Keep it in the Family: Updated Tax Rules for the Transfer of a Family Business
Amongst the pile of tax changes introduced in the 2023 federal budget are several important proposed amendments to the rules on intergenerational business transfers, and we’re here to break them down for you.
The original legislation from 2021 (Bill C-208) still applies to intergenerational share transfers from a parent to a corporation controlled by one or more adult children of the transferring parent, as long as the transferred shares are qualified small business corporation (QSBC) shares or shares of a family farm or fishing corporation.
The proposed rule changes, which will go into effect on January 1, 2024, aim to allow genuine intergenerational business transfers to occur while closing a potential loophole that the government had noticed in the original legislation. Let’s take a closer look at what’s in store and what these changes mean for you and your business, should you be considering passing the proverbial torch in the near future.
Potential Loophole in Bill C-208
Before the adoption of Bill C-208, it was actually more advantageous to transfer a family business to a stranger than to a family member. This was due to the fact that if you sold the business to a family member, the difference between the sale price and the cost of the company shares was treated as a dividend, and therefore taxed like one. In contrast, a sale to a non-family member resulted in a capital gain, which could be eligible for the lifetime capital gains exemption (LCGE) if the shares were QSBC shares.
Bill C-208 was introduced to fix this issue. However, the original legislation did not require the parents selling the business to give up control of the corporation or for the adult child buying the business to have any involvement in its operation. In theory, this could allow a parent to sell their business to an adult child, realize the capital gain and claim the LCGE, all while still running the business.
Proposed Changes to the Tax Rules
To clarify what constitutes a genuine intergenerational business transfer and to address the aforementioned loophole, the proposed changes in Budget 2023 include several requirements that must be met depending on the type of transfer being done. Here are the key changes to the legislation:
- There are two different timelines to choose from for the transfer of a business
- an immediate business transfer that would take place over 3 years; or,
- a gradual business transfer that would take place over 5 to 10 years
- The definition of “adult child” has been expanded to include nieces, nephews, grandnieces, and grandnephews
- The parent(s) and the transferee must jointly elect for the transfer to qualify as either an immediate or gradual intergenerational share transfer
- The transferee will be jointly and severally liable for any additional taxes payable by the transferring parent(s) in respect of a transfer that does not meet the required conditions
- The transferring parent(s) now have an option for a 10-year capital gains reserve
- There are new relieving provisions that would apply upon a subsequent arm’s length transfer or upon the death or disability of a child
- The limitation period for reassessing the transferor’s liability for tax that may arise on the transfer is to be extended by three years for an immediate business transfer, and by ten years for a gradual business transfer
Immediate vs Gradual Business Transfer
Requirements for Immediate Business Transfer (3 years):
- Parent(s) have to immediately and permanently transfer both legal and effective control of the business, and immediately transfer a majority of voting and growth shares. The balance of the voting and growth shares have to be transferred within 3 years;
- Parent(s) would have to transfer business management to child within 3 years;
- Children would have to retain legal control for 3 years;
- At least one child has to remain actively involved in the business for 3 years; and,
- The business must be carried on as an active business for 3 years
Requirements for Gradual Business Transfer (5–10 years):
- Parent(s) have to immediately and permanently transfer legal control of the business, and immediately transfer a majority of voting and growth shares. The balance of the voting and growth shares have to be transferred within 3 years;
- Parent(s) have to reduce the economic value of their debt and equity interest in the business within 10 years of the sale to 30%, in the case of QSBC shares, and to 50%, in the case of shares of a family farm or fishing corporation;
- Parent(s) would have to transfer business management to their child within 5 years;
- Children would have to retain legal control for 5 years or until the business transfer is complete (i.e., the time at which the second test is met), whichever is greater;
- At least one child has to remain actively involved in the business for 5 years or until the business transfer is complete, whichever is greater; and,
- The business must be carried on as an active business for 5 years or until the business transfer is complete, whichever is greater
The reason for choosing an immediate transfer over a gradual transfer will be a personal choice for you to make, but one of the main considerations will likely be how involved their children have been in the business prior to the transfer.
Handing off a family business is already an intricate and intensive process, and new tax rules make things even more complex. If you’re considering transferring your family business to the next generation and are wondering how these proposed changes may affect you, contact your DMCL advisor and they’ll be your guide in navigating the process and ensuring a smooth transition.
Article written by Janice Hutchison, CPA, CGA
Read our summary of the highlights from Budget 2023 for more information on this year’s tax changes.