How estate freezes could affect intergenerational business transfers in Canada

Transferring a family business to the next generation comes with several critical considerations—so keeping your tax planning options flexible is imperative.

Implementing one tax planning strategy may limit or preclude the use of alternative strategies in the future. This could result in higher taxes.

For instance, taxpayers must satisfy specific criteria to use the intergenerational business transfer (IBT) exemption. However, a prior estate freeze—depending on how it was implemented—may prevent these requirements from being met.

As such, taxpayers considering both planning options should structure their transactions in co-ordination with appropriate advisors to avoid any potential conflicts. 

Exploring available options

Owners typically extract funds either through a redemption of their shares of a corporation, which would result in a deemed dividend, or through a sale of shares that would result in a potential capital gain or deemed dividend.

Capital gains are generally preferred because they are taxed at a 50 per cent inclusion rate and taxpayers can use any available lifetime capital gains exemption.

Share transfers between non-arm’s length parties, such as between family members, usually result in a deemed dividend on transfer if the IBT exemption is not available.

To take advantage of favourable capital gains taxation, parents should verify that their estate freeze planning does not prevent them from utilizing the IBT exemption in the future when they extract cash from the corporation. In this context, the term parent could also mean a grandparent, aunt, uncle, great-aunt or great-uncle. 

Intergenerational business transfer

Canada’s IBT rules allow parents to transfer a corporation to the next generation in a tax-efficient manner to avoid costly tax consequences of related-party transactions—provided a series of conditions are met.

Estate freeze

The death of an individual shareholder triggers a deemed disposition of their shares at fair market value and are taxed on any increase in value of the shares since acquisition.

To limit the potential tax burden, an individual may engage in a series of transactions known as an estate freeze, which is structured to place a cap on the value of shares. The shares received in this arrangement are known as freeze shares. 

Estate freezes can look different depending on the factual circumstances and tax planning needs of the parties involved.

A classic example of an estate freeze is where the individual shareholder exchanges common shares of the business for preferred shares on a tax-deferred basis. The terms of the preferred shares are that they are fixed in value. New common shares would subsequently be issued and all future growth would be attributed to them.

Planning considerations for IBT and estate freezes

When planning for an estate freeze, taxpayers should consider whether they may utilize the IBT exemption in the future to take advantage of a tax efficient strategy on eventual share disposition.

This includes being aware of the type of shares that will be issued as part of the estate freeze, which could result in the parent retaining legal control of the corporation and prevent the taxpayer from qualifying for the IBT exemption. 

To qualify for the IBT, the Canada Revenue Agency (CRA) confirmed that there are no legislative stipulations requiring that the transferred shares be common or voting shares. This finding indicates that the shares involved could also be another type of share—such as non-participating preferred shares, which are commonly held after an estate freeze. 

But for the IBT exemption to apply, there are limitations on what shares the parent can hold after the transfer to the next generation.

The IBT exemption requires the parent to immediately and permanently transfer legal control of the corporation. Legal control is normally defined as owning voting shares with the majority of the votes in the election of the corporation’s board of directors.

If the parent retains legal control of the corporation after the transfer—for example, by holding sufficient voting shares to control the corporation as security pending payment—the IBT exemption would not apply. 

In this context, the sale would be treated as a deemed dividend. This treatment, as opposed to capital gains treatment, would prevent the parent from applying any available lifetime capital gains exemption to the share transfer.