budget 2023 affects both issues. For interfamily transfers, the budget announced proposals that would add new conditions and correct flaws in legislation stemming from a private member’s bill that had attempted to resolve the inequity between family and non-family business transfers. For transfers to employees, the budget introduces specific tax rules to govern the use of employee ownership trusts intending to increase employee buyouts. Both sets of rules are scheduled to come into effect on January 1, 2024.
In this blog, we summarize the main features of these rules and some issues with the proposals as they are currently drafted.
FAMILY BUSINESS TRANSFERS
Background: Bill C-208
Bill C-208, An act to amend the Income Tax Act (transfer of small business or family farm or fishing corporation) is a private member’s bill, enacted on June 29, 2021, targeting the tax inequity for non-arms length intergenerational transfers of a business.
When selling a corporation to another arm’s-length corporation, as long as the shares qualify, the sale generally triggers a capital gain eligible for the capital gains exemption. The buyer is permitted to make the purchase using a corporation they own, so they can use the after-tax corporate income to help finance the purchase. If an individual buys the shares directly, they must use after-tax personal cash.
However, under the rules in place before Bill C-208’s enactment, if the same shares were sold to a non-arms-length corporation for non-share consideration under similar conditions, the gain would generally be a deemed dividend under Section 84.1 of the Income Tax Act. If another family member bought the shares personally, then a capital gain would arise that would be eligible for the capital gains exemption (if the usual conditions were met). However, the need to use after-tax cash at the personal level created a significant inequity for business transfers within a family and a tax bias favoring arm’s-length sales.
To eliminate this inequity, Bill C-208 altered the rules that apply to non-arm’s-length sales so that deemed dividend treatment would not apply in certain conditions. As Parliament debated the bill in 2021, the Department of Finance Canada (“Finance”) raised concerns that the bill’s changes could open opportunities for inappropriate surplus stripping. Finance committed to amending the rules to facilitate genuine intergenerational share transfers while preventing tax avoidance and improving tax fairness.
What is a “genuine” intergenerational business transfer?
Almost two years later, these amendments were announced in Budget 2023, which states that the tax treatment introduced in Bill C-208 would “apply only where a genuine intergenerational business transfer takes place.”
The budget then sets several conditions that must be met. These include general conditions that would apply to all transfers and specific conditions that would apply in two scenarios:
Where the conditions are met and an election is made, the business transfer would be excluded from Section 84.1’s deemed dividend rules.
Also in the budget are announcements that would:
If enacted, the budget proposals would apply to dispositions on or after January 1, 2024.
EMPLOYEE OWNERSHIP TRUSTS
Canada’s existing rules have several barriers to the creation of Employee Ownership Trusts (EOTs) and have been the topic of consultations for several years. If enacted, the EOT rules could offer another succession planning option for Canadian business owners.
With an EOT, a business can be sold to employees through a trust that holds that corporation’s shares for their employees’ benefit without requiring employees to pay for shares directly. When many employees are participating in a buyout, using a trust can make it easier to deal with the legal and administrative details than if each employee-owned their shares directly.
How do Employee Ownership Trusts work?
An EOT generally would be set up as follows:
The existing ITA rules have several barriers to the creation of EOTs. After several years of consultation and examining these barriers, Budget 2023 introduced new rules that, if enacted, would allow for the creation of EOTs and introduce an additional succession planning option for Canadian business owners. Unlike some other countries, however, the proposed rules seem to focus on removing tax barriers as opposed to creating additional tax benefits to promote employee ownership and the use of EOTs, as we discuss later in this blog.
Canada’s New EOT Rules
An EOT is generally a Canadian resident trust that has two purposes:
Additional conditions for qualifying as an EOT include:
An EOT is a taxable trust, so it is generally subject to the same tax rules as other personal trusts. Undistributed trust income is taxable at the highest personal marginal rate, and trust income that is distributed to beneficiaries is taxed at the level of the beneficiary and not the EOT.
Tax benefits of EOTs
In addition to providing a new business succession alternative, the proposed EOT rules carry the following tax benefits:
If enacted, the EOT rules would apply as of January 1, 2024. Budget 2023 invites stakeholder feedback on how best to enhance the rights of employees and their participation in the governance of EOTs.
We will continue to follow the progress of the proposals for business transfers to family members and employees as they make their way to law, and we will update you as more information is made available or if either set of proposals is changed significantly.
We are here to assist you to make the process of transfer of family business a seamless and, easy process where we move with you step by step through the transfer process. We need more information about your business and its existing setup to guide you in more detail. If you need any further information our experienced and professional team at Filing Taxes is here to set you on the right path considering your personal business situation. Feel free to reach out to Filing Taxes at 416-479-8532. Schedule an NTR engagement appointment with us and take the first step toward proper management of your finances.
Disclaimer: The information provided on this page is intended to provide general information. The information does not consider your personal situation and is not intended to be used without consultation from accounting firms and financial professionals. Salman Randhawa and Filing Taxes will not be held liable for any problems that arise from the usage of the information provided on this page.