Recent changes to Canada’s tax laws could be costly to family businesses

Article content

A shareholder’s agreement is the cornerstone of any successful family business. This document describes the rights and responsibilities of individuals owning shares in a company. It typically covers the purchase or sale of shares, voting, approval of major changes affecting the business, and the distribution of profits.

“It’s setting up a plan for long-term family ownership and control of a business,” explains Steve Legler, a family legacy guide based in Montreal.

In Part One of this series, we covered how shareholder agreements can be problematic. They often lead to family conflict, and half never get signed at all.

But before an agreement is signed, taxes must be considered, says Raymond Adlington, partner with Miller Thomson LLP in London, Ont.

That’s because Canada’s Income Tax Act has been amended several times in recent years regarding how family relationships are defined, how capital gains are calculated and how life insurance policies are handled. Failing to address these issues can lead to costly tax payouts for a family business and potentially threaten its viability.

Smart planning can minimize these issues, says George Angelopoulos, vice-president, tax department at Richter in Montreal.

The ‘arm’s length rule’

Taxes are calculated based on familial relationships. The key is the “arm’s length rule” in a shareholder agreement.

“You are deemed to not be at arm’s length if you have a blood or marital relationship,” says Adlington. “You’re related to your parents, you’re related to your children, you’re related to your siblings and you’re related to your spouse or common-law partner. But you’re also deemed to be related to your siblings’ common-law partners or spouses. And you’re deemed to be related to your children’s common-law partners or spouses,” he says.

However, an individual is not considered to be related to nieces and nephews, cousins, or uncles and aunts, for tax purposes.

How tax is paid is governed by these relationships. For example, the fair market value of shares is determined by who buys them and from whom. A non-arm’s-length buyer who pays more for shares than they are worth will, under the law, still be seen as having paid fair market value for them; the seller, on the other hand, can report only the capital gain he or she earned based on the actual sale price of the shares, according to Miller Thompson LLP.

Family members often reduce the price of shares when selling them to family members, giving them a “deal.” But if you set a price in that shareholder’s agreement “that is other than the fair market value – because for family reasons you don’t want it to be fair market value – you are deemed to have actually transacted at fair market value,” says Adlington. “It results in double tax.”

At the same time, a non-arm’s-length seller who sells shares for less than they are worth must pay taxes as if they were sold for their fair market value.

“It’s more important than ever in the family shareholder context that transactions occur at fair market value,” says Adlington.

“If you want adjusting mechanisms – or to reflect familial relationships – then you make that adjustment somewhere else in the overall family wealth plan.” He says this means linking the shareholder agreement with the overall wealth succession plan to reduce unnecessary tax.

Capital gains strategies

Another tax strategy is spreading capital gains over long periods. New changes to the Tax Act mean that in cases where the transaction is between parent and child, the selling family shareholder can spread the capital gain over the exemption amount across 10 years instead of the normal five.

If “one sibling wants to buy out the other because one sibling wants cash and the other one wants the business,” says Adlington, then such a tax strategy can now be employed.

For example, “They’ve reached this deal where I’m going to buy your shares for two million dollars,” he says. Because it would be a strain on the business if that money were to be paid out too quickly, the payments can be spread out over a 10-year period, rather than a five-year period, under the Income Tax Act.

“Because of the new rules, the seller would pay tax only on $250,000 per year, because that is how much they would receive annually, he says. “It’s protecting the business from a cash-flow strain.”

Buying back shares

Buying out a shareholder also necessitates special attention in a shareholder agreement. If a minority shareholder wants to move away from the business, there are two possible ways to handle the situation tax-wise, says Angelopoulos. The majority shareholder could purchase the shares of the minority shareholder, or the company could buy back the shares.

In one scenario, the minority shareholder might end up with a capital gain, which would be taxed at roughly 26 per cent. This often occurs when an external person buys the shares from the shareholder, says Angelopoulos.

“Or they could end up with a deemed dividend, which would be taxed at a dividend rate,” says Angelopoulos, which would be around 48 per cent. This commonly occurs when the corporation itself buys the shares back.

“There are different treatments and different taxation rates that might apply,” he says. “That’s where you have to be mindful – which mechanism are you going to choose?” Wording regarding these scenarios should therefore be included in the agreement.

Life insurance can reduce tax load

The presence of life insurance can also change how certain decisions are made. That’s because “life insurance proceeds from a taxation standpoint can be a very important tool in reducing and minimizing taxes,” says Angelopoulos.

Often, corporations may be the beneficiaries of a life insurance policy that is taken out on one of the shareholders, such as the owner-manager, he says. A shareholder agreement should dictate what happens to those life insurance proceeds.

“Once the company receives them, if there is no shareholder agreement, there’s nothing to dictate what happens to those proceeds,” he says, adding that they are often used to pay for such things as the company’s operations or corporate travel. However, because a person will realize a capital gain on the shares that they own at the time they die, life insurance policies can play an important part in saving the client money.

“Every Canadian is deemed to have sold their capital assets immediately before passing away,” says Angelopoulos, and the final tax bill comes after death. Life insurance proceeds can help pay the estate tax on those shares. He therefore advises clients to include wording in the agreement to allow those taxes to be paid with proceeds from a life insurance policy.

Final word

With all of these legal issues, Legler says it’s critical that family office advisors or lawyers take an active role in ensuring that clients understand the language in a shareholder’s agreement ahead of signing. For those family members who are unclear, taking the extra time to explain complex terms is key.

“This would be a huge part of the value-added,” he says.

More from Canadian Family Offices: 

• Shareholder agreements: So critical, yet often a family ‘hot potato’
• How to equip kids with healthy attitude toward money
• In wealthy divorce, why bad behaviour never pays
• When money isn’t an issue, new retirement concerns bubble up

Please visit here to see information about our standards of journalistic excellence.