New 2024 Tax Changes to Intergenerational Business Transfers in Canada

Posted on June 26th, 2024 in Domestic Tax

Executive summary:

Bill C-59, introduced on Nov. 30, 2023 and since receiving Royal Assent on June 20, 2024, proposes amendments to the intergenerational business transfer (IBT) rules to better accommodate genuine transfers of businesses to the next generation. These changes are intended to rectify shortcomings in the current rules, which were initially established by Bill C-208 in 2021. The new amendments introduce two options for business transfers: the Immediate IBT and the Gradual IBT, each with specific criteria to ensure compliance and authenticity in transfers. The amendments aim to exempt genuine intergenerational transfers from the “surplus stripping” rules, which typically recharacterize capital gains as fully taxable dividends. By ensuring the transfers are genuine, the new rules provide tax benefits similar to those of arm’s length sales.

New amendments to Bill C-59: strengthening genuine intergenerational transfers and tackling surplus stripping

Background

The existing intergenerational business transfer (IBT) rules, initially introduced through Bill C-208 and enacted on June 29, 2021, was an important step to encourage transfers of shares of small businesses, family farms, or fishing corporations to the next generation. These regulations were designed to better harmonize the treatment of intergenerational transfers with third-party sales.

Taxpayers wishing to transfer their corporations to the next generation oftentimes plan to sell their shares to a corporation that the children control. But for the previous wording of surplus stripping rules, these dispositions should ordinarily result in capital gains, which are subject to a reduced rate of tax (starting on or after June 25, 2024, the inclusion rates for certain capital gains will increase from 50% to 66.67%). Under certain historic “surplus stripping” provisions in the Income Tax Act (ITA), however, capital gains otherwise realized on intergenerational sales of shares structured this way would be recharacterized to fully taxable dividends instead. Taxable dividends, for individual taxpayers, are taxed less favourably than capital gains. With the implementation of the IBT rules, these gains would instead be excepted from the “surplus stripping” provisions and would thereby retain their character as capital gains.

Bill C-59, introduced on Nov. 30, 2023, encompasses the latest amendments to the IBT rules. Originally suggested in Budget 2023, these amendments aim to better accommodate the goal of encouraging intergenerational transfers first introduced in Bill C-208.

Introduction of proposed amendments:

The amendments in Bill C-59 propose two alternatives to access the exemption from the surplus stripping rules:

a. Immediate IBT: The immediate IBT option is useful for business transfers that are expedited and are based on arm’s length sale terms, with a compressed timeline of three years.

b. Gradual IBT: The gradual IBT option allows for a more protracted transition period, spanning five to ten years, providing greater flexibility for both parties involved in the transfer.

At a high level, the conditions that must be met for both options can be very generally summarized as follows:

Criteria	Immediate business transfer	Gradual business transfer
No duplicate planning test	Parents could not have previously sought the immediate/gradual IBT exception related to the business of the operating company
Purchaser control test	Children must control the purchaser corporation and be at least 18 years of age or older.
Share condition test	Operating company shares must be qualified small business corporation (QSBC) shares or family farm or fishing corporation (QFFC) shares.
Transfer of control test	Parents immediately and permanently transfer both legal and factual/effective control.	Parents immediately and permanently transfer only legal control.
Transfer of voting shares test	Immediate transfer of majority of voting shares.
Remaining share ownership test	arents must not own any shares, other than non-voting preferred shares, within 36 months after the disposition.
Transfer of management test	Parents transfer management of the business within 36 months after the disposition.	Parents transfer management of the business within 60 months after the disposition.
Remaining economic interest limitation test	N/A	Within 10 years after the disposition, the fair market value of all debt and equity previously owned by the parents is reduced below either 30% or 50% of their original amount, depending on whether the shares disposed of were QSBC shares or QFFC shares, respectively
Retention of control test	Children retain legal control of the purchaser corporation for a 36-month period following the initial disposition time.	Children retain legal control of the purchaser corporation for a 60-month period following the initial disposition time.
Child works in the business test	At least one child remains actively involved in the business for the 36-month period following the share transfer.	At least one child remains actively involved in the business for a 60-month period following the initial disposition time.

Administration and special rules of application

In order to be eligible for the new IBT rules, both the parents and the children must file a joint election in prescribed form by the parents’ filing deadline for the year of transfer.

The Canada Revenue Agency (CRA) will have the power to monitor whether the above conditions are met over a period of time and subsequently reassess the original year of transfer when the conditions fail to be met. Both the parents and the children will be jointly and severally liable for any additional taxes payable.

Additionally, certain special rules and treatments will apply for purposes of the new IBT rules, including:

1. Nieces/nephews or grandniece/grandnephews are included in the scope of “child”.
2. Certain criteria can be deemed to met if the time periods are cut short for various reasons, such as in situations where the children sell the shares to an arm’s length party, a child experiences a prolonged impairment or dies, or if the business ceases.
3. Parents will be able to claim an extended capital gains reserve from the ordinary five years to a maximum of ten years.

Surplus stripping and the general anti-avoidance rule

As mentioned before, the new IBT rules from Bill C-59 are an exemption to the surplus stripping rules that apply in certain non-arm’s length transfers of Canadian-resident corporation shares. Courts have consistently interpreted that the purpose of these surplus stripping rules is to prevent taxpayers from performing transactions to strip a corporation of its retained earnings. This purpose is important to keep in mind, especially due to the upcoming changes to the general anti-avoidance rule (GAAR). GAAR is a provision of last resort and can apply to reverse a tax consequence in situations where a taxpayer undergoes a series of transactions to try and circumvent certain tax rules.

Draft GAAR legislative updates have just recently received royal assent in Parliament and are effective from Jan. 1, 2024. One of the changes includes further scrutiny for transactions that lack economic substance. A lack of economic substance can be found in a transaction or series of transactions, although being legally effective, that do not have real economic impact. If a lack of economic substance is found, this suggests there is a higher potential abuse in avoiding taxes.

The current IBT rules from Bill C-208 do not have significant safeguards to ensure genuine transfers take place. As a result, taxpayers will need to be cautious of the newly enacted GAAR when structuring transactions to avoid these surplus stripping rules under current IBT rules, especially if no genuine transfer took place. The proposed changes to the IBT rules would likely result in less risk of GAAR applying to intergenerational transfer transactions, since the conditions required to fall within the purview of the new rules have been significantly increased.

Navigating the challenges and tax benefits under IBT rules for business transfers

While the criteria of the new IBT rules from Bill C-59 are perhaps stricter than the current rules from Bill C-208, this represents a new planning opportunity for taxpayers that are looking to transfer their businesses to the next generation. While the costs of non-compliance can leave some taxpayers feeling uneasy, allowing taxpayers to be afforded the same tax treatment had they sold to an arm’s length party is a highly beneficial. The ability to gain the same benefit under either the immediate or gradual options, depending on taxpayer circumstance, offers some meaningful flexibility. While GAAR will always loom in situations where taxpayers aim to engage in “surplus stripping” transactions, taxpayers should feel at greater ease when structuring transactions to fall under the new IBT rules Additionally, taxpayers should anticipate further tweaks to Bill C-59, enhancing clarity and optimizing transactions structuring under the new IBT rules.

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This article was written by Mamtha Shree, Daniel Mahne and originally appeared on 2024-06-26. Reprinted with permission from RSM Canada LLP.
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