Curated Content Canada: Tax Planning For Intergenerational Business Transfers And Alternative Minimum Tax (AMT) After Bill C-59 (Changes To The Income Tax Act)

Introduction: The Canadian Federal Government's Recent Proposed Amendments to the Income Tax Act

In August 2023, the Canadian Federal government tabled Bill C-59 ("Fall Economic Statement Implementation Act, 2023"), which includes various draft amendments to the Canadian Income Tax Act. Among those proposed amendments is one that may prove very impactful for high-net worth individuals in Canada: new conditions on the use of the newly minted intergenerational business transfer rules, which received royal assent only in 2021. If enacted, these rules would come into force retroactively as of January 1, 2024.. In addition, the Federal Government recently released draft legislation on August 4, 2023, proposing modifications to the "alternative minimum tax" ("AMT") rules, first enacted in 1986.

Both tax regimes have remained largely untouched since they were first enacted by Parliament. The Federal Government's most recent proposals seek to address concerns raised by taxpayers and tax practitioners alike concerning inequities in both systems, and each signals the first attempt by Parliament to clearly reconcile these regimes. The results of these proposals if both are enacted, however, may give rise to new tax planning challenges for Canadian taxpayers and their expert Canadian tax planning lawyers.

This article will begin by briefly setting out the purpose and application of the current rules under the intergenerational business transfer regime and the AMT regime. This will be followed by a summary of pertinent changes proposed for the intergenerational business transfer rules under the current text of Bill C-59, and the Federal Government's other proposed amendments to the AMT regime. This article will conclude with some brief pro tax tips on the intersection between the proposed changes to the intergenerational business transfer regime and the AMT regime, and how these changes will necessitate detailed planning for taxpayers to avoid unfavourable tax consequences for small business transfers within family units.

The Scope of the Current Law

Intergenerational Business Transfers – Sections 84.1 and 55

On June 29, 2021, Bill C-208 ("An Act to amend the Income Tax Act (transfer of small business or family farm or fishing corporation"), received royal assent. Bill C-208 was intended to address two perceived inequities in the Canadian tax system faced by families transferring an incorporated business to the next generation of operators.

First, the purchaser of a privately held business rarely has funds to pay the full purchase price outright, and often a purchaser will finance the purchase price over time by negotiating a deferred payment arrangement, earn-out arrangement, or some other form of vendor take-back financing with the vendor. If a business owner sold the shares of that business to an arm's-length third party, that owner could benefit from the lifetime capital gains exemption ("LCGE") on those shares if it was a qualified small business corporation. But under the prior legal regime, a similar sale of those shares to the child of the owner would have to be financed using after-tax personal funds, or else the sale could trigger the anti-avoidance rules under section 84.1 and the parent would face a deemed dividend that could not be sheltered from tax using the LCGE.

Second, the definition of "related" persons for the purpose of a business spin-off between family members (often referred to as a "butterfly reorganization") did not actually include siblings. So, the ability to divide a business up within a family unit on a tax-deferred basis was arbitrarily limited when a spin-off was to be between siblings, compared to spin-offs involving parents and children which were wholly permissible, even if the spin-off was not an attempt to manipulate or abuse tax rules.

Bill C-208 addressed these inequities in two significant ways:

1. Section 84.1 was amended to include paragraph 84.1(2)(e) and subsection 84.1(2.3), which effectively exempts transfers of qualifying ≈ corporation shares (or shares of the capital stock of a family farm or fishing corporation) operating a family business (the "subject corporation") to a corporation held by a child or grandchild (the "purchaser corporation") from the application of the anti-avoidance rule under section 84.1, so long as: (1) an independent assessment of the value of those shares is obtained and submitted to the CRA; and (2) the purchaser in question does not dispose of those shares for 60 months after the date of purchase (except by reason of death).
2. Section 55 was amended to include subparagraph 55(5)(e)(i), which provide that siblings qualify as "related" for the limited purpose of section 55, allowing tax-deferred spin-offs of corporate businesses between siblings without ambiguity.

Alternative Minimum Tax ("AMT") – Section 127.52

The AMT regime, first introduced in 1986, was enacted to prevent high income earners inequitably benefiting from preferential tax treatment on income sources, deductions and credits under the Canadian income tax regime to pay minimal or no tax. The AMT regime works in parallel to the general income tax regime, and subjects high-income earners to a minimum basic tax where their tax obligations would fall below a specific threshold. Where the AMT exceeds that taxpayer's general income tax otherwise payable, that taxpayer will pay the AMT for that year instead. However, the AMT regime is meant to act as a deterrent, and not a permanent tax. So, an individual subject to the AMT will be entitled to carry that incremental increase in tax under the AMT regime forward to apply against and reduce future income tax for a maximum of seven years.

The AMT regime can be particularly relevant for a taxpayer selling shares of a family business. An eligible taxpayer is entitled to a cumulative lifetime capital gains exemption ("LCGE") on the disposition of qualifying corporate shares, including shares of a qualifying small business corporation. In the normal course, this exemption can partially or entirely shelter any resulting capital gain on the sale of those shares from tax. However, for calculating AMT (under the current rules), 80% of capital gains are included in an individual's "adjustable taxable income" for determining the AMT, and the rate of the LCGE is 50%. This results in an effective inclusion rate for capital gains sheltered by the LCGE when calculating AMT of 30%. So, if a taxpayer disposes of shares and benefits from the LCGE, the AMT regime may still result in taxes payable for that year if that taxpayer has little or no other sources of taxable income. If that individual does not earn enough taxable income in the following seven years to recover the AMT, then that taxpayer may lose part of the benefit received by using the LCGE on the sale of those shares.

The Proposed Amendments to the Intergenerational Business Transfers and the AMT Regime

Bill C-59 proposes to change the intergenerational business transfer rules in two significant ways for high income earners looking to pass on their incorporated family business to the next generation. The Federal Government's August 4, 2023, proposals to amend the Income Tax Act are not included as part of Bill C-59 but can be expected to form part of future legislation. The following sections will discuss those proposed changes in turn.

Proposed Modifications to the Intergenerational Business Transfer Rules

Bill C-59 proposes to amend section 84.1 and the reserve rules under section 40 to address ambiguities raised by Canadian tax practitioners in the current language of the provision, and to prevent potential abuse of the intergenerational transfer rules.

Subsection 84.1

Some of these proposed amendments do not materially affect the way the intergenerational business transfer regime functions, are still worth noting. First, Bill C-59 proposes to mandate, in addition to obtaining an independent valuation, that every parent and child involved in the transaction file an election in the prescribed form with the CRA for the taxation year in which the sale occurred. Second, the definition of "child" would be expanded to include adult nieces and nephews (and their spouses), and grandnieces and grandnephews. (Under the current regime, "child" only includes the child or grandchild of a business owner). These rules together increase supervision by the CRA over intergenerational transfers, and increase the flexibility afforded to family units when transferring a business to the next generation.

More importantly, the proposed amendments create two "timelines" (an "immediate" transfer, and a "gradual" transfer) for the intergenerational transfer to take place so that the exemption can apply. A family unit may prefer one timeline over the other depending on whether they value finality of a transaction more than a gradual transition of the business.

Involvement of Children in the Family Business

Under the proposed rules, the child or children of the parent must take an increased and definitive role in the family business. With an "immediate" transfer, from the date of sale to 36 months after, the following must be satisfied:

1. A child or group of children must control the purchaser corporation;
2. A child or group of children must be actively engaged in the subject corporation's business; and
3. The subject corporation's business must be carried on as an active business.

With a "gradual" transfer, these conditions must be met from the date of sale to 60 months after, or an additional two years.

Transfer of Management Responsibilities

Under both timelines, the parent must transfer management of the family business to at least one child, and must permanently cease to manage any part of the family business, within a set period of time. For an "immediate" transfer, this must occur within 36 months after the sale (or within another reasonable period of time), while with a "gradual" transfer, this time period is extended to 60 months after the sale (sale (or within another reasonable period of time).

Reduction in Share and Equity Interests

For both an "immediate" transfer and a "gradual" transfer, the parent cannot hold 50% or more of any class of shares or equity interest in either the purchaser corporation or subject corporation (except for non-voting preferred shares) immediately following the sale. Further, the parent must relinquish any shares or equity interests (except for non-voting preferred shares) in the subject corporation and purchaser corporation entirely within 36 months of the sale.

Ultimate Control

With an "immediate" transfer, the parent must not have de facto control (or, control in any manner whatever) over the purchaser corporation or subject corporation following the sale.

With a "gradual" transfer, the parent must not have de jure control (or, control in law, which typically corresponds to a majority of voting rights in the capital stock of the corporation) over the purchaser corporation or subject corporation following the sale. As a result, a parent under the "gradual" transfer timeline can still exercise economic influence over the business.

However, a parent under the "gradual" transfer timeline must, within 10 years of the sale, reduce any debt and equity interests in the subject corporation to: (1) 30% of the value received for the subject corporation shares sold; or (2) in the case of a farm or fishing corporation, 50% of the value received for the subject corporation shares sold. As a result, while a parent can exercise economic influence at the outset, that influence must be gradually reduced and permanently eliminated within 10 years.

Section 40 – Expanded Reserve Rules

Bill C-59 also proposes to amend the reserve rules under section 40, which allow for limited-case deferral of capital gains tax when full payment is not received in the year of a property disposition. Under the existing rule, the inclusion period for a reserve is capped at 5 years. If the proposed amendments are enacted, the reserve claimable for the sale of corporate shares for a qualifying intergenerational business transfer will be 10 years, allowing a parent to claim a reserve for up to 9 years after an intergenerational transfer. This rule would provide more favourable tax treatment for parents and children who choose to finance an intergenerational transfer using long-term debt paid to the parent over time, rather than using after-tax proceeds or redeemable share consideration.

Proposed Changes to the Alternative Minimum Tax Regime

The Federal Government has separately proposed to amend the AMT regime in a few important ways. The most critical proposed changes to the AMT regime for intergenerational transfers include the following:

1. The inclusion rate for capital gains will be increased from 80% to 100% (while the net inclusion of 30% of capital dividends sheltered by the LCGE will remain at 30%).
2. The AMT rate will be increased from 15% to 20.5%.
3. The AMT exemption will be raised from $40,000, to be indexed against the fourth federal tax bracket (in 2023, this was $165,430, and it is further indexed annually to inflation).

Whether these changes will result in a lower or higher AMT for a taxpayer selling a family business is very fact-dependant. A taxpayer who is selling a smaller business with gains largely sheltered by the LCGE will likely benefit from these changes, while a taxpayer selling a large family business will be more negatively impact.

This can be illustrated using two simple examples. First, assume that for a particular taxation year, a taxpayer sells a small family business and intends to retire. The taxpayer sells his qualified small business corporation shares for proceeds of $1,000,000, which are fully sheltered by unused cumulative LCGE of $1,000,000. Assume that taxpayer also has no other sources of income for that taxation year. The AMT calculation under the current and proposed regimes would be as follows:

Second, assume that the taxpayer's business is substantially bigger. The taxpayer sells his qualified small business corporation shares for proceeds of $2,000,000, which are only partially sheltered by unused cumulative LCGE of $1,000,000. Assume that taxpayer also has no other sources of income for that taxation year, and that income is taxable at the highest marginal federal rate of 33%. The AMT calculation under the current and proposed regimes would be as follows:

As this streamlined example illustrates, the taxpayer who sells a smaller business will generally benefit more from the proposed AMT regime, as it would result in a total lower AMT payable. However, the taxpayer who sells a business for proceeds which can't be entirely sheltered by the LCGE suffers from a significantly higher AMT payable. As mentioned above, this could conceivably result in trapped AMT if the taxpayer does not have sufficient taxable income in following years to apply the carry-forward amounts from AMT toward.

Pro Tax Tip – Implications of the Proposed AMT Amendments for Recovering AMT Following an Intergenerational Business Transfer

If and when both proposals are implemented, the ability for a parent to recover AMT paid following an intergenerational transfer may be at risk. Under the "immediate" transfer timeline, a parent cannot retain economic control over a business, and must relinquish control over management within 36 months. Under the new "gradual" intergenerational transfer stream, a parent can maintain economic control of a family business following an intergenerational transfer, but only up to five years following the transfer. Oftentimes, a parent might wish to take a salary, which can generate taxes owing to recover AMT paid in the year of sale. These timelines limit the typical 7-year window to recover AMT to 3 or 5 years, depending on how the transfer has been planned.

A parent may be motivated to have an intergenerational transfer financed using long-term interest-bearing debt, to generate taxable income in future years. But, if that parent also plans on claiming a reserve in connection with the sale of those subject corporation shares, there is a risk that AMT will be payable in those following years. So, if a parent does not have other sources of taxable income and is possibly preparing for retirement, the need to consult with a top tax planning lawyer to carefully tax plan for an intergenerational transfer rises significantly. Optimizing an AMT recovery strategy will depend on the nature and size of the business being sold and its anticipated cash flows, applicable interest rates for long-term debt, and the applicability of the reserve rules, among other factors. It is strongly recommended that you engage an expert Toronto tax lawyer at the outset of planning for an intergenerational transfer, not only to ensure the intergenerational transfer rules are satisfied, but also to appropriately plan for the impact of AMT on that transfer, whether under the current legislative scheme or in the future.

FAQs:

What is Bill C-59?

In August 2023, the Canadian Federal government tabled Bill C-59 ("Fall Economic Statement Implementation Act, 2023"), which includes various draft amendments to the Canadian Income Tax Act. Among those proposed amendments that may prove very impactful for high-net worth individuals in Canada includes new conditions on the use of the newly minted intergenerational business transfer rules, which received royal assent only in 2021. If enacted, these rules would come into force retroactively as of January 1, 2024.

What is "Alternative Minimum Tax"?

The "alternative minimum tax" ("AMT") was first introduced in 1986 to prevent high income earners from avoiding paying tax by leveraging specific income sources, deductions and credits available under the Canadian income tax regime. The AMT rules under section 127.52 of the Income Tax Act subject high-income earners to a minimum basic tax where their tax obligations would fall below a specific threshold relative to income actually earned in that taxation year. An individual subject to the AMT will be entitled to carry forward any excess tax paid for seven years against ordinary tax, allowing for partial or total recovery of the tax over time.

How Might Bill-C59 Impact the "Intergenerational Business Transfer" Rules?

If passed, the most crucial impact Bill C-59 would have on the "intergenerational business transfer" rules under section 84.1 would be the creation of two "timelines" (an "immediate" transfer, and a "gradual" transfer) for transfers to take place. In order for the exemption to apply, the terms under one of the timelines must be satisfied following the transfer. A family unit may prefer one timeline over the other depending on whether they value finality of a transaction more than a gradual transition of the business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.