Concerned About Capital Gains Taxes? Comment by Sept. 3!

Evelyn Jacks

Especially if you are working with a business owner thinking of transferring the interests in their small businesses to the next generation, consider commenting on the draft legislation released by the Federal Government on August 12.  These clients require more information about new taxing initiatives; in particular, the changes to the Capital Gains Inclusion Rates (CGIR) and the related Lifetime Capital Gains Exemption (LCGE), the new Canadian Entrepreneurs’ Incentive (CEI) and Employee Ownership Trusts (EOTs).  But the rules are very complex and the deadline for response to the draft rules is short: for the CGIR rules, it’s September 3.  For the case of the CEI it’s September 11.   Here’s what you need to know:

The Backdrop:  Small business owners employed 5.7 million individuals in Canada, or 46.8% of the total private labour force, according to the government’s Key Business Statistics,  while medium-sized businesses employed 2.1 million individuals (17.0% of the private labour force) and large businesses employed 4.4 million individuals (36.0% of the private labour force).

Getting the new capital gains rules right, along with the intergenerational business transfer rules, is of critical importance to the Canadian economy, especially at this inflection point, when the vast majority of business owner are transitioning to retirement in the  next decade.   But the federal government has made this much more difficult recently. Advisors can add big value helping clients understand the rules and make decisions that suit objectives, despite this changing playing field.

The Journey.  Finance Canada has attempted to raise taxes on business owners for some time.  Recall the outrage garnered by proposals made on July 17, 2018, which introduced the Tax on Split Income Rules (TOSI) and proposed to deny the claiming of capital gains where businesses were transferred from one generation to the next.   This made it more advantageous, from a tax point of view, to sell the business to an unrelated neighbor than to keep it in the family.

Enter a private member’s bill (Bill C-208) which was passed on June 29, 2021, with new rules that put family business transfers on par with dispositions to unrelated third parties; it provided assurance that that  intergenerational business transfers (IBT) of Qualified Small Business corporation (QSBC) or Family Farming or Fishing Corporation (FFFC) would qualify for capital gains treatment and with that, the Lifetime Capital Gains Exemption (LCGE), if eligibility requirements were otherwise met.

Finance Canada was not happy about this. The March 2023 Budget introduced proposals to amend the rules introduced by Bill C-208, to ensure that these family business transactions were “genuine” and  only then qualified for an exception from Section 84.1, the “surplus stripping” rules that reclassify offside transactions as a taxable dividend instead. 

Specifically, the government proposed two genuine transfer scenarios under which a transfer of the family business would qualify for capital gains treatment. Draft legislation was released on August 4, 2023 with the rules surrounding each scenario, contained in Bill C-59, which received Royal Assent on June 20, 2024.  However, the rules take effective retroactively as of January 1, 2024.

How the IBT Rules Work.  Briefly, the legislation introduced a gradual (10 year) or immediate (3 year) transfer option, to an adult child, grandchild, (or after January 1, 2024 a niece, nephew, grandniece or nephew).

Parents must transfer control within 36 or 60 months, respectively.  Under an immediate transfer, parents can’t have legal or factual control after the 36 months.  Under the gradual transfer, parents can have an economic interest (but not legal control) but must reduce debt and equity interests within 10 years to 30% of their value for QSBCs and 50% for QFFCs.

The adult children have obligations as well:  they must carry on an active business for the 36 or 60 months, and at least one child must remain actively involved during these periods or until the business transfer is completed, whichever is the later.   

Capital gains treatment will then apply, including access to the capital gains exemption and related capital gains reserve mechanisms (extended to 10 years, however).

New Capital Gains Rules for 2024.  In the meantime, the federal government has released its April 16, 2024 which increased Capital Gains Inclusion Rate (CGIR) to 66 2/3% on capital gains over $250,000 for individuals and from the first dollar for corporations, as of June 25, 2024.

It also increased the Lifetime Capital Gains Exemption (LCGE) to $1.25 Million as of this date and introduced two new provisions for business owners:  the Canadian Entrepreneurs’ Incentive (CEI), which increases the LCGE to $2 Million and the Employee Ownership Trusts (EOT), which features a $10 Millon exemption.

This came with some ordering rules: the LCGE can only be claimed after the $10 Million Employee Ownership Trust (EOT) exemption is applied.  But the LCGE is applied before the Canadian Entrepreneurs’ Incentive (CEI).

Draft legislation for most of the capital gains provisions was released on June 10,2024 and on August 12, 2024.

The CEI.  Successors to the business should take note of the Canadian Entrepreneurs’ Incentive.   It allows for a reduced CGIR of 33 1/3% starting in 2025 on certain qualifying dispositions.  It also features an increased LCGE of $2 Million, to be phased in in $400,000 increments from 2025 to 2029.  This is a provision the next generation of owners may be able to take advantage or when the transferred business is sold down the line. However, the following criteria must be met, with different holding period requirements than the IBT Rules.

• Ownership Period – a continuous 24-month period prior to the disposition of the business
• Ownership Level – during 24-month period, the minimum of 5% of issued and outstanding shares having full voting rights or if the interest is in a partnership, the specified proportion of the partnership for its most recent fiscal year is not less than 5%
• Active Engagement Period – on a regular, substantial and continuous basis for of no less than three years since the founding of the business
• Excluded businesses – professional accounting, financial and insurance, food, recreation, entertainment businesses etc. 

Employee Ownership Trusts   Despite the attractive $10 Million exemption for capital gains arising on the business transfer to employees, these are taxable trusts, taxed like other personal trusts:  undistributed trust income is subject to top personal marginal tax rate.  This means trust income must be distributed to beneficiaries to be taxed at their income level for the best results.

Is that the outcome business owners want or need to retain earnings in the venture for future investments in the business?  Also, Is the runway for the EOT structure long enough for meaningful succession planning?  The plan will only be in effect, so far at lease, for 2024, 2025, and 2026.

The AMT. Further, taxes have potentially been raised with the new definition of Alternative Minimum Tax (AMT), effective January 1, 2024, to include 100% of capital gains in its calculation, but there are exceptions relating to claims for the LCGE.  EOT are not included in the AMT calculations.  The LCGE is calculated at 7/5 of the regular tax calculation.

The Commentary Deadlines.   This backdrop above now brings us back to Finance Canada’s request from comments on these fast-paced and highly complex legislative changes that have big implications for the after-tax proceeds left in the pockets of business owners and investors.  Recall the deadline:  your comments on the capital gains provisions will be accepted until September 3, 2024 and for the CEI by September 11, 2024.

The Bottom Line.  What’s the best option for business owners and their investors when it comes to business transition?  It’s up to the professional consisting of the owners, the accountants, lawyers and business valuators analyze these complex rules and decipher them for both the business and the family, so they can make the most informed decision about their succession plans.

From a broader point of view, this is important for the community as well.   Finance Canada in their law drafting and CRA in their auditing practices, have the opportunity to work with Canadian business owners to enable a successful business transition to future entrepreneurs – related or not – and in the process enable a prosperous future for all Canadians.  That begins with tax policies that recognize the enormous effort it takes to bring a business to the succession goal line in the first place.

Evelyn Jacks is author of 55 books on tax and wealth planning, many of them best-sellers.  She is also the Founder and President of Knowledge Bureau.