In his July 18th, 2017 tax proposals, Finance Minister Morneau included rules to tighten up Section 84.1 and to introduce a new section, Section 246.1. These were introduced as measures to prevent taxpayers from converting ordinary income into capital gains, which would be taxed at a lower rate.
There were a number of significant problems with these provisions, not the least of which was the problems that they posed for inter-family transfers of businesses and family farms.
On October 16th, Morneau introduced changes to the proposals, and indicated that he would not be proceeding with the amendments to Section 84.1 and would not be introducing Section 246.1.
The government patted itself on the back citing their attention to concerns raised during the “consultation period”, and claiming that not proceeding with these changes would make it easier to transfer businesses and farms within families.
This is not what it seems. True that they have not made it more difficult, but neither have they made it any easier or more tax friendly.
Section 84.1 – Why it is still more expensive to sell to your children
Section 84.1 is an anti-avoidance provision that deems amounts that would normally be capital gains to be dividends. In section 84.1, there must be a share transfer from an individual to a corporation.
In very general terms, section 84.1 applies when all of the following conditions are met:
Shares of any class (the "subject shares") of a Canadian resident corporation (the "subject corporation") are disposed of;
The disposition is made by a non-corporate taxpayer (an individual or trust) that is a resident of Canada;
The subject shares are capital property to the taxpayer;
The taxpayer disposes of the subject shares to another corporation (the "purchaser corporation") with which the taxpayer does not deal at arm's length; and
Immediately after the disposition, the subject corporation is connected with the purchaser corporation.
Where section 84.1 is found to apply, one or both of the following consequences may result:
Paid-up capital reduction
The paid-up capital (PUC) reduction found in section 84.1 is intended to prevent the artificial creation of PUC, which can later be extracted by shareholders as a tax-free return of capital.
Generally, shares issued to acquire property begin with PUC equal to the fair market value (FMV) of the property less any non-share consideration paid. Where section 84.1 applies and shares of the purchaser corporation ("new shares") are issued as consideration for the subject shares, the PUC of the new shares is limited to the greater of: a) the PUC of the subject shares, and b) what is commonly referred to as "hard ACB," less any non-share consideration received by the taxpayer on the disposition.
Hard ACB is essentially the adjusted cost base (ACB) of the taxpayer's subject shares, immediately before disposition, reduced by the amount of any capital gains exemption (CGE) claimed by either the taxpayer or a non-arm's length party on the subject shares (or shares for which the subject shares have been substituted). This provision specifically prevents a shareholder from selling, or rolling under section 85, shares of Opco, claiming the capital gains exemption and taking cash or promissory notes equal to the stepped up ACB. To the extent that there is “actual” or “hard” ACB, this amount can be taken in cash or debt. So, the taxpayer can claim his capital gains exemption and if the company is sold the stepped up ACB can be paid free of tax, but the cash cannot be taken on the rollover.
To the extent that the taxpayer receives non-share consideration that exceeds the greater of the PUC and hard ACB of the subject shares, the taxpayer is deemed to have received a dividend equal to the amount of that excess. So, if the taxpayer takes cash on the rollover, the cash amount will be treated as a dividend and the capital gains exemption would not be claimable. Similarly, if a previous shareholder, with whom the shareholder does not deal at arm’s length, most commonly a family member, claimed the capital gains exemption, the stepped up ACB cannot be extracted in cash – only the “actual” or “hard” ACB.
In the scenario above, Mr. X wants to transfer his common shares of Opco to his Holdco and claim the capital gains exemption. Perhaps his Opco is going to cease business and will no longer qualify for the CGE, so it needs to be claimed immediately.
If Mr. X rolls over his Opco shares and takes back shares of Holdco with a PUC higher than $100, 84.1 will grind the PUC of the Holdco shares to $100;
If Mr. X sells, or rolls, his Opco shares to Holdco, if it were not for Section 84.1, he would take back cash or a promissory note for $800,000 and, if rolling under Section 85, some shares of Holdco. If it were a straight sale to Holdco, he would just get the cash or debt. BUT, under Section 84.1, if he did this, the $800,000 of non-share consideration will be treated as a dividend, rather than a capital gain, so the exemption would not be claimable.
Mr. X could sell or roll his Opco shares, claim the CGE while Opco still qualifies and the shares he would receive in Holdco from the rollover would have an ACB of $800,000 which would reduce any future gain on either a sale of Holdco or on death. But 84.1 will ensure that the cash cannot be extracted.
The problem with inter-generational transfers is that the rules in Section 84.1 apply equally to a transfer to one’s children.
If a businessman, or farmer, sells the shares of his business corporation or his farm corporation to an arm’s length party, he can claim his capital gains exemption. The purchaser, who will usually purchase through a corporation, because it is more tax efficient for the purchaser, can borrow against the assets of the business to finance the purchase. This is a win-win for both the vendor, who claims the capital gains exemption, and for the purchaser, who can access corporate money to complete the purchase.
If the same businessman or farmer wants to sell the shares of his business corporation or farm corporation to his child(ren), the amount in excess of his “hard” ACB is treated as a dividend under Section 84.1, as discussed above. The capital gain in respect of which the capital gains exemption has been claimed is not part of the “hard” ACB, so rather than a capital gain which would be exempt, the seller would be treated as having received a dividend.
If the sale takes place in 2017 the full amount of the exempt capital gain for the shares of a business corporation will be $835,716, and for a farm or farm corporation, $1,000,000. The top marginal tax rate on ordinary dividends in Ontario is 45.3%.
The tax cost of selling to one’s children as opposed to an arm’s length third party is summarized as follows:
At a recent Canadian Tax Foundation symposium in Ottawa, Rachel Gervais, a tax partner with BDO, expressed the view that the best way to avoid the problems of the new tax proposals is to not go into business with your children. This is not the form of economy that most Canadians would support.
It is important to realize that the table above reflects the current situation. The rules introduced on July 18th, and which Morneau now says will not proceed, would have tightened up on these rules. But not proceeding with the changes still gives this tax result on a sale to family members, making it all but impossible to justify selling to one’s children.