It is common for business owners to want to pass on their business to their children. However, business owners are often unaware that the sale of their business to family members can be to their financial disadvantage. Section 84.1 of the federal Income Tax Act ("ITA") is an anti-avoidance tax rule intended to target specifically the sale of a business to family members. Under this rule, a business sold to family members is taxed unfavourably compared to a business's sale to strangers.
The sale of a business to a stranger is usually executed with tax considerations in mind. The purchaser will typically create a holding corporation (“Holdco”) and have his newly formed company make the purchase. By purchasing the seller’s company via a Holdco, he/she can use the profits from the acquired company to pay any loans he contracted to purchase the company. Additionally, the purchaser may claim lifetime capital gains exemption.
On the contrary, the sale of a business to family members does not enjoy the same tax treatment. The sale of a business to a Holdco owned by the children or relatives is taxed as a dividend and not capital gains. Consequently, the business owner would not be eligible to claim the lifetime capital gains exemption and would therefore make far less profit from the sale of his business.
The sale of a business to children or relatives can be made without the use of a Holdco. The children or relatives would simply purchase the business in their own name. This would allow the business owner to claim the lifetime capital gains. However, the purchasing children or relatives would then be subject to disadvantageous tax rules. They would be forced to use personal profits to pay the purchase price instead of the newly acquired company's profit. In other words, the family members would have to take out the profits personally from the newly purchased company, pay personal tax on it and then pay the purchase price.
When and why does section 84.1 apply?
This rule applies when 2 conditions are met:
1. A Canadian resident shareholder sells shares of a corporation resident in Canada; and
2. The shares are sold to:
i. Another corporation with whom the shareholder does not deal at arm’s length; or
ii. an individual who does not deal at arm's length with the shareholder and the shareholder
intend to claim the lifetime capital gains exemption.
This anti-avoidance tax rule was created to combat the abuse taking place with the lifetime capital gains exemption. Parents were selling their company to their children for the sole purpose of accessing the exemption. On paper, the children were the business owners, but in fact, the parent's remained the owners. Thus, they were accessing the exemption, all while still owning their business.