Good News for Family Business Transfers: New Tax Measures Now in Effect

Since January 1, 2024, new tax provisions govern the intergenerational transfer of family businesses.

These measures aim to facilitate intergenerational business transfers while preventing the distribution of corporate surpluses as capital gains (which are either tax-exempt or subject to a preferential tax rate) rather than as taxable dividends.

Putting an End to an Unfair Situation

In general terms, section 84.1 of the Income Tax Act (the "ITA") applies when an individual or trust residing in Canada disposes of Canadian corporation shares to another corporation with which the taxpayer does not deal at arm’s length for consideration other than shares (cash or promissory note). When these conditions are met, the capital gain that would otherwise have been realized on the disposition of the shares is requalified as a taxable dividend, thereby preventing the seller from claiming the capital gains deduction.

The application of section 84.1 of the ITA in its previous version resulted in a significant tax disadvantage for taxpayers who chose to sell their business to their children or grandchildren rather than to an arm’s-length third party.

Bill C-208, which has been in effect since June 29, 2021, was designed to mitigate this unfair situation by introducing an exception to the application of section 84.1 of the ITA in the case of an intergenerational transfer of a family business. Nevertheless, these measures had the potential of creating opportunities for stripping surpluses in situations where there was no actual business transfer. The measures implemented as of January 1, 2024, aim to rectify the situation so that only genuine intergenerational business transfers may be considered arm’s-length transactions that do not give rise to a dividend under section 84.1 of the ITA.

Accordingly, as of January 1, 2024, where the conditions listed below are met, a selling parent may claim the capital gains deduction on the disposition of shares of one corporation (“Corporation”) to another (“Purchaser”) controlled by one or more of the selling parent’s children, nephews or nieces aged 18 or more (“Child”/”Children”).

How the New Regulations Apply

The new measures provide for a series of conditions to be met prior to, at the time of, and subsequent to the transfer.

Either of two approaches may be adopted for an intergenerational business transfer:

• An immediate intergenerational business transfer
• A gradual intergenerational business transfer

The criteria to be met for either approach differ only as regards the conditions to be fulfilled subsequent to the transfer.

Prior to the transfer

• The selling parent must not have already claimed the exception to the application of section 84.1 of the ITA for the same business, except with respect to dispositions that occurred before January 1, 2024.

At the time of the transfer

• The seller must be an individual (other than a trust). If the shares are held by a trust, prior transactions must be carried out to transfer them to the selling parent prior to the sale.
• The Purchaser must be controlled by one or more Children.
• The shares sold must be qualified small business corporation shares.

Subsequent to the transfer

Surrender of control by the selling parent:

• Under an immediate intergenerational business transfer, the selling parent must relinquish legal and factual control of the Corporation and the Purchaser.
• Under a gradual intergenerational business transfer, the selling parent must relinquish only legal control immediately. The selling parent may retain factual control for up to 10 years subsequent to the transfer.

Transfer of business ownership:

• At no time subsequent to the disposition may the selling parent own, directly or indirectly, 50% or more of the common shares of the Corporation or the Purchaser. Within 36 months of disposition, all common shares must be transferred.
• Under a gradual intergenerational business transfer, within 10 years of the time of disposition, the selling parent must not hold, directly or indirectly, more than 30% of the fair market value of all interests (including any debt) in the Corporation or the Purchaser immediately prior to the time of disposition.

Maintenance of control by the Child:

• Under an immediate intergenerational business transfer, for a minimum period of 36 months, the Child must retain legal control of the Purchaser and take an active part in the business. Moreover, the business underlying the Corporation must continue to be carried on as an active business.
• Under a gradual intergenerational business transfer, the minimum period is extended to 60 months.

Transfer of business management to the Child:

• Under an immediate intergenerational business transfer, the selling parent must, within 36 months of the disposition or whatever longer period is reasonable in the circumstances, transfer management of the active business carried on by the Corporation to the Child, thereby definitively ceasing to manage the business.
• Under a gradual intergenerational business transfer, the 36-month period is extended to 60 months.

In addition to meeting the foregoing conditions, the selling parent and the Child must jointly elect to apply the exception to section 84.1 of the ITA with respect to the disposition of the shares. This election must be filed no later than the filing due date of the selling parent’s income tax return for the taxation year in which the disposition occurred.

Please also note that, due to the minimum period required for meeting the foregoing conditions, the limitation period for an immediate intergenerational business transfer and a gradual intergenerational business transfer are extended by three and ten years, respectively.

Lastly, certain relief measures are provided when the foregoing conditions are not met, notably due to the death or disability of the Child or the insolvency of the Corporation.

Québec entrepreneurs who wish to transfer their business to family members may now do so without losing their capital gains deduction. The measures introduced on January 1, 2024, offer two options for planning your business succession. BCF’s tax team would be pleased to help you determine which one is right for you.