When Parliamentarians Tinker: Bill C-208 (Part 1)

Your client, Jordan, is the 60% owner of a family business corporation (the “Family Corporation”) with the other 40% being owned by his sister, Chris. Jordan has two adult children, Barry and Susan. The Family Corporation carries on an active business other than farming or fishing. The family has had some recent discussion about succession planning and how to move forward in light of differing visions about the future of the business. Jordan has come to you after reading a newspaper article about changes to the Income Tax Act (“ITA”) which are apparently supposed to make transfers of a business within a family easier.

Jordan is considering each of the following options:

• Jordan and Chris would divide up the Family Corporation between a corporation controlled by Jordan and a corporation controlled by Chris;
• Jordan purchases Chris’ shares in the Family Corporation;
• Barry and Susan purchase Jordan’s shares in the Family Corporation;
• Barry and Susan purchase both Jordan’s shares in the Family Corporation and Chris’ shares in the Family Corporation

The newspaper article indicated that in each of options 2, 3, and 4 the purchaser should purchase the shares of the Family Corporation through a corporation.

In order to determine if the changes will impact Jordan’s situation, you begin to review them in more detail. The changes in question were highly unusual in that they were introduced not through a budget but through a Private Member’s Bill, Bill C-208, which has been passed and received royal assent. The changes involve two sections of the ITA: 55 and 84.1.

Section 55

In general terms, section 55 addresses capital gains stripping by using inter-corporate dividends to reduce capital gains. Subsection 55(3) provides two exceptions which are the basis for what are known as butterfly transactions used to distribute assets from a corporation (the “Transferor Corporation”) to a corporation or corporations controlled by the shareholders of the Transferor Corporation. The exception in paragraph 55(3)(a) is available only when the shareholders of the Transferor Corporation are related. Prior to the amendments, paragraph 55(5)(e) provided that siblings are not considered related or non-arm’s length for this purpose. Bill C-208 amends paragraph 55(5)(e) to provide a carve out. Under the amendment, siblings will be deemed to be non-arm’s length and related when the shares involved are qualified small business corporation (“QSBC”) shares¹ or shares of a family farm or fishing corporation. If that requirement is met, this could provide Jordan and Chris an opportunity to split up the corporation by conducting a butterfly and going their separate ways under paragraph 55(3)(a) rather than the more restrictive paragraph 55(3)(b) butterfly which is available to unrelated parties. A discussion of paragraph 55(3)(a) and paragraph 55(3)(b) butterflies is beyond the scope of this article.

The amendments to section 55 may enable Jordan to utilize option 1. However, further analysis of the requirements of paragraph 55(3)(a) should be undertaken. The amendments to section 55 do not assist the family with respect to options 2, 3, and 4.

Section 84.1

The larger portion of the amendments in Bill C-208 are amendments to section 84.1. In some ways section 84.1 deals with the opposite scenario to section 55 in that when it applies it deems a dividend to have occurred, instead of what would have otherwise been a capital gain. One consequential impact of this is that the lifetime capital gains exemption would not be available even if the shares would otherwise have qualified, since the exemption does not apply to dividends. The portion of the capital gain which is characterized as a dividend depends on the paid-up capital and modified or “hard” adjusted cost base of the purchased shares. We assume that the reader is familiar with section 84.1. Accordingly, we do not describe the mechanics of section 84.1 in this article.

Subsection 84.1 applies to a sale of shares of a corporation (the “Subject Corporation”) to a second corporation which does not deal at arm’s length with the individual selling the shares of the Subject Corporation. For example, section 84.1 applies to sales by Jordan of shares of the Family Corporation to a corporation controlled by family members such as Chris or their parents. Prior to the enactment of Bill C-208, section 84.1 also applied to sales by Jordan of shares of the Family Corporation to a corporation controlled by Jordan’s children or grandchildren.

Section 84.1 does not apply to sales by Jordan of shares of the Family Corporation to a corporation controlled by persons who are not related to Jordan and who deal at arm’s length with Jordan. In those sales, Jordan would realise a capital gain rather than a dividend. Where the requirements for the lifetime capital gains exemption are met, Jordan may be able to utilize the capital gains exemption.

Prior to the enactment of Bill C-208, Jordan would receive more after-tax proceeds on a sale of shares to a corporation controlled by arm’s length strangers than he would on a sale to a corporation controlled by his parents, Chris, or his children. Jordan had a tax incentive to sell shares to corporations controlled by arm’s length strangers. Bill C-208 was intended to put taxpayers, such as Jordan, in the same tax position when selling shares of a corporation such as the Family Corporation to a corporation controlled by his children as he would be in when selling shares of the Family Corporation to a person who is not related to him and who deals at arm’s length with him.

The new paragraph 84.1(2)(e)

The first amendment to section 84.1 is a new paragraph 84.1(2)(e) which again addresses situations involving QSBC shares or shares of a family farm or fishing corporation (the “Subject Shares”) owned by an individual (the “Selling Taxpayer”). It provides that the purchaser corporation is deemed to be dealing at arm’s length with the Selling Taxpayer (in which case the transaction would not be caught by section 84.1) if the purchaser corporation is controlled by one or more children or grandchildren of the Selling Taxpayer who are at least 18 years of age. The purchaser corporation is also required to hold the shares for 60 months. Interestingly, this is longer than the normal reassessment period.

The amendment is limited to children and grandchildren, so it does not include other relatives such as siblings like Jordan and Chris. It is also one-directional, in that it would not include a situation where the purchaser corporation was controlled by the parents. However, it may be relevant if a transfer of shares by Jordan to a corporation controlled by his children or grandchildren would make sense.²

The amendments to section 84.1 would impact Jordan’s options 2, 3, and 4 as follows:

Option 2

The amendments would not assist a corporation controlled by Jordan in purchasing Chris’ shares of the Family Corporation from Chris. Chris will continue to obtain a tax advantage by selling her shares in the Family Corporation to a corporation controlled by a person who is not related to her and who deals at arm’s length with her.

Option 3

The amendments may assist a corporation controlled by Barry and Susan in purchasing Jordan’s shares of the Family Corporation. However, further analysis of section 84.1 and the Bill C-208 amendments to section 84.1 should be conducted. In doing so, you should pay attention to the anti-avoidance rules in the new subsection 84.1(2.3).

Option 4

Barry and Susan are not related to Chris for the purposes of the ITA. Whether Barry and Susan deal at arm’s length with Chris is a question of fact.³ Bill C-208 does not change the tax consequences of a corporation controlled by Barry and Susan purchasing Chris’ shares of the Family Corporation. Section 84.1 will apply if Barry and Susan do not deal at arm’s length with Chris. It will not apply if Barry and Susan deal at arm’s length with Chris.

The new subsection 84.1(2.3)

Depending on how Jordan chooses to proceed, the other amendments may also be relevant. Those amendments are the addition of a new subsection 84.1(2.3) which contains three distinct paragraphs. The common thread appears to be an attempt to prevent the new paragraph 84.1(2)(e) from being abused. The preamble to subsection 84.1(2.3) provides that the three paragraphs which follow apply for the purposes of 84.1(2)(e).

Paragraph 84.1(2.3)(a) addresses what happens if the purchaser disposes of the shares within 60 months “otherwise than by reason of death.” The purchaser contemplated under this section is a corporation which cannot die, so the death clause is likely of limited application. It might apply in scenarios such as where the purchaser corporation is a party to a shareholders’ agreement which requires it to sell of the Subject Shares on the death of an individual. If there is a disposition within 60 months not covered by the death clause, there are a number of consequences. First, paragraph 84.1(2)(e) is deemed to have never applied and that protection is lost. Second, the original seller is deemed to have sold the Subject Shares to the party who purchased the Subject Shares from the original purchaser corporation. The amendments do not address the value at which the new deemed disposition takes place or explicitly address the timing. The wording of paragraph 84.1(2.3)(a) is unclear. One possible interpretation is that this deemed disposition could itself qualify for 84.1(2)(e) in some situations. This interpretation is supported by the fact that subparagraph 84(2.1)(a)(iii) provides that the 60-month holding period for the deemed disposition is deemed to have begun at the time of the sale to the original purchaser corporation. Reorganizations involving the corporation whose shares were the Subject Shares under sections 85, 86, and 87 would constitute dispositions of the Subject Shares. The provisions of paragraph 84.1(2.3)(a) should be carefully considered if the reorganizations take place within the 60-month holding period.

Paragraph 84.1(2.3)(b), also subject to the statement in the preamble that it is “for the purposes of paragraph 84.1(2)(e)”⁴, provides for a grind of the capital gains exemption. It takes effect once the corporation’s taxable capital employed in Canada is $10 million or more and fully phases out the exemption once taxable capital is $15 million. As a result, it will be necessary to confirm the amount of taxable capital employed in the family business to fully assess the options available to Jordan.

The final paragraph in the new subsection, 84.1(2.3)(c), is an evidentiary requirement which is also subject to the statement in the preamble that it is “for the purposes of paragraph 84.1(2)(e).” It requires that the taxpayer provide an independent assessment of the value of the shares as well as an affidavit from the taxpayer and a third-party attesting to the disposal of the shares. It does not address who qualifies as a third party for this purpose. It also does not address taxable capital which is the value relevant for paragraph 84.1(2.3)(b).

It seems that the new amendments may be helpful in certain situations. However, they do have limitations and will not be helpful in every situation involving an inter-family transfer. They do also leave some unanswered questions and have apparent technical limitations and gaps. Given those gaps and the fact the amendments came from a private member’s bill, it seems likely that the Department of Finance will review these provisions and introduce further amendments.

This article was originally published in Wolter Kluwer Tax Topics. Republished with permission.

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Brian Nichols and Kelsey Horning of Goldman Sloan Nash & Haber LLP, Toronto. Brian Nichols practises law through Brian Nichols Professional Corporation