Double tax standard can complicate selling your business

So you want to sell your business to another corporation with no family ties to you. That is considered an arm’s length deal and you can claim your lifetime capital exemption.

Try and do the same with a family member. That’s called a non-arm’s-length deal, and a nasty bit of the Income Tax Act kicks in called Section 84.1.

If you sell your business directly to a family member using a promissory note to finance the purchase, you still qualify for the lifetime capital gains exemption, but your family member will pay a full tax load on any dividends taken from the purchased company to service the promissory note owed the seller.

What if the sale goes to the family member’s corporation? The repayment of the promissory note will negate the seller’s capital gains exemption, and the repayment of the loan will be treated as taxable dividends in the hands of the seller.

The reason for this treatment is that the federal government believes the sale of businesses to a non-arm’s-length corporation strips out a surplus reflecting the growth in value of the selling corporation on which the Canada Revenue Agency wants its tax bight.

The federal finance department has for some time said that it is considering finding a way to treat “genuine” transfers of businesses at fair market value to family members while leaving in place the rules that apply to anti-tax-avoidance strategies. For some reason, however, there is no movement on this issue by the government for the past three years.

There is one bright light, albeit not blinding, in a single court case that overturned the application of Section 84.1 in an arm’s-length transaction. The court case took place in 2016 and was called Poulin v. the Queen.

Poulin and the buyer were principal shareholders of a closely held private corporation. His ownership was through common shares and certain fixed-value non-voting preferred shares with a redemption value of $450,004. In 2007, Poulin sold his preferred shares to a corporation controlled by his partner for a purchase price of $450,004. This was paid with $45,000 cash and a promissory note for the balance bearing interest at five percent per year, which was paid off in three years. 

The balance was paid off using funds primarily derived from the redemption of the preferred shares held by the partner.  In 2012, Poulin sold his remaining shares and control of the company to the partner. Poulin subsequently exited the company.

He claimed his capital gains exemption related to $450,004, but CRA declared it dividend income under the Section 84.1 provision.

The court overturned the decision, finding that Section 84.1did not apply because it served the interests of both businesses — exit of Poulin and control for the partner — and it was a legitimate arm’s-length transaction. So as an arm’s-length deal, all tax exemptions were in force, but if the unfortunate circumstance of birth had made Poulin and his partner related, they would have been heavily penalized.

Grant Diamond is a tax analyst in Saskatoon, SK., with FBC, a company that specializes in farm tax. Contact: fbc@fbc.ca or 800-265-1002.

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