Measures to Facilitate the Transfer of a Family Business Are Poorly Adapted to the Reality of SMEs
Julie Hélène Tremblay, LL.B., M. Fisc., Senior Manager, Tax
Michel Babeu, CPA, CA, M. Fisc., Partner, Tax
Intergenerational Transfers Pose a Problem
As unbelievable as this may seem, there are currently more advantages for an entrepreneur to transfer ownership of a company to external shareholders as compared to members of his or her own family. In fact, entrepreneurs who sell an incorporated business to another corporation that is controlled by one or more of their children, for an amount of $825,000, may have to pay up to $360,000 more in income tax than if the shares were sold to an unrelated third party. This situation has been criticized by members of the tax community as well as a number of economic players for many years. Quebec’s Finance Minister, Mr. Carlos Leitão, was eager to announce changes to the Taxation Act(Quebec) in his 2015 and 2016 budgets which were aimed at facilitating the transfer of family businesses operating in the resource and manufacturing sectors to a family member. It will be possible for such transfers, made after March 17, 2016, to result in the same tax treatment as transfers made between unrelated persons.
However, these changes are not enough. The conditions to be met by business owners wishing to benefit from the new measures are poorly adapted to the reality of SMEs.
Seven Conditions Must be Met
To ensure that transactions actually occur and that they are really being carried out to transfer ownership of a business, the Finance Minister requires that seven conditions be met in order for the new rules to apply to the sale of shares. These conditions are outlined below.
|1) The shares are being sold by an individual||The transferor must be an individual. A family trust that sells shares cannot benefit from these new rules.|
|2) The seller is playing an active role in the business prior to the transaction||The transferor, or the transferor’s spouse, must play an active role in the company’s operations in the 24 months preceding the sale.|
|3) The seller’s involvement is limited after the transaction||Following the transaction, the transferor should no longer play an active role in the business, other than to ensure the harmonious transfer of his or her knowledge to the acquirer. In this respect, the person’s salary must not exceed the maximum pensionable earnings under the Quebec
Pension Plan for the year (approximately $55,000).
|4) The seller relinquishes control following the transaction||The transferor, or the transferor’s spouse, must relinquish de jure control of the company that has been sold in the month following the sale of shares. This person must not be able to exercise more than 50% of voting rights.|
|5) The seller cannot hold any common shares following the transaction||The transferor, or the transferor’s spouse, must no longer hold any common shares in the company that was sold no later than one month following the sale. This person may therefore no longer share in earnings (other than through preferred shares) or in the company’s future increase in value.|
|6) A residual interest may be held in the company that was sold||The transferor and the transferor’s spouse may retain a residual interest in the company (in the form of shares or debt). This residual interest must have a rate of return not exceeding a reasonable market rate for cumulative dividends or interest. The value of these interests must not exceed 60% of the total share value (80% for farming or fishing businesses) at the time of the transfer. This financial interest must be reduced to 30% (50% for farming or fishing businesses) no later than 10 years following the transfer of the company.
During the 10 years following the transfer of the business, the transferor cannot demand the repayment or redemption of the residual interest (other than to satisfy the tests in the 10th year).
|7) The acquirer plays an active role following the transaction||At least one person, or that person’s spouse, participating in the acquirer’s body of shareholders must play an active role in the company’s operations immediately following the transaction.|
Certain exceptions apply. It is possible to waive the conditions pertaining to an active role (or not) set out in points 2, 3 and 7 in the event of illness or death.
Inadequate and Poorly Adapted Measures
Although some people may say that this is a step in the right direction, we see three major irritants.
First of all, until similar provisions are introduced at the federal level, these measures will not provide tax neutrality to business owners who would like to see the same result as though the business were being sold to an unrelated third party.
Secondly, these measures apply only to companies operating in the resource and manufacturing sectors. We understand that the challenges for balancing the budget are delaying the application of this new measure for all SMEs in Quebec. However, the application of this measure, in its current form, is too limited to have a significant impact.
Thirdly, these Quebec measures are clearly inadequate and poorly adapted to the issues being faced by business owners wishing to transfer their company to their children. Some of these issues include:
- The long-term success of the business;
- The monetization of their ownership interest;
- Minimization of the tax burden;
- The transfer of risks to the purchasers; and
- Guarantees provided on any balance of sale.
Unfortunately, a number of these conditions will seriously hinder the possibility of benefiting from these new rules. The main problems for business owners wishing to transfer a company to their children are as follows:
- The tax relief measures make it difficult to sell a business gradually which, in our opinion, is generally the best solution for the family’s situation;
- The measures in place force business owners to relinquish control over the company, even though they may continue to hold a significant residual interest in the company; this could seriously affect the company’s ability to pay for the value of this interest;
- Due to the inability to require the redemption of the residual interest within the 10 years following the transfer of the business, the business owner continues to assume all of the risks relating to the business without being able to have any means of control or guarantees to protect the value of the residual interest;
- Finally, by benefitting from this tax measure the business owner becomes unable to play an active role in the company’s operations and, therefore, to influence the acquirer’s decisions.
Alternative Solutions for Business Owners
Do business owners need to wait for major changes to be made to the measures that have been announced, as well as a little extra help from the federal government, to avoid being put at a disadvantage? Not necessarily. A number of options are available to substantially reduce income taxes when transferring a family business while allowing the business owner to benefit from the gradual transfer of the business and from guarantees. These solutions warrant a closer look and seem to be much more interesting than the measures announced by the Quebec government.
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