Sale of a Business: New Tax Planning Option

June 26, 2020

The sale of a business is often the most significant business transaction in an entrepreneur’s life. In addition, the net proceeds from such a sale often represent an entrepreneur’s only retirement fund. Therefore, it is crucial to maximize such proceeds by reducing or deferring the taxes resulting from the transaction as much as possible.

The Canada Revenue Agency (“CRA”) recently reversed an administrative position that it had expressed in 2002 with respect to beneficial tax planning as part of the sale of a business. This change in its rather technical administrative position opens the door to very effective tax planning that offers real tax deferral opportunities to business owners wishing to sell their business.

Consider the following example:

Sale of 100% of shares to a third party without prior planning

Ms. Tremblay wishes to sell 100% of the shares of her company (“Opco”) to a third party for their fair market value (“FMV”) of $10 million. These shares have an adjusted cost base of $1.00. Ms. Tremblay’s direct sale of 100% of Opco shares to a third party would result in a capital gain of approximately $10 million and total income taxes of approximately $2.7 million, assuming that her capital gain is not eligible for the capital gains exemption. In this scenario, Ms. Tremblay would be left with a sum of approximately $7.3 million after taxes.

Sale of shares with the newly approved prior tax planning

In the second scenario, prior to the sale to the third party, Ms. Tremblay would create a management company (“Gesco”) and transfer 50% of Opco shares to it on a rollover basis, with no immediate tax consequences.

Gesco would then internally exchange Opco shares in order to realize a $5 million capital gain within Gesco, resulting in income taxes of approximately $1.26 million for Gesco, a portion of which would later be refunded through the use of a non-eligible refundable dividend tax on hand account.

Subsequently, Ms. Tremblay would sell her remaining 50% of Opco shares to Gesco in two transactions of 25% each, both payable by a promissory note equal to the FMV of the shares—in our example, $2.5 million per transaction. Ms. Tremblay would then be deemed to have received two dividends of $2.5 million each. The first would be designated as a capital dividend by Gesco and would therefore be tax-free for Ms. Tremblay. The second would be designated as an ordinary (non-eligible) dividend, resulting in total income taxes of approximately $1.18 million for Ms. Tremblay.

The designation of the second dividend as an ordinary dividend would result in a refundable dividend tax on hand for Gesco of approximately $766,000.

Gesco, owning 100% of Opco shares having an adjusted cost base equal to their FMV, would sell them to a third party for a sum of $10 million, generating no additional capital gain within Gesco.

By using the tax mechanisms of a capital dividend account and a non-eligible refundable dividend tax on hand account, the sale of Opco shares would result in total income taxes of approximately $1.67 million, split between Ms. Tremblay and Gesco.

Ms. Tremblay would then be left with proceeds of $3.82 million after taxes, while Gesco would be left with $4.51 million after taxes.

Given that Ms.Tremblay would keep funds within Gesco, she would be able to defer the time at which she would be taxed on them, that is, when Gesco would pay her a dividend. In the meantime, she could make investments through Gesco.

This type of planning would result in a tax deferral of almost 38% of the income taxes that, without prior planning, would have been payable on the sale of the shares.

Our taxation team will be happy to answer all your questions and advise you on the most appropriate tax planning for your business.

The information and comments contained herein do not constitute legal advice. They are intended solely to enable readers, who assume full responsibility, to use them for their own purposes.

Back to the publications list

Written by

Luc Pariseau
Partner, Lawyer
Éric Gélinas
Counsel

Stay tuned for the latest legal news. Subscribe to our newsletter.

Subscribe to publications

Publications that might interest you

November 27, 2024

Announcement of U.S. tariffs: repercussions and trade strategies for Quebec businesses?

Nearly four years after the Canada-United States-Mexico Agreement (the “CUSMA” or the “Agreement”) came into force, U.S. President-elect Donald Trump announced on November 25, 2024, that he would impose 25% tariffs on all products entering the U.S. from Canada and Mexico, starting on the first day of his presidency, that is, January 20, 2025. Mr. Trump added that the tariffs would remain in effect until Canada and Mexico strengthened their border policies, which he blames for the increase in illegal immigration and the trafficking of devastating drugs in the United States. As a reminder, under the current provisions of the CUSMA, most products made in Quebec and Canada can be sold on U.S. markets without tariffs applying. And so, although we can only speculate and although Mr. Trump did not give details on this subject in his announcement, his future administration could indeed invoke a number of legislative authorities to implement such a measure. In particular, it could invoke the CUSMA’s essential security exception, which allows a party to the Agreement to apply any measure deemed necessary to protect its essential security interests, the national security exception in the Trade Expansion Act of 1962, which President Trump’s first administration used in 2018 to introduce tariffs on U.S. imports of certain steel and aluminum products, or the provisions of the National Emergencies Act. Needless to say, the announcement sent shockwaves through the political and business communities in Canada and Quebec what with the close commercial ties that the U.S. has with Canada, including with Quebec. In the first quarter of 2024 alone, Quebec’s merchandise exports to the U.S. reached CAN$21.2 billion, which accounts for nearly 74.6% of the province’s international merchandise exports and makes the U.S. Quebec’s main trading partner on the world stage. The imposition of 25% tariffs would therefore significantly affect Quebec businesses. It would make them less competitive on the U.S. market, on which they rely heavily to export their products. The measure could be particularly detrimental to the Canadian forestry industry, which is already severely affected by tariffs of nearly 15% on lumber. The U.S. economy would also be considerably affected by such protectionist tariffs. While in the short term, tariffs could benefit certain domestic manufacturers and producers, in the longer term, they are likely to harm the U.S. economy as a whole. Many U.S. manufacturers would face higher costs of inputs, and established supply chains would be disrupted, in particular in the automotive and steel industries. To continue to make profits, many U.S. companies could be forced to pass on the additional costs to their end consumers by raising the prices of their products, which would undoubtedly result in another wave of inflation. Worth mentioning also are the retaliatory measures that the Canadian government may want to implement in response to such tariffs, which could affect certain parts of the U.S. economy. Although the CUSMA provides for dispute resolution mechanisms, they are unlikely to lessen the impact of the measures that the Trump administration is considering in the short term, as a final decision under these mechanisms could take a long time to be issued. The new U.S. administration could use the announcement made on November 25 as leverage in future CUSMA renewal negotiations, the preparatory discussions for which are slated to begin next year, or in negotiations for a separate trade agreement between the U.S. and Canada that would exclude Mexico. Canadian businesses would do well to encourage their various trade associations to take steps to lobby both American decision-makers and their corporate customers in the U.S. and remind them of the harmful effects that the announced tariffs may have on American businesses. While we wait for a more detailed announcement with information concerning specific tariff exemptions in particular, we suggest that businesses choose their future trading partners with great care. In an increasingly protectionist global economic context, a strategy involving the diversification of trading partners is the best way for businesses to offset the risks associated with a particular country’s tariff policies. The Comprehensive Economic and Trade Agreement signed by Canada and the European Union in 2017, which our firm helped to negotiate, may prove to be an interesting solution in this respect. Our team of commercial law and tax professionals is available to help you find solutions to the issues arising from this announcement. With our expertise, we can assist you in your commercial negotiations and help you develop strategies to mitigate the impact that the announced tariff increase may have on your business.

Read more
September 19, 2024

Financing Quebec’s Energy Transition: Unlocking the Potential of Flow-Through Shares

Quebec has set ambitious energy transition and industrial decarbonization targets. The shift to greener practices has to be taken in a context where our energy consumption could rapidly grow under the combined effect of a number of factors, such as the reindustrialization of our economy, population growth, transport electrification and the potential for artificial intelligence to consume vast amounts of energy. Investing in the development of energy infrastructure is therefore critically important, as an abundance of energy is key to economic prosperity. The problem is that public finances are already stretched to the limit with the need to renovate our aging infrastructure, among other things. Encouraging private equity investment is thus vital, and tax incentives can be very effective in this respect. The American example In 2022, the United States passed its Inflation Reduction Act (IRA), with the goal of stimulating investment in the renewable energy sector, in particular. More specifically, the IRA altered or created a number of tax credits to encourage private investment.1 Over the past two years, US businesses have announced a total of almost US$276 billion in new investments in clean energy generation and the capturing or elimination of carbon dioxide and other forms of industrial decarbonization, an increase of 34% on the two years previous.2 The IRA is effective in that it takes the respective situations of various energy sector stakeholders into account in a creative, flexible and pragmatic way, especially where taxation is involved. Energy project promoters often have to wait many years for their projects to generate income and profits, even though the banks and other investment funds they solicit financing from can be presumed to be operating profitable businesses. The tax losses that occur in the years during which such projects are designed and built are therefore of little interest to developers, but of immediate interest to investors. And so, a tax equity market has emerged, in which businesses subject to taxes can invest in the shares of entities set up to develop such projects so as to benefit from tax credits and faster depreciation. Typically, the entity that cashes in the investment and develops the project distributes 99% of income, losses and tax credits to investors until a predetermined return is achieved. Once that return is achieved, the investor’s share of the benefits decreases, and the developer has the option of buying out the investor’s residual share. The IRA has transformed how federal clean energy tax credits are monetized, and it is now possible to buy and sell such credits without having to make a long-term investment. For businesses, this new way of doing things is an additional and attractive way to participate in the growing tax credit market.3 In 2023, the volume of the tax equity market for American projects was around US$20 to 21 billion, up about US$18 billion from the previous year.4 It appears that the trend will continue. It is estimated that the value of the current market, which is particularly attractive to banks, is set to double to US$50 billion a year by 2025.5 The equivalent of flow-through shares The Quebec and Canadian tax deductions mechanism that most closely resembles the US tax equity market is probably flow-through shares. Through these, businesses in the mining and renewable energy sectors can transfer their mining exploration expenses and other expenses—specifically designated as eligible—to investors, who can then deduct them from their own taxable incomes.6 These businesses can thus issue shares at a higher price than they would receive for common shares to finance their exploration and development operations. Investors are willing to pay a higher price in return for the tax deductions afforded by the eligible expenses incurred by the issuing businesses, which can amount to a maximum of 120% of the equity invested in the shares.7 Investors can also claim a 15% or 30% federal tax credit. However, because tax incentives cannot be transferred, our mechanism is more rigid than the American one, and it can only be applied to mineral exploration and development expenses and certain specific expenditures related to renewable energy and energy conservation projects, such as electricity generation using renewable sources like wind, solar energy and geothermal energy.8 With ambition and innovation comes the need to take action Quebec could draw inspiration from the IRA to increase the attractiveness of flow-through shares and broaden their scope of application, thereby creating a new tool to finance the energy transition. The renewable energy sector is similar to the mining sector in many respects, not least in terms of the considerable amount of capital required to build the infrastructure needed to operate a mine or energy generation facility. The flow-through share mechanism, which is well-established and popular with investors,9 could be just as successful in our energy transition context. Making such incentives easier to transfer would also drive the emergence of a market similar to the US tax equity market. A number of Québec flagship companies, such as Hydro-Québec,10 Innergex11 and Boralex,12 are also very ambitious when it comes to developing large-scale energy projects. They face major financing challenges, as do those in the industrial decarbonization and infrastructure renewal sectors. Innovation is necessary to meet these challenges and make the transition to a more sustainable, but just as prosperous, world, and to do so in good time.13 Link Rhodium Group and MIT’s Center for Energy and Environmental Policy Research (CEEPR), Clean Investment Monitor, link Brandon Hill, How to take advantage of tax credit transferability though the Inflation Reduction Act, Thomson Reuters Institute, April 16, 2024, link Allison Good, Renewables project finance to keep pace in 2024, but tax equity rule looms, S&P Global, January 12, 2024, link Lesley Hunter and Mason Vliet, The Risk Profile of Renewable Energy Tax Equity Investments, American Council on Renewable Energy, December 2023, link Link, page in French only Link Link Prospectors & Developers Association of Canada, Flow-through shares & the mineral exploration tax credit explained, link Link Link Link The authors would like to acknowledge the participation and the work done by Sophie Poirier in this publication

Read more
April 26, 2024

New rules will make it easier to transfer family businesses

The 2023 Federal Budget (the “Budget”), tabled on March 28, 2023, proposes amendments to certain provisions of the Income Tax Act (ITA) that would make “genuine” intergenerational business transfers no longer subject to the anti-avoidance rules of section 84.1 and allow the transferor to benefit from their capital gains exemption. To do so, the Budget establishes new general conditions that the parties must meet, as well as specific conditions that apply to “immediate” transfers, or those made over a period of no more than 36 months, and “gradual” transfers, or those that take five to ten years to complete. The general conditions that the parties must meet when disposing of a company may be summarized as follows: The vendor must be an individual other than a trust. Immediately prior to the transfer, the vendor, alone or with their spouse, must control the currently operating company. At the time of the transfer, the purchasing company must be controlled by one or more of the vendor’s children, who must be at least 18 years of age. The notion of “child” also includes stepchildren, grandchildren and nieces and nephews. The shares of the company being transferred must be qualified small business corporation (QSBC) shares or shares of the capital stock of a family-farm or family-fishing corporation (QFFP). The specific conditions relate to the transfer of control, economic interests and management of the company, and vary from case to case. FOR AN IMMEDIATE TRANSFER (36-MONTH TEST) In the case of immediate transfers, de jure control (being the holding of the majority of shares having voting rights), and de facto control (which includes the economic influence making effective control of the company likely), must be transferred at the time of sale. Voting and participating shares not transferred to the purchasing company at the time of sale must be transferred within the following 36 months, such that after this period, the transferor may hold only preferred shares, that is, non-voting or non-participating shares for an indefinite period (vs 10 years in the case of a gradual transfer). Also, the child, or at least one member of the group of children, must participate in the family business on a regular, significant and continuous basis for a minimum period of at least 36 months after the transfer is made. Lastly, the transferor must take reasonable steps to transfer the business’s administration and know-how and completely cease to manage the business before the 36th month after the transfer was made. FOR A GRADUAL TRANSFER (FIVE–TO–TEN–YEAR TEST) If the transfer is gradual, only de jure control must be transferred at the time of disposition. The balance of the voting and participating shares not transferred at the time of disposition must be transferred within 36 months of the first transfer. However, under the rules respecting gradual transfers, the transferor will only be bound to transfer de facto control of the business within 10 years of the initial transfer. In the case of a transfer of economic interests, the vendor is expected to significantly reduce the value of the equity and advance they have invested in the business within 10 years of the initial sale. The same requirement for a child’s active participation in the company and transfer of the management of the business apply, but this time for a period of 60 months after acquisition. PREVIOUS RULES (Bill C-208) The provisions of the 2023 Federal Budget have the effect of setting aside certain requirements of Bill C-208 applicable to the realization of a capital gain. Under Bill C-208, for the transferor to benefit from their capital gains exemption, the operating company and the purchasing company could not be amalgamated within 60 months of the sale. The bill also required that an independent assessment of the fair market value of the company’s shares be filed with the Canada Revenue Agency, along with an affidavit signed by the vendor. However, as of January 1, 2024, these criteria are no longer applicable. An assessment will no longer be required, although under section 69 of the ITA, the transfer will still have to be made at fair market value. The 2023 budget (reinforced by the 2024 Federal Budget) also introduces new rules for the alternative minimum tax, a temporary tax that the transferor in an intergenerational business transfer often has to pay. To avoid having this temporary tax becoming permanent, it’s important to understand the subtleties of these new rules. Our team of tax professionals will be happy to help you and answer any questions you may have about these new legislative changes.

Read more
April 16, 2024

Tax opportunities under the Indian Act

Although it is not often well-understood in business and tax circles, the Indian Act (the “Act”), coupled with federal and provincial tax laws, provides several tax planning opportunities for Indigenous taxpayers. These laws provide various tax exemptions for people who qualify as “Indians” under the Act, as well as for “bands” and other “councils.” These terms are defined in the Act and require case-by-case analysis, but essentially they refer to people of Indigenous origin who have at least one family member who is registered or entitled to be registered as an Indian within the meaning of the Act. The criteria for a tax exemption In particular, those who qualify can benefit from a tax exemption when income is earned on a “reserve.” There are several criteria to be met, and although the Canada Revenue Agency (“CRA”) has issued guidelines on the subject, their application remains a question of fact that varies depending on the particular circumstances applicable to each taxpayer. In general, the CRA requires that income earned by an “Indian” within the meaning of the Act be sufficiently connected to a reserve to be exempt. This is the case when, for example, income-generating services are performed entirely or almost entirely within the territory of a reserve, when the employer and the employee reside on a reserve, or when income is derived from non-commercial activities carried out by a band. Business income can also be tax-exempt, but the criteria for being considered connected to a reserve are stricter, since generally only income-generating activities situated on a reserve will be tax-exempt. However, it is still possible to organize the affairs of a taxpayer and their corporate entities to ensure that these criteria are met, or to highlight certain connecting factors. Such planning, if done properly, is entirely legitimate and can result in significant tax savings. In a recent interpretation (CRA Views 2022-0932231I7), the CRA illustrated this principle by considering employment income related to an off-reserve airport to be exempt, even if none of the guidelines are followed, in cases where such an airport is necessary to supply a reserve that has no other means of transportation and delivery. This interpretation shows that the connection between an income and a reserve is not established solely by the physical presence of the income-generating business, and that several other arguments, sometimes more subtle, can be used to support the connection between an income and a reserve. A few nuances to consider However, care must be taken when a company is incorporated by someone who qualifies as an “Indian.” A company with its head office on a reserve cannot qualify as “Indian” within the meaning of the Act. Its income therefore cannot be tax-exempt, and will be taxed according to the usual rules. Despite this, certain plans can ease the tax burden on these companies and on shareholders who qualify as “Indians” under the Act, such as paying wages and bonuses to an employee shareholder. But it’s essential to carefully analyze the various pitfalls and risks that such planning entails. Furthermore, certain exemptions exist for companies formed by bands, but the eligibility criteria are strict and require a thorough analysis of the proposed structure. In addition to the income tax exemption, “Indians” within the meaning of the Act and certain entities mandated by bands may benefit from a tax exemption when they purchase goods on a reserve or have goods delivered to them on a reserve. Different exceptions and nuances apply. However, companies headquartered on a reserve are not exempt from their tax collection obligations and may be required to register for the GST/QST. To help you understand these rules and ensure optimal tax planning, we invite you to consult our tax team. We look forward to working with you on your business projects.

Read more