Budget 2023 in Canada has introduced two sets of tax rules aimed at facilitating business succession when transferring businesses to family members and employees. These measures address long-standing tax issues faced by business owners, providing new conditions and correcting flaws to ensure fairness and encourage intergenerational transfers. This article summarizes the main features of these rules and discusses their potential impact on business succession in 2024 and beyond.
Family Business Transfers
Background: Bill C-208
Bill C-208, enacted on June 29, 2021, addressed tax inequities in non-arm’s-length intergenerational transfers of businesses. Prior to its enactment, selling shares to a non-arm’s-length corporation triggered a deemed dividend, creating inequity compared to arm’s-length sales. Bill C-208 aimed to eliminate this inequity by altering the rules for non-arm’s-length sales. However, concerns were raised about potential tax avoidance, leading to further amendments in Budget 2023.
“Genuine” Intergenerational Business Transfer
Almost two years later, these amendments were announced in Budget 2023, which states that the tax treatment introduced in Bill C-208 would “apply only where a genuine intergenerational business transfer takes place.”
The budget then sets several conditions that must be met. These include general conditions that would apply to all transfers and specific conditions that would apply in two scenarios:
- “immediate transfers” made within 36 months
- “gradual transfers” made over 5 to 10 years
Where the conditions are met and an election is made, the business transfer would be excluded from Section 84.1’s deemed dividend rules.
Also in the budget are announcements that would:
- eliminate the requirement to provide the Canada Revenue Agency with an independent assessment of the fair market value of the shares sold and an affidavit signed by the vendor and a third party attesting to the share sale;
- eliminate the grind on capital gains exemption claims where the corporation sold (or associated group) has taxable capital employed in Canada exceeding $10 million;
- enhance the capital gain reserve rules by allowing a reserve over 10 years for sales that qualify as immediate or gradual transfers;
- increase the normal reassessment period by 3 years for immediate transfers and 10 years for gradual transfers; and
- add joint and several liability for payment of tax under certain conditions.
Note that Budget 2023 does not affect Bill C-208’s amendments to Section 55.
If enacted, the budget proposals would apply to dispositions on or after January 1, 2024.
Employee Ownership Trusts (EOTs)
Existing tax rules in Canada have hindered the creation of Employee Ownership Trusts, which provide a succession planning option for business owners. Budget 2023 proposes new rules to allow for the creation of EOTs and remove tax barriers associated with them.
How EOTs Work
An EOT is a trust set up to hold shares of a qualifying business for the benefit of employees. It allows employees to participate in the buyout of a business without directly purchasing shares. The EOT repays the debt from earnings distributed by the business.
Canada’s New EOT Rules:
An EOT is generally a Canadian resident trust that has two purposes:
- to hold shares of a qualifying business for the benefit of trust’s employee beneficiaries; and
- to make distributions to employee beneficiaries under a distribution formula that can only consider any combination of an employee’s length of service, remuneration and hours worked (and otherwise treats all its beneficiaries similarly).
The EOT’s share acquisition must be a qualifying business transfer, which would occur when a taxpayer disposes of shares of a qualifying business to an EOT (or a corporation wholly owned by the EOT) and both these conditions are met:
- the proceeds received by the vendor do not exceed fair market value; and
- the trust qualifies as an EOT immediately after the sale, and the EOT has a controlling interest in the qualifying business immediately after the transfer.
Additional conditions for qualifying as an EOT include:
- The trust holds a controlling interest in the shares of one or more qualifying businesses. A qualifying business is a Canadian-controlled private corporation where all or substantially all of the fair market value of its assets are attributable to assets (other than an interest in a partnership) used in an active business carried on in Canada. All or substantially all of the EOT’s assets must be shares of qualifying businesses.
- The EOT’s beneficiaries are comprised of qualifying employees only. Qualifying employees generally include all individuals employed by qualifying businesses controlled by the trust (other than new employees on probation and certain employees who own a significant investment in the qualifying business’s shares).
- Distributions of trust property are restricted. EOTs cannot distribute shares of qualifying businesses to individual beneficiaries.
- Specific rules apply for appointing trustees. All trustees of the EOT generally must be Canadian residents. Trust beneficiaries elect the trustees at least once every five years. Individuals and their related persons who held a significant economic interest in the business before a sale to the EOT cannot comprise more than 40 percent of the EOT’s trustees, directors of a corporate trustee’s board, or directors of any qualifying business of the EOT.
An EOT is a taxable trust, so it is generally subject to the same tax rules as other personal trusts. Undistributed trust income is taxable at the highest personal marginal rate, and trust income that is distributed to beneficiaries is taxed at the level of the beneficiary and not the EOT.
Tax benefits of EOTs
In addition to providing a new business succession alternative, the proposed EOT rules carry the following tax benefits:
- No 21-year deemed disposition rule — As EOTs are intended to exist indefinitely for the benefit of employees, EOTs would not be subject to the 21-year deemed disposition rule (which deems a trust to dispose of its capital property every 21 years).
- Extended shareholder loan repayment period — The repayment period to avoid an income inclusion under the shareholder loan rules would be extended to 15 years (from one year) for amounts loaned to an EOT from a qualifying business to purchase shares in a qualifying business. The shareholder loan rules would otherwise present a significant tax barrier.
- Extension of capital gains reserve — On a sale of qualifying corporation to an EOT, the existing capital gains reserve would be extended to up to 10 years (from 5 years) so that a vendor could defer recognizing part of the capital gain for up to 10 years, based on the amount of unpaid proceeds at the end of a tax year. Under these rules, the vendor would have to bring at least 10 percent of the gain into income each year for 10 years. This makes the treatment of share transfers to an EOT consistent with other transfers.
Comparison with EOT Regimes in Other Countries
While Canada’s proposed EOT regime provides a framework for creating EOTs and removes some barriers, it does not offer additional tax incentives beyond the mentioned benefits. In contrast, countries like the UK and the US have more extensive tax incentives to encourage the creation of EOTs and favor sales to EOTs over conventional buyers.
Budget 2023 marks a significant milestone in addressing Canada’s tax treatment of business sales and succession. The budget introduced two sets of tax rules aimed at facilitating business transfers to family members and employees. For interfamily transfers, the proposals aim to correct previous tax inequities and add new conditions to ensure fairness between family and non-family business transfers. The introduction of specific tax rules for Employee Ownership Trusts (EOTs) offers an additional succession planning option for Canadian business owners.
The changes brought forth by Budget 2023 aim to foster genuine intergenerational business transfers and encourage employee buyouts through EOTs. The budget sets out specific conditions that must be met for business transfers to qualify for the proposed tax treatment, depending on whether they are immediate transfers within 36 months or gradual transfers over 5 to 10 years. By excluding such transfers from deemed dividend rules and providing certain tax benefits, the government aims to promote fairness and equity in business succession.
The proposed rules for EOTs introduce a new framework for creating trusts to hold shares of qualifying businesses for the benefit of employees. While these changes remove existing barriers, the current proposals do not offer additional tax incentives beyond the mentioned benefits, unlike some other countries with established EOT regimes.
Overall, Budget 2023 brings potential transformation to the landscape of business succession in Canada. As the proposed tax rules are scheduled to come into effect on January 1, 2024, it remains to be seen how business owners will respond to these changes and whether EOTs will gain popularity as a succession planning option in the country.