How capital gains tax changes impact brokerage succession

Asked about business succession in Canadian Underwriter’s 2024 National Broker Survey, most brokerage owners said they want to sell their companies to family members, or to current managers and employees. But recent changes to Canada’s tax code could make a business sale to family members both more attractive and complicated.

It all revolves around Section 84.1 of the Income Tax Act, an anti-avoidance rule that deals with the sale of a business to non-arm’s length parties including family members.

Drafted in the 1980s, the rules address business owners with growing values in their companies, which would normally be distributed to shareholders in the form of dividends. Those dividends would be taxed at close to the highest rates in the tax code.

“But if [the business owner] could sell that business to an accommodating purchaser, they could get capital gains treatment, which is taxed at a much lower rate. And they would get access to the lifetime capital gains exemption,” says Kevin Wark, managing partner, Integrated Estate Solutions, and tax consultant for Conference for Advanced Life Underwriting.

The anti-avoidance rule prevents this by converting the capital gain arising on a non-arm’s length sale into dividend income.

Ownership concerns

For years, concerns have been expressed about the rules in section 84.1. The business community said denial of capital gains treatment could force business owners to sell their business to arm’s length parties to obtain capital gains treatment, rather than retain the business in the family.

This would not only adversely impact the family, but also local communities where those businesses operated and employed people.

Responding to these concerns, the Finance Ministry announced in 2017 it would review the rules in section 84.1 as they apply to family sales. But the government dallied and after continued delays a Private Member (Bill C 208) became law in 2021.

“It allowed for an exception to 84.1, where shares in small business corporations are sold to a corporation owned by adult children. In this case ‘children’ included spouses of the children, and grandchildren; so a fairly broad group of family members can qualify for this exception,” Wark tells CU.

Finance wasn’t entirely happy with Bill C 208, believing the rules  permitted  business owners to continue participating in, and benefitting from, the growth of the business, unlike what would happen if it was sold to an arm’s length purchaser.

So the government introduced stricter rules which passed this year as part of Bill C 59.  These new rules apply to business sales taking place after 2023, and are very complex.

“While they still preserve the ability to sell shares of qualifying small businesses to children, the owner has to give up factual and legal control of the business within a certain period of time,” explains Wark. “And at least one family member has to be actively engaged in the business.”

New sales conditions

A series of conditions must be met at the time of the sale, as well after the sale, for the exemption to apply, notes Wark.

And if those requirements are not met, the Canada Revenue Agency can go back and deny capital gains treatment to the selling business owner. There are two different streams for structuring the sale, one in which all required criteria must be completed within three years, and a second where the various conditions must be completed within 10 years.

“There’s a lot more rules and provisions now in effect than was the case under Bill C-208 and you’ve got to be very careful, not only when you make the sale, but afterwards, to ensure compliance with those rules,” he says.

Plus, the new rules require a seller to relinquish what’s called ‘factual and legal control’ which means an owner must commit to leaving the business to obtain access to capital gains treatment and the tax exemption.

Related: Carol Jardine discusses retirement, succession planning and knowledge transfer

“The business owner might have to delay making the sale, just because they’re not ready to give up all that control to children,” Wark tells us.

Or, he notes, an owner may not think their child is ready to assume control, or would have to take on too much debt to make the purchase. Such owners could still be spurred by the prevailing tax treatment to seek other purchasers for the business.

“When you’re selling to family members, you’re typically being paid out of future corporate profits or maybe some debt assumed by the children,” says Wark. “Typically, this is a buyout where the bulk of the purchase price is paid  over a long period of time, whereas if you’re dealing with a consolidator or another larger entity, they’re prepared to put more money on the table up front.”

Taken together, those factors could potentially change a selling business owner’s mind.

“There’s also probably less risk of [a consolidator] defaulting, because they know how to run a business. Without careful grooming, [an owner’s] children may not,” he adds.

Feature image courtesy of iStock/designer491