Budget 2024 shakes up exit opportunities for professional services

The Budget 2024 tax changes significantly impact exit opportunities for businesses professional services in Canada. These changes, including alterations to the capital gains inclusion rate and exclusions from tax incentives like the Canadian entrepreneurs' incentive (CEI) and employee ownership trust (EOT), pose challenges for owners considering exits. However, compensatory measures such as the increased lifetime capital gains exemption offer opportunities for tax optimization.

Canada’s 2024 Federal Budget (Budget 2024), released on April 16, 2024, introduces significant changes that impact professional corporations, presenting both challenges and opportunities for these businesses.

Background

Owners of businesses that operate in the services industry will need to navigate shifting federal government policies, especially when planning exit opportunities. Budget 2024 introduced changes to the capital gains inclusion rate for the first time in over 20 years, which means business owners that are considering exit opportunities after June 25, 2024, will need to consider whether planning is required before that date. 

In making this decision, owner/managers will need to consider the specific exclusion of dispositions of shares of professional corporations from (i) the CEI and (ii) the EOT tax exemption. Professional corporations, typically comprised of accounting, healthcare, legal, or engineering services, will not benefit from these incentives designed to encourage entrepreneurship and promote employee ownership. This exclusion makes it harder (and costlier) for professional companies to change ownership or plan for the future. However, this change is balanced by an increased lifetime capital gains exemption, highlighting the importance of strategic tax planning for business and professional services (BPS) corporations. 

Increased inclusion rate for corporations and its shareholders upon exit

For capital gains realized on or after June 25, 2024, Budget 2024 proposes to increase the capital gains inclusion rate for corporations from 50% to 66.67%. Individuals with capital gains will be subject to the same inclusion rate increase, only to the extent that the amount exceeds $250,000 (subject to certain adjustments). Special transitional rules will apply for gains incurred during taxation years that straddle this date. 

Any net capital losses carried forward are adjusted to their value to reflect the inclusion rate of the capital gains being offset. As a result, any capital losses realized before the rate change would fully offset an equivalent capital gain after the rate change.

Business owners that are considering exit opportunities after June 25, 2024, will need to consider whether planning is required before that date. Corporations could avail any capital losses realized before the rate change to alleviate tax owing.

Exclusion from Canadian entrepreneurs' incentive and employee ownership trust tax exemption

The proposed CEI aims at reducing the tax rate on capital gains for eligible individuals. Under this incentive, a qualifying individual can benefit from a reduced capital gains inclusion rate of 33.3% starting on Jan. 1, 2025, with a lifetime limit that would be phased by increments of $200,000 each year until it reaches a lifetime maximum of $2 million by Jan 1, 2034. This incentive aims to attract and retain entrepreneurial investors by providing substantial tax advantages on the sale of businesses. However, to qualify for this incentive, the disposition must meet certain conditions, one of which is that the shares held cannot represent direct or indirect interest in a professional corporation. 

Budget 2024 also specified the conditions which must be met to qualify for the EOT tax exemption, first discussed in the 2023 Fall Economic Statement. Individuals realizing a capital gain on the sale of shares to an EOT can benefit from a lifetime exemption of up to $10 million, subject to certain conditions. Notably, however, dispositions of shares of professional corporations will be excluded from this incentive. 

Without access to these incentives, professional corporations may face difficulties in attracting and retaining talent and investors, as well as facilitating ownership transfers. Entrepreneurs within professional corporations may find it more challenging to incentivize key employees or successors, potentially impacting long-term business sustainability and growth. Moreover, the exclusion from these tax incentives may require a reevaluation of overall tax planning strategies for professional corporations, requiring them to explore alternative avenues for incentivizing entrepreneurship and ownership transitions.

Mitigations through increased lifetime capital gains exemption

To offset the impact of the exclusion from the CEI and EOT tax exemption, professional corporations are permitted an increased lifetime capital gains exemption (LCGE). The proposed increase to the LCGE would apply up to $1.25 million of eligible capital gains, up from $1,016,836 in 2024. The exemption will be indexed for inflation starting in 2026. 

This adjustment provides professional corporations with enhanced opportunities for tax savings, particularly concerning capital gains realized from the disposition of qualified small business corporation shares. By leveraging this exemption effectively, businesses can optimize their tax positions and enhance long-term financial sustainability.

Budget 2024 gives and takes for BPS companies

While adjustments to incentives and exemptions may pose initial complexities, proactive planning and strategic decision-making can help mitigate adverse effects and capitalize on available opportunities. Corporations operating in the BPS industry should assess their current structures and consider potential strategies to optimize tax outcomes, especially in advance the capital gains inclusion rate increase on June 25, 2024. This may involve revisiting ownership arrangements, evaluating eligibility for various exemptions, and exploring alternative avenues for tax efficiency.

There does not appear to be clear tax policy reason as to why professional corporations were excluded from these valuable measures. Many professional corporations hire professionals as employees who would be open to taking over the business once the owner/manager professional decides to retire. Denying these incentives to those taxpayers seems contrary to encouraging entrepreneurship in Canada.