Need to know: Tax law for transferring a family business

CPAs should be aware of new tax rules for transferring a business to next generation family members coming in January 2024. (Getty Images/ Westend61)

The 2023 federal budget introduced new tax rules for owners transferring businesses to next generation family members or employees, which take effect January 1, 2024. Draft legislation was released in August 2023, and included revisions to the proposals for intergenerational business transfers and employee ownership trusts (EOTs). CPA Canada spoke to John Oakey, CPA, vice president of taxation with CPA Canada to find out more about the latest updates to the legislation and what CPAs need to consider moving forward.

Intergenerational business transfers

CPA CANADA: Can you tell us why the amendments were needed to the intergenerational business transfer rules?

John Oakey (JO): On June 29, 2021, private member Bill C-208 was enacted to allow for a more tax-efficient intergenerational transfer of a corporate business from parents and grandparents to children and grandchildren. Prior to that date, there was unequal income tax treatment between intergenerational family transfers of Canadian-Controlled Private Corporations (CCPCs) and arm’s length sales of CCPCs, thus resulting in a disadvantage to keeping the corporate business within the family. The legislation enacted under Bill C-208 attempted to level the playing field.

However, the legislation had minimal safeguards in place to force the actual transfer of the business operations. An owner could legally transfer shares of the corporate business without the children taking control of the actual business itself. Thus, the 2023 budget announced further amendments to put in those safeguards. In very simple terms, taxpayers went from no legislation, to legislation with minimal safeguards, to detailed rules designed to only allow genuine transfers.

CPA CANADA: What are the key highlights in the proposed changes for intergenerational transfers?

JO: In order to qualify under the proposed rules, certain conditions must be met: First is transferring the economic interests of the business; second is transferring the control of the business (the children must have control); third is transferring full management of the company (one or more of the children must be actively involved); and fourth, the business must be active. If the transfer fails any of these four conditions, the owner will realize a dividend instead of a capital gain resulting in an average increased tax burden of approximately 20 per cent. The four criteria are woven together in complex legislation requiring detailed analysis to ensure the criteria is met.

CPA CANADA: What are the options for intergenerational transfers?

JO: There are two options for the proposed intergenerational transfers. There is the immediate transfer option in which the transfer must be executed within 36 months. The second is a gradual transfer that allows up to 10 years for certain aspects of the transfer. In both cases there are criteria that must be met at various stages: pre-sale, at the time of sale, immediately after the sale, and within the designated time frame. A detailed summary of the timelines and criteria can be found here.

CPA CANADA: What impact will the legislation have on family business transfers?

JO: The biggest impact is that taxpayers will have the ability to accomplish tax efficient intergenerational transfers, and CPAs can help those taxpayers navigate the myriad of detailed rules. The challenge however is that the rules don’t fit every transfer scenario.

That is why CPAs who are tax advisors need to understand these rules inside and out, to make certain the taxpayer’s actual situation fits within the rules. This may require upfront planning and good communication of the rules with the taxpayer and their children to ensure the criteria for a genuine transfer is met throughout the period in question.

CPA CANADA: What changes were introduced in the August revisions?

JO: There were two changes to note in the August revisions. The first is a provision that allows a taxpayer to access the preferential tax efficient transfer only once. In the original draft legislation introduced in the 2023 Federal Budget, an owner was not restricted in the number of times they utilized the intergenerational transfer rules. It would appear that Department of Finance introduced this limitation to try and make the non-arm’s length intergenerational transfer resemble an arm’s length transfer. The Joint Committee on Taxation of the CBA and CPA Canada has addressed the negative implications of this limitation with Department of Finance.

The second important change was the ontroduction of two additional relieving provisions accounting for two scenarios where certain conditions cannot be met:

• if the business ceases to exist due to the selling off its assets to pay creditors, or
• the business is sold to another child.

Employee Ownership Trusts

CPA CANADA: How significant is the government’s introduction of Employee Ownership Trusts?

JO: That remains to be seen. The proposed legislation is the first introduction of the employee ownership trust option for business owners in Canada. It is an option that has been used in the UK and the US for a number of years. EOTs provide another avenue for transition to happen, especially in situations where it is difficult to find a buyer.

The attraction of having an employee-owned business is that it allows for a wider distribution of ownership and wealth. One major stumbling block however is that the current legislation offers little tax incentive to the owner of the business to transition to an EOT other than an extension of the capital gains reserve.

All we have to do is look to the UK to understand how the lack of tax incentives for owners discourages business transfers to EOT’s. With minimal tax incentives, the UK EOT was rarely used. Ultimately the UK modified their original EOT framework to provide an exemption from capital gains tax for the owner leading to greater adoption. We will have to wait and see if Canada monitors the adoption rate of Canadian EOTs and makes any future revisions similar to the UK.

CPA CANADA: Are there other options for owners wanting to transfer businesses to employees?

JO: Owners can still transition their company to employees through a holding company owned by the employees. This holding company ownership will lack some of the benefits afforded by an EOT, but the utilization of a holding company is well established in practice, and through a properly executed governance model, can be very effective.

CPA CANADA: What’s next?

JO: The proposed intergenerational transfer rules are very complicated and will not accommodate every family business transfer situation. CPAs need to be very careful when advising taxpayers. Detailed knowledge of the rules and good communication with taxpayers will be critical to avoiding problems.

The proposed employee ownership trust rules are not overly complicated, but there are very specific criteria that must be met in order to qualify. CPAs must review the detailed rules very carefully to ensure that the criteria is met and consider the compliance requirements and tax implications to determine if EOTs are the right structure for their clients.

Additional materials

A detailed explanation of the legislation can be found in a previous CPA Canada blog Business succession – tax rules to consider for family business transfers.