Bill C-208: Advisors work overtime on succession plans as tax changes loom

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Canadian family offices are working overtime with their family businesses since new federal tax rules were announced in the spring budget.

That’s because the new rules, regarding the transfer of small businesses, will significantly affect how much tax family business owners will pay when they pass these businesses on to the next generation. The rules are expected to come into effect on Jan. 1, 2024.

The changes have put some clients on high alert.

In the past, it was more advantageous from a tax perspective to transfer a family business to someone outside the family rather than a family member.

“If the business was sold to a corporation controlled by a family member, the transfer of shares would be taxed as dividends rather than capital gains, which would result in the seller being taxed at a much higher rate,” says Dino Infanti, the Vancouver-based partner and national leader, Enterprise Tax, at KPMG in Canada.

Capital gains are taxed at up to 27 per cent, while dividends are taxed at nearly 50 per cent for individuals in the top tax bracket, he says.

Bill C-208, a private member’s bill enacted in 2021, sought to level the tax playing field between family business owners selling to third parties and those transferring their business to a family member. Specifically, the bill provided for the same tax benefits regardless of whether shares of a family business are sold to a corporation controlled by an adult child (or grandchild) or sold to an unrelated person.

However, the new rules have a few wrinkles of their own, prompting the federal finance department to bring forward amendments “that honour the spirit of Bill C-208 while safeguarding against any unintended tax avoidance loopholes.” The changes announced in the budget to tighten the rules are set to come into effect on January 1, 2024.

The finance department had indicated the rules were too broad, says Am Lidder, senior vice-president, Tax Services, at MNP based in Surrey, B.C.

“The changes announced in the budget appear to address the specific areas where the Department of Finance felt that the current rules – as introduced by Bill C-208 – contained insufficient safeguards,” Lidder says.

The fine print

The proposed amendments in this year’s budget restrict the rules by establishing two timeframes in which a seller can pass on the business to the next generation and qualify for the more favourable capital gains treatment.

• One option is an immediate transfer, says Infanti. Under this transfer, the parent/owner must transfer both legal and factual control immediately to the adult child/successor. The parent must also transfer most of the voting and growth shares immediately and then the balance of these shares within 36 months. The child/successor must start to work in the business immediately and take over management of the business within 36 months.
• The other option is a gradual transfer, as Infanti explains. In this scenario, the parent/owner has to transfer only legal control immediately. The parent must also transfer most of the voting and growth shares immediately, and then the balance of these shares within 36 months. The child/successor must start to work in the business immediately and take over its management within 60 months. Also, within 10 years of the sale, the parent has to reduce the value of their debt and equity interests in the business to 30 per cent of the value of all their interests at the time of sale (50 per cent of the value for a family farm or fishing corporation).

Infanti says how a family business might react to these changes depends on how they see their succession rolling out. He says that in cases where a parent is concerned about maintaining some control, “a transfer might be important to consider now rather than wait until Jan. 1, 2024.” Under the new rules, business owners will have to transfer legal control of the business immediately, says Infanti.

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Some first-generation owners who might want to retain some control of their business – or hold onto control for longer than the new rules allow – might want to start their succession plan before year’s end.

“With less than five months to go, the window to structure a transaction under the current tax rules will close soon,” warns Infanti. “If you’re thinking about transferring your business to the next generation, take the time to understand these rules and weigh your options now.”

Some see rules as more restrictive

Lidder thinks the new rules, while well-intended, may not bring about the efficiency promised.

“The rules will have a minimal impact on streamlining the succession process,” she says. “Transitions of family businesses are often complex, and it will be challenging to try to plan for these transitions to fall neatly within specific requirements.”

She gives an example in which parents plan to transition ownership of their automotive repair company to their adult son over 10 years. The first five years go according to plan, but “in year six, the son is forced to permanently step away from day-to-day operations of the business due to a medical condition that, although not disabling, would threaten his longevity and well-being if his day-to-day involvement in the business continued.”

In this situation, the only option available to the family might be to have a non-family member employee run the business until it can be sold, says Lidder.

“As the son can no longer work in the business, the requirements of the five- to 10-year test cannot be met,” she says. “The parents would face a substantial and retroactive increase in the tax arising from their initial transfer in year one.”

The rules are more restrictive than in the previous legislation, Lidder says. “Business owners who are considering a transition to family members will be disincentivized from doing so because the rules have become more onerous,” she says. “Under the new rules, selling to a family member could once again be viewed as less desirable than selling to a third party in order to achieve the same after-tax result.”

Infanti is more optimistic. He says the rules offer more clarity around transfers, filling in the holes that existed before.

“These rules allow families to position themselves so their legacy and dream can continue,” he says.

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