For small business owners, passing on their life’s work is an important part of preserving their legacy. However, when it comes time to move on from the business, many have been faced with a difficult choice: a bigger retirement nest egg if they sold the business to someone outside the family, or a higher tax bill if they sold it to their children or grandchildren.
Under Canadian tax laws, small business owners and owners of family farms or fishing corporations who sold the shares of the business to a company owned by their children were taxed at a higher tax rate than if they sold those same shares to an arm’s length party.
Tax relief is expected soon, however, as new legislation to address this long-standing issue was passed by the Senate recently and received Royal Assent on June 29.
Previously under the Income Tax Act, when a business owner sold shares of his or her incorporated business to a non-family member, the sale was generally considered a capital gain, which may be eligible for the lifetime capital gains exemption. This option was not available when the sale of shares was made to a corporation controlled by a family member.
For example, if the husband and wife who own a successful auto repair company sold shares of their business to a third party, the increase in the value of the company was considered a capital gain for tax purposes. If the shares qualified for the lifetime capital gains exemption, the owner might not be required to pay any regular income tax on the sale.
Denying capital-gains tax treatment
In contrast, if the parents sold those same shares to a corporation controlled by a daughter or son, they could have been hit with a steep tax bill when they retired or exited the business. Canadian tax law treated the difference between the sale price of the shares and the cost to the owner of those shares as a dividend, rather than a capital gain.
As a result, the business owners would lose out on the capital gain tax treatment and, if they qualified, the lifetime capital gains exemption, and be taxed at the higher dividend rate. Depending on the province they live in, the type of dividend and their overall income, they could have been taxed at a rate of 49 per cent. For example, on a $900,000 sale, the parent’s tax bill would have been a whopping $441,000 more to keep the business in family hands.
Bill C-208 addresses this by amending a section of the Income Tax Act to essentially treat a business owner’s child or grandchild as being at arm’s length from them. Specifically, this amendment considers the business owner and the purchaser of the shares as dealing at arm’s length if:
- The company buying the business is controlled by one or more of the seller’s children or grandchildren who are 18 or older; and
- The shares must be of a “qualified small business corporation, family farm or fishing corporation.”
The bill prohibits selling the shares within 60 months of purchase. There are also tax changes that would provide greater flexibility in cases where intergenerational transfers involve corporate reorganizations with siblings.
Some concerns expressed
There were some concerns expressed about the bill, as drafted, during a House Standing Committee on Finance meeting in March and again at a Senate Standing Committee on Agriculture and Forestry meeting earlier in June. Specifically, the legislation was thought too broad. As a result, amendments may follow in the future.
While the legislation may not be perfect, it does create a level playing field for business owners when it comes time to exit. By eliminating the tax penalty for intergenerational transfers, the legislation has made it more attractive to keep family business in the family. Ultimately, business owners will no longer have to choose between enjoying a richer retirement and leaving a legacy. They can do both.
Dino Infanti is Partner, National Leader, Enterprise Tax for KPMG LLP in Canada. He is also a member of the Family Office leadership team at KPMG.