Introduction – What is Bill C-208? (Transfer Of Small Business Or Family Farm Or Fishing Corporation)
Bill C-208, An Act to amend the Income Tax Act (transfer of small business or family farm or fishing corporation), received royal assent and became law in Canada on June 22, 2021. Bill C-208 was sponsored as a private member’s bill by Conservative Senator Larry Maguire for the Brandon-Souris district. It is extremely rare for a private member’s bill to propose amendments to the Income Tax Act, and even more rare to see it obtain royal assent. Bill C-208 was principally designed to level the tax burdens faced by small business owners when making intergenerational transfers of shares of an incorporated small business or shares of the capital stock of a family farm or fishing corporation to family members. These changes have provided new and positive opportunities for families to keep businesses thriving into subsequent generations without being penalized under the Income Tax Act.
Bill C-208 has altered two significant provisions of the Income Tax Act. First, the language of section 84.1 of the Income Tax Act, a technical anti-avoidance surplus stripping provision, has been amended to allow a taxpayer to avoid surplus stripping rules on the value of a qualifying family business when making a transfer of ownership to a child or grandchild of sufficient age. Section 55 of the Income Tax Act, that allows butterfly divisive reorganizations on a tax-free basis, has also been amended to include siblings under the definition of “related” transactions, reducing the potential tax burden faced by family members when electing to transfer business property to a shareholder. This article will be broken into two separate sections in order to discuss the rules of the Income Tax and the significance of these amendments. If you are considering an intergenerational transfer of your family businesses’ assets to your children or to your siblings, then you should consult with our Certified Specialist in taxation Canadian tax lawyer to determine how these rules will apply to you, and how you may benefit under them.
Modifications to Section 84.1 – Dividend Stripping
The first set of amendments are to section 84.1 and concern the dividend stripping rules under the Income Tax Act. “Dividend stripping,” or “surplus stripping,” is defined as a deliberate attempt by an individual to structure payments received from a corporation on account of retained earnings in such a way that the payments are received as capital gains rather than as dividends, in order to receive those payments on a lower taxable rate or on a tax-free basis. Generally, only 50% of the value of capital gains will be included in calculating a taxpayer’s income, which makes receipt of capital gains far more favourable for tax purposes than receiving dividends. As well, for shares of certain businesses such as a Canadian Controlled Private Corporation (CCPC), or shares in a family farm or fishing corporation, a taxpayer may be eligible to benefit from the Lifetime Capital Gains Exemption (LCGE). The Lifetime Capital Gains Exemption allows a taxpayer who disposes of qualifying shares to claim a lifetime exemption of over $800,000 on the gross capital gains as tax-free income.
Section 84.1 of the Income Tax Act is a very complex and technical anti-avoidance provision that applies where a non-arm’s length transfer of shares from a Canadian corporation (a “subject corporation”) occurs between a taxpayer and another non-arm’s length corporation (a “purchaser corporation”). It is also a well-known tax trap for unwary Canadian tax professionals. The purpose of Section 84.1 is to prevent a taxpayer from using any non-arm’s length sale to unfairly ‘extract’ the surplus value (retained earnings) in a corporation on a reduced-tax or tax-free basis. Where a transaction such as this occurs, subsection 84.1(1) will require that the paid-up capital (PUC) of the shares (which is the value of the original contributed capital for those shares issued) in the purchaser corporation is limited to either the paid-up capital of the shares in the subject corporation, or the adjusted cost base (ACB) of the shares in the subject corporation. In effect, any capital gain on the subject corporation’s shares that is beyond the original purchase price of those shares will be automatically converted into a deemed dividend in the hands of the taxpayer. The taxpayer will be subject to the full tax consequences of that deemed dividend and will not have the ability to use the Lifetime Capital Gains Exemption to receive that amount on a tax-free basis. A taxpayer who would receive non-share consideration like cash or debt is also deemed to receive a dividend equal to the fair-market value (FMV) of the non-share consideration under section 84.1, less either the greater of paid-up capital or the adjusted cost base of the subject shares. In essence, the rules under section 84.1 are very stringent for the taxpayer engaging in a non-arm’s length structuring arrangement and those types of reorganizations should only be done under the expert guidance of a Canadian tax lawyer.
Under the amendments enacted by Bill C-208, a new exception is provided under paragraph 84.1(2)(e) to this rule which deems the taxpayer and a purchasing corporation to deal at arm’s length and avoid these surplus stripping rules where three conditions are met:
- The subject shares are qualified small business corporation shares or capital stock shares in a family farm/fishing corporation;
- The purchasing corporation is controlled by one or more of the taxpayer’s children or grandchildren at least 18 years of age;
- The purchaser corporation does not dispose of the subject shares within 60 months (5 years) of purchase.
Where these three conditions are met, section 84.1 surplus stripping rules will not be triggered for the corporations or for the taxpayer. However, the provision has been constructed to avoid the convenience of family relations as a means by which to simply disguise a surplus stripping transaction. Bill C-208 has also amended subsection 84.1(2.3) to require that a purchaser corporation hold the shares for a minimum of 60 consecutive months. Where the purchasing corporation distributes the shares before those 60 months have elapsed, the new rules under paragraph 84.1(2)(e) are deemed to have never applied and the surplus stripping rules will then apply to prevent beneficial tax treatment as of the date of the tax reorganization.
Bill C-208 has, specifically for the purpose of paragraph 84.1(2)(e), also targeted these rules to smaller family corporations and has reduced the capital gains exemption available under subsections 110.6(2) and (2.1) for taxable capital employed in Canada in excess of $10 million.) It also fully eliminates the capital gain exemption where that taxable capital is $15 million or more.
The final result of these amendments is to create a window for families to engage in tax-reduced or tax-free transfers of ownership in a family business between parents and children or grandchildren. This exception is a very powerful tax-planning tool for families, allowing for treatment equal to other third-party transactions and avoiding unfair tax treatment for a genuine family business transfer arrangement. As a regulatory matter, however, the amendments also require that the taxpayer provide the Canada Revenue Agency with an independent assessment of the fair market value of the subject corporation’s shares and an affidavit signed by the taxpayer and a third party attesting to disposal of the shares. This use of affidavits in Canadian tax administration is unique and may establish a new policy requiring taxpayers to swear in respect of transactions being carried out. This is a potentially disturbing development. The amendments have been cautiously structured to only benefit families engaging in genuine transfers of ownership, and not those attempting to defeat these new tax rules.
Modifications to Subsection 55(2) – Capital Gains Stripping
The second amendment concerns subsection 55(2) of the Income Tax Act and the capital gains stripping rules. Where a corporation owns shares in a different corporation, and the value of those shares has since increased, the corporation will recognize a gain upon disposition of those shares. Corporations are precluded from benefiting under the Lifetime Capital Gains Exemption, and so when that corporation disposes of those shares that corporation’s taxable income will increase in respect of the capital gain.
Capital gains may be subject to corporate income tax rates, but dividends received from taxable Canadian corporations may escape corporate taxation as tax-free intercorporate dividends. If a corporation can dispose of its investment so that the accrued capital can be received in the form of dividends rather than as a taxable capital gain, the payment of corporate taxes can be avoided. “Capital gains stripping” occurs where a capital gain is “stripped” from a corporation in the form of a non-taxable, intercorporate dividend. Subsection 55(2) is an anti-avoidance provision designed to prevent improper conversions of capital gains into dividends by a corporation that disposes of shares in another corporation.
Under subsection 55(2) of the Income Tax Act, a taxable intercorporate dividend that a recipient receives may be re-characterized as a capital gain if that dividend received exceeds the safe income (the after-tax income contributing to the capital gain on those shares) of the corporation. An exemption is provided to certain reorganization transactions under subsection 55(2), by way of a related party exemption under paragraph 55(3)(a) and the “butterfly” exemption under paragraph 55(3)(b). Where either exemption is satisfied, it will prevent the re-characterization of the intercorporate dividend in the hands of the recipient and avoid realizing accrued capital gains.
In general, the rules concerning related parties under paragraph 55(3)(a) are more favourable than for unrelated parties under paragraph 55(3)(b) because fewer restrictions are placed on what transactions that can be engaged in throughout and after the corporate reorganization. Under the previous rules, siblings, and by extension corporations owned by siblings, were deemed unrelated for the purposes of section 55. As a consequence, arranging intergenerational transfers of property held by a family business involving siblings were substantially difficult to arrange without triggering significant tax consequences for family members.
Under the amendments in Bill C-208, subparagraph 55(5)(e)(i) has been amended to allow siblings to be recognized as “related” under subsection 55(3) where the dividend in question is received or paid as part of a transaction or even by a corporation whose shares are those of a:
- Qualified small business corporation
- A family farm or fishing corporation
The amendments in Bill C-208 have also opened the door for transferors in an arrangement with siblings to claim the Lifetime Capital Gains Exemption on the transfer of qualifying shares. This is a major tax planning benefit for owner managed family businesses.
Pro Tax Tip
With the passage of Bill C-208, it will become substantially easier for families consult with an expert Canadian tax lawyer to arrange for transfers of family businesses through to related family members, and from parent to child. With respect to changes made to both sections 84.1 and 55, however, these amendments do not change the applicability of other anti-avoidance provisions under the Income Tax Act. Section 245 of the Income tax Act sets out the General Anti-Avoidance Rule (GAAR) for Canadian transactions. A transaction that creates a tax benefit may still be viewed as an avoidance transaction if, on the facts, that transaction was not arranged primarily for a bona fide purpose other than to obtain a tax benefit. The simple fact that Bill C-208 has expanded the scope of legitimate arm’s-length transactions under sections 84.1 and 55 does not alter the applicability of the General Anti-Avoidance Rule. Bill C-208 was carefully structured to avoid these new amendments to the Income Tax Act from becoming vehicles for fraud or improper tax planning purposes. If the CRA views a transaction involving transfer of a family business, farm or fishing corporation to be without a bona fide purpose, the taxpayer may face a significant uphill battle fighting the tax assessment. If you are planning to transfer family business property to your children or to any other family members, or if you are planning to pass along your business to a family member, speak to one of our top Canadian tax lawyers.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."