Many business owners dream of passing their businesses on to their children. But thanks to a specific anti-avoidance tax rule, it’s often more profitable to sell to an outsider.
The federal rule, in section 84.1 of the Income Tax Act, means that “when family goes to buy a business from family members, they’re on a completely different footing than non-family members,” says James Kraft, vice-president and head of business advisory and succession planning at BMO Wealth Management.
If a stranger wants to buy a company, says Kraft, usually the most tax-efficient way to do it is to create a holding company to buy the target company. Profits from the target company can be used to pay off any loans that were required for the purchase, and the sale benefits from the tax regime’s lifetime capital gains exemption.
But, under section 84.1, if a parent sells their corporation to a child or relative’s holding company, the sale is taxed as a dividend instead of a capital gain. “If children go to buy it from parents, if they form a BuyCo, the parents get bad [tax] treatment,” says Kraft. (See “Case Study: a family-run business,” below.)
The federal government says nothing in the tax act prevents a parent from selling the family business directly to a child (without using a BuyCo) and benefiting from the lifetime capital gains exemption. But, says Kraft, if the child doesn’t form a BuyCo, “they have to take the profits of the company out personally, pay personal taxes and then use the profits to pay for the purchase. They have much more significant tax issues than a stranger.”
Why does section 84.1 exist?
“It came in because there are ways to abuse the lifetime capital gains exemption,” says Kraft, which in 2017 is worth $835,716.
A mother could sell her company to her child for the sole purpose of accessing the exemption, and make her child the owner for legal and tax purposes only. “If I can get you $800,000 and use up your capital gains exemption, you’ve got $800,000 to spend tax-free, and you still own your business,” says Kraft. Since that would not be considered a bona fide sale, it would be tax avoidance.
But what if there is a bona fide sale for family estate planning? Unfortunately for family businesses, 84.1 still applies, and there aren’t many ways around it.
“Sometimes we’re lucky that the business can do an estate freeze,” says Kraft. But with most estate freezes, sellers get cash in exchange for shares gradually, and the process can take decades. Further, if the seller needs additional cash before the full transfer is complete, he says, the business can only pay the seller dividends, which are taxed higher than capital gains.
“You get really frustrated that there’s a good, honest family incurring additional taxes that the neighbours don’t have to because they’re not dealing with family,” says Kraft. “I’ve got a family demanding to use the capital gains exemption. Mom and dad are going to get $1 million each, and it’s going to cost the son $4 million in profits to give it to them. And he’s beside himself, because what looks like his mom and dad saving taxes, the government’s just picking up in the other pocket.”
Kraft’s clients aren’t alone. NDP MP Guy Caron says more than $50 billion in farm assets are set to change hands over the next 10 years, and more than 8,000 family farms have disappeared in the past decade.
Pushing for amendments
“It’s a problem more and more, because farmers, especially, and fishers, are seeing the benefits of being incorporated,” says Caron, who last year introduced private member’s bill C-274 to address section 84.1. (Update: on February 8, 2017, the bill was defeated.)
The bill proposes a limited exception to section 84.1 for share transfers from a corporation’s owner to a child or grandchild. Bill C-274 would require the child to own the business for at least five years after the transfer for the exception to apply (unless the buyer dies). Under the bill, the exception would not apply to transactions above $15 million, and CRA could request additional paperwork relevant to the family transfer.
The provision as it stands, Caron says, is causing tough choices for small business owners who have to consider the savings of transferring their corporation to someone outside the family.
“Those people have to consider, ‘Am I going to keep the business, the farm or the fishing boat in the family, at the cost of having a more decent retirement?’” Caron says. “It’s a choice you should not be confronted with.”
Caron’s bill has the support of all opposition parties and groups as diverse as the Chicken Farmers of Canada and the Conference for Advanced Life Underwriting (CALU). The opposition parties don’t have the support of the Liberal government as a parliamentary vote on February 8 threatens to defeat the legislation. Caron would need a handful of Liberals to support the bill’s passage, though that would be rare, since most private member’s bills don’t become law.
Grappling with a higher-than-expected federal deficit, the Liberal government argues the provision is really about avoiding abuse.
“Our government is aware of the challenge facing small business owners — including farmers — as more and more of them approach retirement age and wish to leave their businesses to their children,” Annie Donolo, spokesperson for the minister of Finance, says in an emailed statement. “Let’s be clear: nothing currently prevents a parent from selling the family company directly to their child and claiming the lifetime capital gains exemption on the resulting capital gain. The issue at hand isn’t passing on the family business, but rather corporations potentially abusing the tax code to avoid paying their fair share of taxes.”
If enacted, Bill C-274 could “lead to tax planning consequences that could cost the federal treasury up to $1.2 billion per year,” says Donolo, adding that the government will be studying the issue for solutions.
Caron argues the government’s tax revenue claims “make no sense at all.” He says the government’s estimate did not take into account current tax minimization practices for business transfers, and that he has consulted tax lawyers, including at Eric Dufour of Raymond Chabot Grant Thornton, who estimate the bill would cost the government $75 million to $90 million annually.
CALU has its own suggestions on how to change section 84.1:
- Limit an exception to 84.1 to children or grandchildren of the transferor.
- Require the purchaser or their spouse/partner to be active in the business after the purchase.
- Limit the exception to only that portion of the capital gain that can be offset by the shareholder’s capital gains exemption. This would more clearly limit the benefit to owners of smaller businesses, and in turn restrict the tax benefit available to owners of larger businesses.
- To ensure the business owner is retiring, require the owner to be of a certain minimum age to access the exemption (e.g., 50 or 55).
- Have a specific anti-avoidance rule to prevent abuse of the exception (e.g., a minimum holding period for the shares).
- Require the transferor(s) to report, in the year of sale, that they are claiming the exception under section 84.1. This would give CRA the opportunity to review the transaction and ensure a bona fide sale is taking place, and allow tracking of tax expenditures.
“No wants this thing to be a slam dunk,” says Kraft, referring to ways around 84.1. “They really want it to be for scenarios when there’s a full transfer.”
And if C-274 passes and the Department of Finance finds that people are later abusing the exemptions, Kraft says the Income Tax Act is already equipped to handle that.
“The nice thing about abuse is you can always pull out GAAR [the general anti-avoidance rules] and chase them down.”
When does section 84.1 apply?
- a Canadian-resident individual shareholder has disposed of shares of a corporation resident in Canada; and
- the disposition is to another corporation with whom the shareholder does not deal at arm’s length.
The rules also apply if the shares are acquired by an individual who does not deal at arm’s length with the shareholder, and the vendor claims the capital gains exemption. In that case, there is a reduction in the hard basis of the acquired shares to the purchaser, which affects the ability of the that person to withdraw corporate surplus on a tax-effective basis.
Source: Income Tax Act; CALU
This following fictional example is courtesy of the Conference for Advanced Life Underwriting (CALU)
Ron Nelson started a plumbing business almost 40 years ago. It was tough in the early years, but the business managed to grow in both good times and bad. His wife, Joanie, joined the business once their children Mike and Tenley were old enough to start day school. As the years passed, Ron successfully bid on larger construction projects. Mike decided to follow in his father’s footsteps, eventually becoming a master plumber in the company. In turn, Tenley graduated with a business degree and joined the company, gradually assuming most of her mom’s responsibilities as office manager.
Now in their mid-60s, Ron and Joanie have told Tenley and Mike that they plan to retire in the next few years and let them take over. The parents simply want enough to retire comfortably, do some travelling and buy a small condo down south. Like most small business owners, they left most of the profits in the company to fund expansion, and only recently paid off their mortgage.
Then the unexpected happened. Tom Welding, the owner of a plumbing business in a neighbouring town, offered to buy Ron out. He offered him $1.5 million with $500,000 up front and the rest over five years. This was more than Ron thought the business was worth, and would erase his money worries. But what about Tenley and Mike?
Ron and Joanie met with the children to discuss this latest development. Ron noted this was a strong offer, and was worried that Tom might buy another local business and become a major rival if they turned him down. The children had thought they would eventually take over the business, but now feared they would be looking for new jobs. Ron agreed to let Tenley and Mike pull together their own offer.
Later that week, Tenley and Mike presented a counter-proposal. Their plan was to incorporate a new company to purchase Ron’s shares for $1.5 million.
However, they could only come up with $100,000 in cash, with the remainder funded by a 10-year loan from Ron. Although not quite as good as Tom’s offer, Ron and Joanie wanted the business to stay in the family. They tentatively agreed, subject to discussions with Sharon, their accountant and business advisor.
The meeting between Ron, Joanie and Sharon took place two days later. She told Ron he still had access to his full capital gains exemption of just over $800,000.
This was a relief, as the cost base and paid-up capital of his shares in the company was nominal.
She then explained that with Tom’s offer, the first $800,000 of sale proceeds would be completely tax-free due to his capital gains exemption. The remaining $700,000 would be a capital gain, of which $350,000 would be included in his income. But this income could be spread out, since most of the sale proceeds would be paid over five years. This would result in that income being taxed at a lower marginal tax rate. She estimated that Tom would net approximately $1.35 million after tax once all the money had been paid out.
Unfortunately, this would not be the case under the children’s offer. Sharon noted there is a special rule in the Income Tax Act, which applies where an individual sells shares in a private corporation to another corporation owned by non-arm’s length persons, such as Ron and Joanie’s children. In this case, the sale proceeds would be treated as dividend income rather than capital gains. For Ron, this meant no access to his capital gains exemption, and no capital gains reserve. Instead of netting $1.35 million after tax, he would only receive approximately $900,000 — a shortfall of $450,000 from Tom’s offer.
Sharon explained that Ron could sell his shares directly to his children, rather than through a corporation, and essentially get the same after-tax result as Tom’s offer. But in this case, the children would need to withdraw the money from the company as taxable dividends, which would mean they’d have less available after tax to repay the loan to Ron. She noted this would likely result in the children needing 15 to 20 years to repay their father, rather than the 10 years they estimated. This would also adversely affect the firm’s cash flow, and put Ron at greater risk in terms of having the children repay the loan.
Why does this happen?
Sharon was referring the rule found in section 84.1 of the Income Tax Act. The rule prevents the withdrawal of corporate surplus on a tax-free basis by using the capital gains exemption on a disposition of shares in a non-arm’s length transfer. When section 84.1 applies, it will either convert a capital gain into a deemed dividend, or reduce the paid-up capital of shares received on the sale transaction.