Since the introduction of the draft legislation for intergenerational business transfers (IBT) on March 28, 2023, the National tax services team at Baker Tilly Canada has reviewed the IBT rules in detail. For a convenient summary of the proposed IBT rules, please refer to the following document prepared by the team – Genuine intergenerational transfers – comparison of the rules. The objective of this blog is to provide an analysis of some of the issues with the IBT rules as currently proposed. A thorough analysis of the rules is beyond the scope of this blog.
Subject to change
The proposed IBT rules, which apply to transfers occurring on or after January 1, 2024, are subject to change prior to being introduced in a bill to the House of Commons. Baker Tilly will provide the issues identified below to the Department of Finance for consideration to provide further clarity and hopefully to alter the legislation.
Potential issues – the control rule
Several potential issues with the draft legislation have been uncovered during our review. For the purposes of this blog, the focus will be on the issues identified with the control rule under paragraphs 84.1(2.31)(a) and 84.1(2.32)(b) – control immediately before disposition time.
Control immediately before disposition time
The proposed IBT rules dictate who may or may not control the subject corporation[i] immediately prior to sale. This control rule requires that “the taxpayer — either alone or together with their spouse — controls the subject corporation, and no other person or group of persons controls, directly or indirectly in any manner whatever, the subject corporation”. This proposed rule does not consider dynamic family situations where control is spread out over various family members or arm’s length persons.
The specific wording used in the first part of this control test “the taxpayer – either alone or together with their spouse — controls the subject corporation” may cause a non-controlling spouse to not qualify. For example, let’s assume that Mr. and Mrs. Smith each own 50 per cent of the non-voting common shares of Company A, and Mrs. Smith owns 100 per cent of the voting preferred shares of Company A. Both Mr. and Mrs. Smith are selling all their shares to their daughter. With regards to this control rule, Mrs. Smith, alone, would have control of Company A and meets the first part of this control rule. Mr. Smith, on the other hand, does not have control of Company A either alone or together with his spouse (since Mrs. Smith has sole control), and does not meet the first part of this control rule. As a result, only Mrs. A would be able to rely on the intergenerational transfer rules.
Following are four examples of how this control rule does not reflect the reality of diversely controlled and operated family businesses.
Mom, dad, daughter and son each own 25 per cent of the common voting shares of Company A. Mom and dad want to sell their 50 per cent interest to their children. Neither mom nor dad, either alone or together, have control of Company A, so neither would meet the first part of the control test.
Mom, dad, mom’s brother and his spouse each own 25 per cent of the common voting shares of Company B. Mom and dad want to sell their 50 per cent interest to their children. Neither mom nor dad, either alone or together, have control of Company B, so neither would meet the first part of the control test.
Mom, dad and mom’s brother each own 33 per cent of Company C. Mom and dad want to sell their 66 per cent interest to their children. Mom and dad, together, have control of Company C, which meets the first part of the control rule. The problem is the second part of the control rule, which states “no other person or group of persons controls, directly or indirectly in any manner whatever, the subject corporation”. Mom, dad and brother may be considered a group of persons[ii], which collectively controls Company C. As a result, the second part of the control rule may not be met.
Mom and dad are in their 80’s and still retain a significant fixed value equity interest in FarmCo with full voting control. Their two children, both in their 50’s, equally own 100 per cent of the non-voting common shares. Given the lack of involvement by mom and dad over the years, the children have financed and managed FarmCo and made all business-related decisions for an extended period of time. The two children are also listed as the sole directors and officers of FarmCo. Mom and dad are finally ready to let go of their equity and voting interest in the company and want to sell their shares to their children. Mom and dad would meet the first part of the control rule, but they would fail the second part of the control rule because their children have de facto control over FarmCo.
Control can only be given up once – relinquishment of control rule
A serious issue has been identified with the rule discussed above. This control rule does not integrate with paragraphs 84.1(2.31)(c) and 84.1(2.32)(c) – relinquishment of control.
These two paragraphs require the relinquishment of control immediately after the disposition time. The specific wording is: “the taxpayer does not — either alone or together with a spouse or common law partner of the taxpayer — control…the subject corporation”. Assuming mom and dad own 100 per cent of the common shares of Company A, meeting the control test, and they sell 51 per cent of their shares to their two children (disposition time), then mom and dad would meet the relinquishment of control test. This is great for the initial disposition of 51 per cent of the shares of Company A, but a subsequent disposition of mom and dad’s remaining 49 per cent share equity would not meet the conditions of the control test immediately before the subsequent disposition time, thus excluding the subsequent disposition from benefiting from the intergenerational transfer rules.
It is not easy drawing a line in the sand to distinguish genuine intergenerational transfers from non-genuine. While time remains, it is important that Canadian tax professionals continue to review the draft legislation and provide feedback to the Department of Finance regarding any potential technical issues identified with the proposed legislation prior to introduction in a bill.
[i] The subject corporation is the corporation for which the shares are being sold.
[ii] IT-302R3, p.3 “A group of persons who own the majority of the voting shares of a corporation will be considered as having collectively acquired control of the corporation where there is an agreement amongst them to vote their shares jointly, when there is evidence that they act in concert to control the corporation, or when there is evidence of their intention to act in concert to control the corporation.”
Rock LapalmeMay 16, 2023 - 2:26 pm
Great article and great points. Hopefully, we will see some meaningful changes to the proposed rules.
Hugh NeilsonMay 16, 2023 - 6:52 pm
Excellent examples, John. It feels like the test should look at a process, rather than a point in time. Are the vendors truly transitioning the ownership, operations and management to the purchasers? If so, the fact that the transition began before the sale and/or continues after the sale should not prevent the tax benefits.
This is especially important with a de facto control test – the children may have been involved for years before a sale (and therefore could be perceived as part of the controlling group, regardless of any votes owned) and the parents’ business acumen and experience may be respected for years after (so they still have some informal measure of control).