Principal Issues: Various questions regarding the qualification criteria pursuant to subsections 84.1(2.31) and 84.1(2.32) I.T.A., including: the possibility to qualify for the exception in the case of non-voting and non-participating shares, as typical estate freeze shares; the possibility to qualify for the exception if the parent remains director or in other positions of power; and how the exception mechanism applies to successive transfers of shares.
FINANCE: Finance reviewed the questions and answers, including the ones on successive transfers (not possible to claim the exception more than once regarding the same business), and confirmed that the answers were in accordance with the underlying tax policy. Finance also confirmed that it would be in accordance with the underlying tax policy to claim the exception in respect of more than one class of shares that are sold as part of the same transfer.
Reasons: The law.
APFF FEDERAL TAX ROUNDTABLE 10 OCTOBER 2024
2024 APFF CONFERENCE
2. New Intergenerational business transfer rules
A parent wishes to transfer an incorporated business (“Parent Inc.”) to the parent’s child(ren) by taking advantage of the new measures provided for in subsection 84.1(2.31) or 84.1(2.32).
The parent has already effected an estate freeze in favour of the children. The parent holds voting preferred shares of the capital stock of Parent Inc. conferring de jure control to the parent (the “Control Shares”), as well as freeze preferred shares of the capital stock of Parent Inc. (the “Freeze Shares”), redeemable at the parent's demandt for a value equivalent to the FMV of Parent Inc. at the time of the freeze.
From the time of the freeze, the children held the new common, participating and voting shares of the capital stock of Parent Inc.
The children have been actively employed by Parent Inc. since the date of the freeze (and even before the freeze).
The parent has not yet used his capital gains deduction (“CGD”).
Parent Inc. has been a small business corporation for at least 24 months (Parent Inc. does not carry on a farming or fishing business).
Parent now intends to sell the freeze shares to a holding company (“Buyco”) controlled by the children, all of whom have reached the age of majority. The parent does not hold any shares of Buyco.
Questions to the CRA
(a) Will Parent be able to realize a capital gain on the sale of the freeze shares to Buyco in the following circumstances?
Assuming that the test for transferring the management of the business carried on by Parent Inc. to the children is satisfied (paragraphs 84.1(2.31)(g) or 84.1(2. 32(h)), as well as the transfer of economic interests test (84.1(2.31)(d) and 84.1(2.31)(e) or 84.1(2.32)(d), 84.1(2.32)(e) and 84.1(2.32)(f):
(i) the parent sells all of the Freeze Shares and Control Shares to Buyco;
(ii) the Parent sells all of the Freeze Shares to Buyco but still retains the Control Shares as security pending payment of the value of the Freeze Shares or a substantial portion thereof.
(b) Will the test for transferring the management of the business carried on by Parent Inc. to the children (paragraphs 84.1(2.31)(g) and 84.1(2.32)(h)) be considered satisfied if:
(i) Parent remains the sole director of Parent Inc.;
(ii) Parent remains the sole director of Parent Inc. but only during the first 36 months of an “immediate” transfer (paragraph 84.1(2.31)(g)) or the first 60 months (paragraph 84.1(2.32)(h)) of a “gradual” transfer;
(iii) Parent remains the sole director of Parent Inc. but the day-to-day management of the business is in the hands of the children;
(iv) Parent remains a director, along with one or more children, of Parent Inc.;
(v) Parent is no longer a director or officer of Parent Inc. but still signs or co-signs cheques or is otherwise responsible for the cash outlays of the business.
(c) Would the transfer of the economic interests test (84.1(2.31)(d), 84.1(2.31)(e), 84.1(2.32)(d), 84.1(2.32)(e) and 84.1(2.32)(f) I.T.A.) be satisfied by Parent if:
(i) whether the transfer is immediate or gradual, Parent sells the Freeze Shares to Buyco in three equal tranches, 1/3 on the date of the transaction (the “Date”), 1/3 on the 1st anniversary date of that Date and the final 1/3 on the 2nd anniversary date of that Date. However, Control Shares are retained until the sale of the final 1/3 of the Freeze Shares, on which date Parent sells both them and that 1/3 of the Freeze Shares;
(ii) the same scenario as in (i), except that the Control Shares are sold at the same time as the first 1/3 of the Freeze Shares;
(iii) in the case of a gradual (rather than immediate) transfer, Buyco has purchased all of the Parent's Freeze Shares, but has only paid for 20% of them over the 10 years following the Transaction Date. However, the value of Parent's indirect interest in Parent Inc. represents less than 30% of the FMV of all the interests in Parent Inc;
(d) Among the preferred shares held by the parent in Parent Inc. and sold to Buyco in addition to its Freeze Shares and Control Shares, the parent held $200,000 worth of preferred shares issued in connection with a crystallization transaction (redemption value and adjusted cost base (“ACB”) to Parent of $200,000; paid-up capital of $100) when the parent was the sole shareholder of Parent Inc.
The answer should be that the exception in paragraph 84.1(2)(e) will not apply, because it cannot be said that the taxpayer ... “has not previously, at any time after 2023” sought an exception to the application of subsection 84. 1(1) pursuant to subsection 84.1(2)(e): subparagraph 84.1(2.31)(a)(ii) (immediate transfer) or subparagraph 84.1(2.32)(a)(ii) (gradual transfer).
Would the CRA confirm that, because of a prior crystallization of a taxpayer’s CGD, the individual would be deprived of the possibility of benefiting from the new measures for selling to the children (through a corporation owned by them) under paragraph 84.1(2)(e)?
CRA Response to Question 2(a)
The new rules in paragraph 84.1(2)(e) and subsections 84.1(2.3), 84.1(2.31) and 84.1(2.32) seek a balance between:
- on the one hand, facilitating genuine intergenerational transfers of businesses between an owner-manager parent and an adult "child" or "children" who are themselves owner-managers; and
- on the other hand, to prevent the stripping of surplus from a corporation where there is no genuine transfer to the next generation.
There is no specific legislative requirement that shares sold by a parent to a corporation controlled by one or more "children" must be common shares or voting shares. Subject to compliance with the specific requirements set out in subsections 84.1(2.31) (“Immediate intergenerational business transfer”) and 84.1(2.32) (“Gradual intergenerational business transfer”), including in particular the requirements set out in paragraphs 84.1(2.31)(g) and 84.1(2.32)(h), we are of the view that non-participating preferred shares would not be excluded outright from the exception in paragraph 84.1(2)(e) (the “Exception”).
Retaining the Control Shares would, however, prevent the parent from benefiting from the Exception. In fact, the parent would still control the corporation in question at a time subsequent to the disposition of the shares concerned, which would not satisfy the requirements of subparagraphs 84.1(2.31)(c)(i) and 84(2.32)(c)(i) Furthermore, the parent would hold all of the Control Shares after the disposition of the shares concerned. Those shares would not qualify as shares of a “specified class”, in particular because of paragraph 256(1.1)(b), which requires that the shares not carry voting rights. Thus, the requirements of subparagraphs 84.1(2.31)(d)(i) and 84(2.32)(d)(i) would not be satisfied.
CRA Response to Question 2(b)
In order to answer this question, for each of the given scenarios, we have assumed that the parent does not exercise de facto control of Parent Inc.
We have also assumed that the parent still exercised management at the time of the disposition of the shares concerned and that the parent is taking reasonable steps to transfer such management to the children within the required period in addition to the responsibilities listed in this question. Our comments relate exclusively to the duties and responsibilities that would constitute management activities for the purposes of paragraphs 84.1(2.31)(g) and 84.1(2.32)(h)
Paragraph 84.1(2.3)(i) specifies that, for the purposes of paragraphs 84.1(2.31)(g) and 84.1(2.32)(h), management refers to the direction or supervision of business activities but does not include the provision of advice.
Paragraphs 84.1(2.31)(g) and 84.1(2.32)(h) read as follows:
“[S]ubject to subsection (2.3), within 36 months after [or within sixty months of, depending on the relevant paragraph] the disposition time or such greater period as is reasonable in the circumstances, the taxpayer and a spouse or common-law partner of the taxpayer take reasonable steps to
(i) transfer management of each relevant business of the subject corporation and any relevant group entity to the child or at least one member of the group of children referred to in subparagraph (f)(ii), and
(ii) permanently cease to manage each relevant business of the subject corporation and any relevant group entity;”
Whether a task or responsibility is management within the meaning of paragraph 84.1(2.3)(i) is largely a question of fact. Since the statement of the question only briefly describes a hypothetical situation, we cannot give a definitive opinion on such a question. However, we can make the following general comments.
Directing or supervising the activities of the business, within the meaning of paragraphs 84.1(2.3)(i), 84.1(2.31)(g) and 84.1(2.32)(h), involves relatively significant decision-making power in relation to the business. As a general rule, a director manages the corporation's business and affairs or supervises such management (footnote 1) . Either of these roles would likely come within the interpretive rule in paragraph 84(2.3)(i) Thus, in the case where the parent remains a director of Parent Inc. and steps are not taken to completely and permanently cease to hold such office, within the time periods stipulated by paragraphs 84.1(2.31)(g) and 84.1(2.32)(h), including any longer period that is reasonable in the circumstances, the requirements of subparagraphs 84.1(2.31)(g)(ii) and 84.1(2.32)(h)(ii) would not be satisfied. Our conclusion would be the same, regardless of whether the parent is the sole director or one of the directors, and regardless of whether the direction of the day-to-day activities is in the hands of the children.
That said, the mere fact that the parent is not a director or officer of Parent Inc. would not lead us to conclude that the parent no longer participates in the management or supervision of the business. This is essentially a factual determination requiring analysis of all relevant facts and circumstances. Generally speaking, the more the tasks for which the parent will remain responsible involve significant decision-making power, in the context of the particular business, the more they could constitute "management" within the meaning of paragraph 84.1(2.3)(i).
Based on an analysis of the full factual context, we could consider that discretionary control over a corporation's cash expenditures is a significant function that could constitute managing or supervising activities of the business, within the meaning of paragraph 84(2.3)(i). If so, it would be up to the taxpayers to demonstrate that it was reasonable for the parent to retain such responsibilities beyond the periods provided for in paragraphs 84.1(2.31)(g) and 84.1(2.32)(h).
CRA Response to Question 2(c)
In order to answer these questions, we have assumed that the Freeze Shares qualify as shares of a "specified class" within the meaning of subsection 256(1.1) and that, for the purposes of the 2nd and 3rd scenarios, the parent does not exercise de facto control after the disposition of the shares concerned.
Paragraphs 84.1(2.31)(a) and 84.1(2.32)(a) provide that the taxpayer must not previously, at any time after 2023, have sought an exception in respect of a disposition of shares that, at that time, derived their value from an active business that is relevant to the determination of whether the subject shares are qualified small business corporation shares (“QSBCS”) or shares of the capital stock of a family farm or fishing corporation as those terms are defined in subsection 110.6(1). In the case of the Freeze Shares, the shares sold successively would all relate to the same business. In addition, dispositions subsequent to the first disposition for which the Exception is sought would be governed by the rules otherwise applicable to section 84.1, including the rules relating to non-arm's length relationships.
With respect to the first disposition, however, the fact that the parent retains all of the Control Shares would prevent it from benefiting from the Exception. We refer you to our answer to Question 2(a) in this regard.
Furthermore, if the parent also disposed of all of the Control Shares at the time of the first disposition, although the conditions set out in paragraphs 84.1(2.31)(d), 84.1(2.31)(e), 84.1(2.32)(d) and 84(2.32)(e) may be satisfied, as stated above, the Exception would only apply to the first disposition of shares by the taxpayer for which it is claimed.
Finally, with regard to the last scenario submitted, the conditions required by paragraph 84.1(2.32)(f) would not be satisfied. The conditions stated therein must be satisfied within 10 years of the time of the disposition for which the Exception is claimed and at any time after the time of the "final sale." Since the shares sold on the first disposition were QSBCS, subparagraph 84.1(2.32)(f)(ii) requires that, during such a period, the taxpayer and the taxpayer's spouse or common-law partner not own, directly or indirectly, interests in certain entities, including the purchaser corporation, having a fair market value that exceeds 30% of the fair market value of all the interests that were owned, directly or indirectly, by the taxpayer and a spouse or common-law partner of the taxpayer immediately before the disposition of the shares for which the Exception is claimed. At the end of the 10-year period, the parent will still hold a claim against the purchaser corporation having a FMV equal to 80% of the FMV of all of the parent's interests held immediately before the disposition for which the Exception was claimed.
CRA Response to Question 2(d)
The provisions of subsections 84.1(2.31) and 84.1(2.32) do not distinguish between a situation where typical freeze preferred shares are issued and a situation where preferred shares of the same nature would have been issued for the sole purpose of increasing the ACB of the shares held by the parent through the use of the CGD (i.e., "crystallized" shares).
If these crystallized shares were sold by the parent to a corporation controlled by one or more children and all the conditions set out in one of subsections 84.1(2.31) or 84.1(2.32) were satisfied, an election could be made in respect of the shares sold, to the extent that no other Exception had previously been claimed, after 2023, in respect of the same underlying business. Our understanding is the same, regardless of whether the shares were crystallized before 2024 or after 2023.
Simon Lemieux
October 10, 2024
2024-102837
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 Section 112 of the Business Corporations Act, R.S.Q., c. S-31.1 and section 102(1) of the Canada Business Corporations Act, R.S.C., 1985, c. C-44.