Canada’s 2024 Federal Budget – Impact on Taxation of Sale of Business
On April 16, 2024, the Deputy Prime Minister and Finance Minister presented Budget 2024 to the House
of Commons. This budget has significantly impacted the tax triggered on the sale of a small-to-medium sized business (SME’s) in the context of a private M&A transaction. As such, these changes are highly relevant to our practice and for our clients. For ease of reference, we have summarized these changes in this article.
Capital Gains Inclusion Rate
Currently, one half of capital gains are included in a taxpayer’s income which is then taxed at the applicable tax rate. For example, if you were to have a $100 capital gain on the sale of shares, then fifty per cent (50%) of this amount would be included in income (in this example, $50), to be taxed at the applicable rate. Personal rates of tax are marginal, which means the rate increases the more income you earn however for the purposes of this article we can presume that the average combined marginal rate is 38%. Therefore, if $50 is included in income x 38% (average combined personal tax rate), the amount of tax paid on the $100 gain would be $19.00, leaving $81.00 in the taxpayers hands.
Budget 2024 proposed to increase this inclusion rate to two-thirds of the actual gain, effective for capital gains realized on or after June 25, 2024. This adjustment to the inclusion rate will also apply to capital losses applied to offset capital gains. Taking our $100 example, our inclusion rate is now 66 2/3%, meaning $66.66 is included in income for taxation, multiplied by the average rate of 38% = $25.33 in tax payable leaving $74.66 in the taxpayers hands. When speaking in large sums, this tax increase is significant.
It should be noted that there is a $250,000 threshold baked into these provisions to capture the 66% tax rate. In other words, the first $250,000 of capital gains (net of gains offset by capital losses, the lifetime capital gains exemption and the proposed employee ownership trust exemption and Canadian entrepreneurs’ incentive) will capture the historic inclusion rate of 50% however gains above $250,000 will capture the increased inclusion rate of 66%.
Lifetime Capital Gains Exemption
Currently, individuals are eligible to offset up to $1,016,836 of capital gains on qualified small business corporation shares under the Lifetime Capital Gains Exemption (LCGE). Budget 2024 proposed to increase this lifetime limit to $1,250,000 for dispositions taking place on or after June 25, 2024. As in the past, this amount continue to be indexed for inflation commencing in 2026.
Canadian Entrepreneurs’ Incentive
Budget 2024 introduces a new Canadian Entrepreneurs’ Incentive program (CEI) to reduce the capital gains inclusion rate on capital gains realized on the disposition of qualifying shares by an eligible individual. The inclusion rate would be halved, resulting in 1/3 of such gains being taxable under the inclusion rates proposed in Budget 2024 as opposed to 2/3. This reduced inclusion rate would apply to gains not offset by the lifetime capital gains exemption.
In other words, if a business owner were to sell qualifying shares for $2,000,000 of which the entire amount can be attributable to a capital gain, then (assuming the shares are qualifying) the first $1,250,000 is exempt from taxation under the LCGE as explained above. The resulting taxable capital gain would be $750,000.
Of the remaining $750,000 taxable capital gain, the sum of $200,000 would capture the reduced inclusion rate of 33% (as opposed to 66%), and therefore $66,000 would be included in income for taxation, to be taxed at the individuals applicable marginal rate.
The remaining $550,000 gain would capture the higher inclusion rate of 66%, meaning $363,000 would be included in income and then taxed at the individuals marginal rate.
There would be a lifetime limit on gains eligible for this reduced rate, initially set at $200,000 commencing in 2025, and increasing by $200,000 annually until reaching a total of $2 million in 2034.
To be eligible for this reduced inclusion rate, several important conditions would be required to be met, including the following:
- the shares were directly owned by the taxpayer at the time of sale;
- the shares meet the asset tests required to be qualified small business corporation shares (generally, at the time of sale, all or substantially all assets were used in an active business carried on in Canada, and throughout the 24 months preceding the sale, more than 50% of the assets were so used); Note however that this is the same test used to determine eligibility for the LCGE
- the taxpayer was a founding investor at the time the corporation was initially capitalized; This is important since it would exclude the sale of existing businesses that were acquired by the seller after inception;
- the shares were held by the taxpayer for a minimum of five years prior to the sale;
- at all times from the initial share subscription until immediately before the sale, the taxpayer directly owned shares accounting for more than 10% of the votes and 10% of the fair market value of the corporation; the ‘votes and value’ test is drawn from similar tests to determine income splitting with family members. The idea being that one must hold at least 10% of the votes and value of a corporation to qualify for the CEI which would exclude minority non voting shareholders.
- throughout the five years immediately preceding the sale, the taxpayer was actively engaged on a regular, continuous and substantial basis in the activities of the business; and
- the shares were acquired for fair market value consideration. For this reason, an initial corporate minute book evidencing the subscription for initial shares for value is critical.
It should be noted however that the incentive would not be available where the shares sold were of the following types of corporations:
- a professional corporation (that is, a corporation that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor);
- a corporation whose principal asset is the reputation or skill of one or more employees;
- a corporation that carries on a business operating in the financial, insurance, real estate, food and accommodation, arts, recreation or entertainment sector; or
- a corporation providing consulting or personal care services.
Employee Ownership Trust (EOT) Tax Exemption
Last year’s Budget 2023 proposed tax rules to facilitate the creation of EOTs which is a form of employee ownership where a trust holds shares of a corporation for the benefit of the corporation’s employees. EOTs can be used to facilitate the acquisition by employees of their employer’s business, without requiring them to pay directly to acquire shares.
These proposed rules are currently before Parliament in Bill C-59 which included a proposed $10m exemption to capital gains realized on the sale of certain businesses to an EOT. Budget 2024 provided further details on this proposed $10m exemption noting that this exemption would be available where the following conditions are met:
- the corporation is not a professional corporation;
- the sale is a qualifying business transfer (QBT);
- the trust acquiring the shares is not already an EOT or a similar trust with employee beneficiaries;
- throughout the 24 months immediately prior to the QBT (the holding period), the shares were owned by the individual, a related person or a partnership in which the individual is a partner;
- throughout the holding period, over 50% of the fair market value of the corporation’s assets were used principally in an active business;
- at any time prior to the QBT, the taxpayer, or their spouse or common-law partner, was actively engaged in the qualifying business on a regular and continuous basis for a minimum period of 24 months;
- immediately after the QBT, at least 90% of the beneficiaries of the EOT were resident in Canada; and
- no disqualifying event occurs within 36 months of the QBT.
It should be noted that the rules proposed in Budget 2023 require both the EOTs themselves and the QBTs by which they acquire businesses to meet numerous complex requirements. The exemption would be available for dispositions that occur between January 1, 2024 and December 31, 2026.
Conclusion
The above changes have material impact on the taxation of the sale of a business including both asset and share sales. The sale of shares trigger capital gains tax in the hands of the individual shareholder, whereas the sale of assets capture capital gains tax within the corporation itself. For a sale of shares, the higher rate is now subject to a $250,000 threshold, as well as the CEI benefit. However for corporations, the higher inclusion rate is levied across the board with no relieving provisions.
For further guidance on the taxation of your small business, contact one of our lawyers.
-Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and private M&A law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law.
© Kalfa Law 2024
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
