A parent who sells the family business to the children usually wants two things. The first is to be taxed on a capital gain basis (and not an income basis), some or all of which the lifetime capital gains’ exemption may shelter. The second is to keep coming into the office. The intergenerational business transfer exception in s. 84.1(2.31) and (2.32) of the Income Tax Act (“ITA”) gives the parent the first on the condition that the parent gives up the second.
The starting point is s. 84.1(1). When a parent sells shares to a corporation controlled by a child, the rule treats the proceeds as a dividend rather than a capital gain, on the theory that the family has taken money out of the company without really selling it. At the top Ontario bracket that means tax of as much as about 48 per cent instead of about 27, before any exception. The exception switches the rule off where the parent sells qualified small business corporation shares (or family farm or fishing shares) to a corporation controlled by one or more adult children, and certain conditions are met. The exception has applied in its Bill C-59 form to dispositions since January 1, 2024, and CRA has spent two years answering questions about it. The answers point one way: the exception is for a parent who actually ceases to operate the business. Most of the failures I see in planning discussions come from families who want the capital gain and the parent’s continued hand on the business at the same time.
There are two ways for a transferor to leave the business. On the immediate path, the parent gives up both legal and factual control at closing and hands over management within 36 months. The children have to keep control of the purchaser, and at least one of them has to stay actively engaged in the business, for 36 months. On the gradual path, the parent gives up legal control at closing but may keep factual control, such as the kind of influence a parent can have as the company’s main lender, or as the person everyone still phones. In exchange, the control and engagement period for the children is at least 60 months, and within ten years the parent’s remaining economic interest, debt and shares together, has to fall to 30 per cent of what the parent’s interests were worth immediately before the sale (50 per cent for farm and fishing shares). On both paths the parent has to be out of every share other than non-voting preferred shares within 36 months, and every test applies to the parent together with a spouse or common-law partner.
The parent who stays on the board
At the Association of Fiscal and Financial Planning (APFF) Roundtable on October 10, 2024 (Question 2), CRA was asked about a parent who sells the shares and stays on as a director. CRA answered that a parent who stays in office, and does not take steps to leave it completely and permanently within the required time, has not ceased to manage the business, and the exception does not apply. It made no difference that the parent was one of several directors, or that the children ran the business day to day. CRA gave the same answer for a parent who keeps a class of voting “control” shares. That parent still controls the corporation after the sale, and the shares are not the non-voting preferred shares the exception allows the parent to keep.
The drafting response is a dated resignation and a share purchase agreement that makes the resignation a condition of closing. If the family wants the parent to stay involved, the vehicle is a consulting agreement, not a board seat. Paragraph 84.1(2.3)(i) of the ITA helps here: it defines management as the direction or supervision of business activities and says that it does not include giving advice. The consulting agreement should therefore have a defined scope and give the parent no authority over hiring, spending or strategy.
The vendor take-back and de facto control
Most family transfers are financed in part by the parent. In technical interpretation 2024-1038891E5, the parents had sold shares of their business to their child’s corporation and taken back a promissory note for a substantial part of the price. The note bore no interest unless there was a default, was repayable over 15 years, and was guaranteed by the child. CRA took the position that a non-interest-bearing note payable over a commercially reasonable period does not, by itself, give the parent de facto control of the purchaser under s. 84.1(2.31)(c). It said that the child’s personal guarantee will generally not do so either, where the purchaser can service the debt. CRA also said that it looks at all the circumstances: how much of the total financing the note represents, the repayment terms, the guarantees, and whether the purchaser could find other financing if repayment were demanded.
That comfort has a condition attached. Picture the opposite note: most of the price, repayable on demand, secured over all the assets, with covenants that let the parent veto operating decisions. Those are the facts CRA’s listed factors are aimed at. The note should read like third-party debt: a fixed amortization; security that is ordinary for the amount; and covenants limited to financial reporting and payment.
One disposition, not several
CRA’s APFF answer also confirmed that the exception is available only for the first disposition for which it is claimed. A parent who sells 60 per cent of the shares to the children’s corporation now and plans to sell it the other 40 per cent in three years, gets the exception on the first sale only. The second sale is caught by s. 84.1(1). Selling less than a majority first is worse. A parent who still owns half or more of the common shares after closing fails the ownership condition on the first sale as well.
A family that wants the parent paid out over time can do it through the consideration instead. The parent sells once and takes back a note or non-voting preferred shares. Both paths allow the parent to hold those, and the gradual path sets the schedule for reducing them, to 30 per cent within ten years. The agreements should say which path the family is on and set the milestones against the dates outlined in the ITA.
The rules are strict. They are also workable for a family in which the parent has decided to transfer a business to the next generation.
About the Author
Koby Smutylo is a business lawyer and mediator at Smutylo Law+ in Ottawa, called to the Bar of Ontario in 2001. He acts for founders and owner-managed companies.
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