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Like many tax accountants, the past two months have been a blur of trying to fully understand all the impacts the proposed federal tax changes would have on our clients, while also answering clients’ questions and concerns about the serious implications these changes could have. There are numerous concerns with these proposed rules, including their high degree of complexity and subjectivity in application, the possible impact on existing and future business owners to choose Canada as the place to carry on their business and their retroactive and punitive nature in some situations, to name a few.
Personally, perhaps the most significant disadvantage these proposed changes created was eluded to in a
previous post comparing the disposition of shares in a corporation to a child compared to an unrelated party. Under a complex and lengthy process, the proposed change effectively would see a sale of shares to an unrelated party resulting in a 24 percent tax, whereby a sale to a child, grandchild or a sibling would result in taxes of 40 percent.
A farmer from Nipawin, Saskatchewan, who has been an advocate against these changes on behalf of farmers and small business owners, recently had the opportunity to speak to federal Finance Minister Bill Morneau about these rules. The advocate specifically raised this unfair outcome between family and non-family transactions to the minister. The response from the federal finance minister was it was simply not true.
As you can imagine, this put the farmer in an awkward position; the federal minister responsible for proposing these rules and a professional tax accountant interpreting the draft legislation have opposite views of the impact of these rules. So, who is right?
In short, both views could be correct — if you ignore how transactions are done between almost all entrepreneurs who don’t have access to substantial amounts of personal cash that has been tax paid previously.
Let’s assume we are comparing two people who both want to purchase 20 percent of a successful company from the founder for $1 million each. Both purchasers are key executives in the business, one is unrelated to the founder and the other is the daughter of the founder.
If both purchasers had $1 million of personal cash to fund the acquisition, the founder would be taxed as a capital gain on both sales and would have a top tax rate of 24 percent. In this hypothetical situation, the federal finance minister would be correct: the rate would be the same.
However, the outcome changes when we introduce the situation encountered in almost every sale of private corporations: the purchaser does not have personal tax-paid funds and is banking on using a combination of accumulated and future profits of the corporation to pay off the acquisition of the business. The only way the buyer has access to the accumulated and future profits of the business is from paying dividends on the shares they have purchased. In the case of an individual shareholder, the tax on this dividend could be as high as 40 percent. In the case of a holding company, the tax is zero percent.
Obviously not having a 40-percent bite taken out of every dollar lets a holding company pay down its investment much quicker than an individual shareholder and enables that holding company to quickly grow its equity. This is where the proposed rules treat related persons differently from unrelated persons in a sale of shares.
Under the proposed changes, when an unrelated person uses a holding company to acquire shares, the founder still has a capital gain taxed at 24 percent. Whereas when a related person uses a holding company, the gain is converted into a dividend that is taxed at 40 percent, making it impossible for the related party to acquire shares on equal footing to an unrelated person.
Even worse would be a situation where the individual first acquired the shares personally, perhaps through an estate or from a parent directly who paid the capital gains at 24 percent and in the future the business assets were sold and the funds distributed.
This future distribution would be taxed as a dividend at 40 percent without receiving any credit for the previous taxes paid, resulting in total taxes of 64 percent on that value.
Again, the unrelated party is better off, as even if they originally acquired the shares personally, they could avoid the double tax by adding a holding company prior to the dissolution of the assets.
The route the federal department of finance would use to implement these proposed changes is contained in an anti-avoidance provision designed to stop family members from using their capital gains exemption on related party transfers, which is now expanded to include transactions even if taxes have previously been paid on a gain. As part of these broad proposals, a new section was also added to convert transactions that were undertaken primarily to create a tax savings (and not for commercial reasons) from gains into dividends. Given that new provision, the rule discussed above is completely unnecessary and hopefully is eliminated or substantially narrowed before these rules are implemented.
In summary, the differences proposed in these new rules create an incentive to sell your business to unrelated parties as opposed to family, which to me is an unfortunate message to send to the family-based entrepreneurs who are the backbone of our economy.
For more information on how these changes may impact your existing or future succession plan please contact Wayne Paproski CPA, CA or Shanna Hoffman, CPA, CA at 306.790.7900.
Related Topics:Farmers; Small Business
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