Executive Summaries Feb 1, 2023
Tax Relief for Family Business Succession in the Province of Québec
For many years, the Québec business community has complained about the unfavourable, and sometimes unfair tax treatment granted to family businesses when it’s time for the founders to hand over the reins to the next generation.
Tax laws include provisions, often referred to as anti-avoidance rules, which deny favourable tax treatment to capital gains where a transaction occurs between non-arm’s length corporations. Entrepreneurs and their tax advisors’ requests were finally heard, and relief was adopted in 2016 by the Québec government and in 2021 by the federal government. The following is a summary of the general rules that apply to family succession transactions, as well as the benefits resulting from the tax relief measures adopted in recent years.
Classic Acquisition Structure
Most acquisitions are carried out by proceeding with the following steps:
- 1) The purchaser forms a new company (“Buyco”) that will acquire the shares of the company involved in the transaction (“Target Company”);
- 2) The purchaser invests its equity in Buyco in the form of share capital;
- 3) Buyco also takes out a loan to secure the funds necessary to buy the target’s shares;
- 4) Buyco buys target’s share;
- 5) Buyco and the Target Company are merged immediately after the closing of the transaction, creating a new company (“Mergerco”).
These steps allow the seller to generate a capital gain, which may be exempt in whole or in part once certain criterias are met. It also allows the purchaser to use future profits earned by the Target Company, now Mergerco, to repay the loan and for the Target Company to deduct the interest on the loan from its taxable income.
Anti-Avoidance Rules for Family Relief Transactions
When a founder considers transferring his company’s shares to his children, he obviously hopes to benefit from the favourable tax treatment reserved for capital gains, i.e., the possibility of using both the exemption and the tax rate on the capital gain.
If the children implement the above-mentioned steps to do so, the anti-avoidance rule will convert the capital gain, which would otherwise be earned by the seller, into a dividend. Such a conversion will result in two negative outcomes for the seller:
- Since a dividend will result from the sale of the shares to Buyco, and not a capital gain, the seller will not benefit from the capital gain exemption.
- The top marginal tax rate for a dividend is 48.7%, whereas the rate for a capital gain is 26.7%.
To counteract these extremely punitive rules, families had two options when making intergenerational transfers:
- The seller had to forgo the capital gains exemption and agree to pay a higher tax on the disposition of their shares, or;
- The purchasers had to agree to complete the acquisition personally, therefore without incorporating Buyco. As a result of this compromise, they had to withdraw profits from the target company, often in the form of a dividend, to repay the loan. Since taxes on such a dividend can be as high as 48.7%, the profits needed to repay the loan had to be much higher to allow the purchasers to meet their obligations.
Good News, Relief Now Available
As of March 17, 2016, Revenu Québec announced that the anti-avoidance rule would not apply to an intergenerational transfer if all of the following seven conditions are met:
- The seller is an individual;
- The seller has been active in the company in the 24 months before the sale of the shares
- The seller is not active in the company after the sale, other than to ensure a smooth transfer;
- The seller has no control over the company after the sale;
- The seller doesn’t own, either directly or indirectly, any participating shares in the Target Company after the sale;
- The seller’s remaining financial interest in the Target Company or the purchaser may not exceed 60% after the sale;
- The individual shareholder of the purchaser must be actively involved in the operations of the Target Company’s business.
Once these conditions are met, the part of the capital gain that qualifies as a capital gain exemption will not be subject to the anti-avoidance rule. The capital gains exemption will therefore be available, but the excess of the total gain over the exempt gain will still be considered a dividend.
The federal government also announced relief that has been in effect since June 29, 2021. They are available when these three conditions are met, namely:
- The purchasing corporation is owned by children or grandchildren of the seller who are at least 18 years old;
- The seller’s shares are “qualified small business corporation shares” and therefore eligible for the capital gains exemption;
- The purchaser holds the shares for a minimum of 60 months after the transaction.
When relief is available, the entire capital gain remains unchanged, and no portion is converted to a dividend for the seller.
Although the announced relief has been welcomed as good news in the business community, there are still many conditions that must be met to benefit from it and, most of the time, a tax specialist’s intervention is required to achieve it.
Moreover, significant discrepancies between the criteria and tax treatment at the federal and provincial levels may lead to very different results in the federal and provincial tax returns for the same transaction. We therefore strongly advise you to seek the advice of a tax specialist as early as possible in the family succession process.
Feel free to contact , who will be pleased to assist you in planning your business succession.
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