In a sudden reversal, Finance Minister Chrystia Freeland announced that the government will not, after all, refuse to enforce a private member’s bill — Bill C-208 — related to transfers of family businesses that became law in late June. Her announcement was praised by business advocacy groups who say that intergenerational transfers are a long-standing problem that should have been addressed years ago. That is true. But the bill creates a gaping new tax-avoidance loophole that will now be used by many private corporations, large and small.
Individuals pay lower tax rates on capital gains than they do on dividends, so there is an incentive to convert dividends from private corporations into capital gains. This is called “surplus stripping,” and tax planners have developed a number of ways to access capital gains rates. However, before Bill C-208, cash could not be stripped out of a corporation on a totally tax-free basis by using the lifetime capital gains exemption (LCGE). The new bill changes that.
The bill tries to accommodate intergenerational transfers of family businesses by allowing parents to sell their business to a new corporation controlled by their children or grandchildren. Under the bill, parents can sell the business at capital gains rates and also access the LCGE of $892,218 — the 2021 indexed amount.
For example, assume that Mrs. A is a top-bracket individual living in Ontario. She owns Co. A — a corporation that carries on an active business. While Mrs. A has no plans to sell the business, her accountant tells her there is a new plan that will allow her to strip cash of $892,000 out of the business at zero tax cost.
Mrs. A forms a new corporation, and her children invest a small amount — say a hundred dollars — for fixed-value preferred shares that give them voting control of Newco. Mrs. A sells her shares of Co. A to Newco for cash of $892,000 and pays no tax. If Co. A had paid her a dividend of $892,000, her tax would have been roughly $425,000. Under the bill, she avoids this tax completely, and continues to own and operate the business — all thanks to a hundred dollars of voting preferred shares held by her children.
The government knew about this loophole and, the day after the bill was enacted in late June, suggested it would ask Parliament to repeal it retroactively and approve new rules with proper safeguards. For example, new restrictions might require the children or grandchildren to own most of the common shares of the new corporation and become actively involved in the business.
Opposition MPs were outraged. Flaws or no flaws, how could the government simply ignore legislation that Parliament had enacted? On July 19, a day before the finance committee of the House of Commons was scheduled to meet to grill Finance Department officials, the government reversed its position. The finance minister now says “the law is the law.” The bill will remain in force until new rules are developed and finalized, with a target date of Nov. 1. Until that time, the surplus-stripping floodgates are wide open.
How much tax revenue may be lost in the next three to four months before new rules take effect is hard to say, but it will certainly be in the hundreds of millions of dollars. There are more than1.2 million small and medium-sized businesses in Canada. If one per cent of these businesses had top-bracket owners who implemented Mrs. A’s plan, the federal-provincial cost would exceed $5 billion.
The tax issue with transfers of family businesses has been with us since 1985 when the LCGE was introduced. Successive governments, both Liberal and Conservative, have failed to act over many years. So there is lots of blame to go around. That said, the current government allowed this legislative fiasco to unfold. For the next several weeks — until new rules are released and finalized — tax advisers will be flogging an abusive plan that was handed to them on a silver platter. And you and I will pick up the very expensive tab that results.
Allan Lanthier is a retired partner of an international accounting firm and has been an adviser to both the Department of Finance and the Canada Revenue Agency.