The passage of Bill C-208, effective June 29, 2021, has generated increased attention to the issues and planning opportunities surrounding the sale of family owned businesses, particularly where a sale of shares may qualify for the lifetime capital gains exemption for “qualified small business corporation” shares, or QSBC shares.
The stated intent of Bill C-208, a private member’s bill, was to facilitate the sale of QSBC shares to a related party purchaser. This was accomplished by amending the rules in section 84.1 of the Income Tax Act (Canada) (herein the “Act“) which apply to a non-arm’s length sale of shares. Bill C-208 also amended section 55 of the Act, in connection with related party butterfly reorganizations, which will not be addressed in this article.
Under section 84.1 of the Act, on any sale of shares of a Canadian resident corporation (the “subject corporation“) by an individual or trust to another corporation (the “purchaser corporation“) with which the seller does not deal at arm’s length, where the subject corporation will be connected with the purchaser corporation following the sale (which would be the case if the purchaser corporation acquires shares with more than 10% of the votes and fair market value of all the issued shares of the subject corporation), the seller will generally be unable to claim capital gains treatment for any consideration received on the sale which exceeds an amount (the “threshold“) equal to the greater of the paid-up capital of the shares being sold, or the seller’s adjusted cost base thereof (subject to certain adjustments). Where the purchase price for the shares includes cash or promissory notes from the purchaser corporation, the seller will be deemed to have received a dividend to the extent that the non-share consideration exceeds the threshold. The seller will not be able to claim the lifetime capital gains exemption, and in addition will be faced with a higher tax rate on dividend income as opposed to capital gains rates.
Bill C-208 represents an attempt to level the playing field between arm’s length and non-arm’s length sales, limited to the situation where the shares being sold are QSBC shares, by treating a sale to a purchaser corporation which is controlled by a child or grandchild of the selling individual on the same basis as a sale to an arm’s length stranger. New paragraph 84.1(2)(e) will deem the seller and the purchaser corporation to be dealing at arm’s length (and therefore not subject to the rules in section 84.1) in respect of the sale of QSBC shares if: (i) the purchaser corporation is controlled by one or more children or grandchildren of the seller who are 18 or older; and (ii) the purchaser corporation does not dispose of the shares of the subject corporation for a period of 60 months.
New subsection 84.1(2.3) sets out certain rules which apply for the purposes of paragraph 84.1(2)(e), including a grind down of the seller’s ability to claim the capital gains exemption, where the aggregate taxable capital of the subject corporation and all corporations associated with the subject corporation exceeds a certain threshold.
Planning based on Bill C-208
The amendments to section 84.1 permit an individual seller to claim the capital gains exemption on a sale of QSBC shares (subject to certain limitations) to a corporation controlled by a child or grandchild of the individual, in a transaction where the sale is structured for consideration of a promissory note and/or shares of the purchaser corporation with high paid-up capital. The purchaser corporation can then access the funds of the subject corporation, by way of tax-free intercorporate dividends or intercorporate loans, in order to pay down the note or return capital on the shares held by the seller, with the result that the seller will have paid no tax. This is precisely the type of “surplus stripping” (i.e. the extraction of corporate funds by an individual shareholder on a tax-free basis) which the Canada Revenue Agency (the “CRA“) has long held to be contrary to the general object and spirit of the Act.
Consequently, the Department of Finance took the highly unusual step, following the passage of Bill C-208, to announce that it would legislate amendments to correct the perceived deficiencies in the Bill, and that the Bill would only be given effect to transactions commencing on or after January 1, 2022. After public backlash, the Department later announced that any amending legislation would only apply after November 1, 2021, leaving Bill C-208 to take effect in its present form until that date.
A taxpayer who wishes to take advantage of the amendments made by Bill C-208 between now and November 1st should be aware that the CRA will undoubtedly scrutinize any transaction which relies on new paragraph 84.1(2)(e), in its present form, with a view to determining whether the transaction may be considered abusive within the meaning of the general anti-avoidance rule (“GAAR“) contained in section 245 of the Act, in light of the CRA’s desire to limit any opportunity for surplus stripping except in a legitimate case of an intergenerational sale.
For example, the reference in the legislation to “control” by one or more children or grandchildren of the taxpayer may be subject to abuse if “thin voting shares” are issued to a child or grandchild in order to constitute legal or “de jure” control of the purchaser corporation. The Federal Court of Appeal, in a recent case called Deans Knight, imported a notion of “actual” control as taking precedence over de jure control, in the context of loss streaming rules in the Act which limit the ability to utilize losses following an acquisition of control. It is quite likely that the CRA will seek to apply a similarly broad concept of control in the case of a purchaser corporation, akin to the concept of de facto control, or control in fact, which is applicable to certain specific provisions of the Act.
Whereas Bill C-208 only specifically restricts the sale of the subject shares by the purchaser corporation within the period of 60 months following the sale by the taxpayer, presumably the CRA will also look carefully at any transactions involving the shares of the purchaser corporation within that timeframe. For example, where the purchaser corporation finances the acquisition through debt, the shares of the purchaser corporation would likely have nominal value immediately following the acquisition, and the child shareholder could theoretically transfer those shares back to the parent, either directly or indirectly through a discretionary trust, with no immediate tax consequences. This would clearly circumvent the object and spirit of Bill C-208 and would invite a GAAR challenge by the CRA.
The Window of Opportunity
For a taxpayer who is relatively risk averse and conservative, but who wishes to take advantage of the window of opportunity between now and November 1st to pass on a family business to the next generation in a tax effective manner, it is suggested that, in order to limit the possibility of the CRA challenging the transaction under GAAR, the taxpayer be prepared to genuinely withdraw from the operation of the business, and to have no interest in the future growth in equity value of the purchaser corporation. Ideally, the purchaser corporation would not fund the acquisition directly from the existing corporate surplus of the subject corporation but might, for example, issue shares with full cost base and paid-up capital which could be redeemed over a period of time out of future earnings. We would also strongly suggest that any transactions involving the shares of the purchaser corporation be limited. Taxpayers will have to satisfy themselves that the shares in question qualify as QSBC shares, subject to the normal rules for claiming the capital gains exemption, in order to take advantage of the opportunity given by Bill C-208.
Given the public statements made by the Department of Finance, any taxpayer who is looking to carry out a transaction prior to November 1st based on the current wording of the amendments made by Bill C-208 should be prepared to face an audit and potentially a challenge by the CRA — definitely not for the faint of heart!