This content originally published in the Canadian Tax Foundations newsletter: Canadian Tax Focus. Republished with permission.
Bill C-208 has made waves across the professional services industry ever since it received royal assent at the end of June. With the uncertainty about which political party would form the government now resolved, there is nothing to prevent Finance from following through on its intention to install formal guardrails around what, at first glance, appears to be open season on surplus stripping. Aggressive plans that do not consider the criteria outlined in Finance’s statement in July are still likely to attract CRA scrutiny and the application of GAAR. According to the statement, changes are to apply as of the later of November 1, 2021, and the date of publication of the final draft legislation. In the meantime, taxpayers may be motivated to implement transactions that follow the general intent of the bill, but that may not be permitted by the more restrictive draft legislation that is expected.
While Bill C-208 seems to have created an opportunity for surplus stripping—where dividends are converted into a capital gain allowing taxpayers to take advantage of a lower tax rate and the lifetime capital gains exemption (LCGE) with no genuine change in ownership—taxpayers should be cautious and consider the object, spirit, and purpose of the new legislation before entering into aggressive transactions. Parliamentary discussion during the passing of Bill C-208 identified the risk of the legislation allowing surplus stripping, but it also clearly showed that the intention of the bill was to facilitate true transfers to the next generation without a punitive tax impact. It will likely be some time before this is tested; however, it is also likely that the courts will review the parliamentary intention when considering the application of GAAR.
Currently, section 84.1 allows for the transfer of shares from one generation to the next in exchange for a note, while maintaining access to the LCGE, provided that the following general conditions are satisfied: paragraph 84.1(2)(e) deems the vendor and the purchaser to be dealing at arm’s length where (1) the subject shares are qualified small business corporation (QSBC) shares or shares of a family farm or fishing corporation (pursuant to subsection 110.6(1)), (2) the purchaser corporation is controlled by one or more of the taxpayer’s adult children or grandchildren, and (3) the purchaser corporation holds the subject shares for at least 60 months.
But there are some gaps in the new law:
- Since the legislation does not strictly limit the sale of the purchaser corporation, and instead limits only the sale of the subject QSBC shares, in theory the purchaser corporation could be sold immediately after the intergenerational transfer without attracting the negative consequences contained in subsection 84.1(2.3).
- The taxable capital limitation appears to be intended to reduce the LCGE in instances where the taxable capital of the subject corporation and associated corporations exceeds $10 million, fully eliminating access to the LCGE at $15 million. Although the intention of the taxable capital rule appears to be clear, the actual application of the rule is not. Paragraph 84.1(2.3)(b) applies only for the purposes of paragraph 84.1(2)(e), which does not discuss or refer to the LCGE and instead refers only to the definition of a QSBC. As a result, it is unclear whether this calculation actually applies to limit any deduction, and arguably the provision has no impact owing to faulty referencing; it may in fact be possible to transfer businesses with taxable capital in excess of $15 million while still claiming the LCGE with no adverse consequences.
Taking advantage of these gaps could be considered an abuse of the object, spirit, and purpose of section 84.1 and attract a GAAR assessment. Although Finance has not addressed these gaps directly, it is likely a good assumption that it will attempt to correct them when it amends the legislation.
For those wishing to undertake a genuine transfer, there is motivation to act before the draft legislation is issued (which is the earliest that the new rules are planned to take effect). Finance has indicated that any new amendments would still preserve capital gains treatment and access to the LCGE on true intergenerational transfers, but much is up in the air. Currently, there are no parameters in place as to how much involvement or ownership by the seller will be required after the sale, and there is no limitation on how quickly the note must be repaid. Since Finance has stated a clear intention to install guardrails related to these very issues, changes to the legislation will likely narrow its applicability in a significant way. Transactions undertaken now may attract review by the CRA, but they are unlikely to be assessed under GAAR if they fit within the true intention of the bill.
One problem with acting now is that paragraph 84.1(2.3)(c) requires an independent valuation for much of this type of planning. It may be challenging for taxpayers to obtain a valuation in the period leading up to the release of the new legislation since Bill C-208 has kept valuators busy.
Changes to section 55 provide some opportunities for siblings to undertake a paragraph 55(3)(a) related-party butterfly in the context of a QSBC, which previously would have been deemed to be at arm’s length. Finance has made no comment on whether this change will be rolled back.