© 2008 grant thornton llp. a canadian member of grant thornton international ltd. all rights...

Business succession planningTax considerations

Paul Deighan, CATax PartnerGrant Thornton LLP

Business succession planning

• process that determines how and when a business will be transferred to others

• can span a number of years• original plan may undergo many changes as

circumstances change• may involve many complex transactions• different “triggering events” – retirement, death,

disability, divorce, bankruptcy• changes in tax legislation

Importance of succession planning

75% of businesses are owner managed

only 15% make it to the second generation

fewer than 3% make it beyond

Source: C A F E (Canadian Association of Family Enterprises)

A comprehensive succession plan will address several key concerns

Ensure that:

• the owner's spouse and dependants have sufficient income to maintain their current lifestyle

• the owner's family will be able to realize the value of the business through a sale, if the family chooses not to continue to operate the business

A comprehensive succession plan will address several key concerns

• the children are treated fairly (though not necessarily equally), and if more than one is active in the business, the succession arrangement preserves harmony among them

• there is sufficient liquidity at the time of the owner's death to cover capital gains taxation on death

Succession alternatives

• family continues to own and manage the business

• Different family members

• continue with the current family ownership but bring in outside management to run the business

• sell the business to key executives or employees on favourable extended payment terms

Succession alternatives

• sell the business to a competitor who wishes to expand his market share

• reorganize the business into separate parcels, so that some may be sold and others retained

• discontinue where no solution can be found

Tax considerations

• minimize (eliminate??) any income tax on the change of ownership of the business

• defer for as long as possible any capital gains tax or other taxes that relate to the transfer

• minimize capital gains tax arising on death under the "deemed disposition" rule

• avoid any possible "double taxation" effects that may occur because of the imposition of capital gains taxation at both the personal and corporate level

Most succession arrangements fall into two categories

1. the "Paper transaction" - ownership transferred immediately or over time to one or more children without any money changing hands; and

2. the "Purchase" succession plan - the new owner (or the business itself) must make payments to the current owner or to other members of the family

Paper Transactions

Traditional structure

Service Co

Parents

My father wanted me to be a partner in his business, but Revenue Canada got there first!

Estate freeze

Arrangement to permit futureappreciation in asset values to be

transferred to others, without loss ofcontrol or current income tax

Restrict amount of capital gains ondeath and allow others to participate

in growth of assets

Income splitting, capital splittingand "freeze" ultimate tax

exposure

Concept

Benefits

Purpose

Traditional freeze

Service Co

Parents Children

P/S C/S

Freeze using a family trust

Service Co

ParentsTrust

P/S C/S

voting

Children (future growth)

Corporate beneficiary freeze

Service Co

ParentsTrust

P/S C/S

voting

Corp Beneficiary Co

Estate freeze with a holding company

Parents

Hold Co

commonshares

non-votinggrowth

Service Co

debtobligation

votingcontrol

Estate freeze with a holding company

Benefits:• present value is converted to debt obligation which

is secured• parents control Service Co• children run Service Co• investment of funds by Hold Co defers tax• bequeathing of interest in Hold Co

What is a trust?

A vehicle that separates legal ownership from beneficial ownership

What is a trust?

• Settlor– typically recommend a personal friend, a non-

resident family member or another family member such as grandparents

– settlor should not be a trustee or beneficiary. If they are, attribution rules would apply

• Settlement property– gold coin, silver coin, five or ten dollar bill– critical that settlor use their own funds to acquire and

gift the settlement assets– recommend that settlement assets should not be

used to acquire income producing shares due to potential attribution

What is a trust?

• Trustee– this is where control over the trust assets will be

while the trust exists– typically recommend the business owner and their

spouse plus a third trustee (not the settlor)• Beneficiary

– income versus capital beneficiaries– commonly include – mom, dad, and children– other potential beneficiaries include grandchildren,

grandparents, in-laws, or holding company– beneficiaries can not be changed or added in the

future

Selected trust indenture clauses

• replacement of trustees• removal of discretionary powers• alternative plan of distribution• gift over clause• interest determination date• division date• ability to amend• ability to make tax elections

Non-tax reasons to consider a family trust

• control and decision making• creditor protection• secrecy• parents' cash requirements• marriage• children's cash requirements

Tax considerations when using family trusts

• reversionary trust - Subsection 75(2) applies if settlor is beneficiary

• corporate attribution - Section 74.4– can get around – stock dividend freeze, drop

down assets and freeze – Pay dividend to parent if Service Co is not a

SBC otherwise deemed interest benefit to parent

• association – each beneficiary of a discretionary trust is deemed to own 100% of Service Co shares

Tax considerations when using family trusts

• kiddie tax– highest marginal tax rate applies to “split

income” paid to minor children– dividends, interest and rental income caught– capital gains to minor children okay– planning ideas – create capital gains

"Purchase" succession plan

Selling to family

• outright sale versus overtime• vendor take-back – 10 year capital gains reserve

available on QSBC share proceeds not received• use of capital gains exemption• forgiveness of debt in will – no tax implications• shares as collateral

Selling to familySection 84.1 trap

• prevents the tax-free removal of corporate earnings on non arm’s length share sales by Canadian residents

• gives rise to bizarre result that is more expensive to sell to a relative then to an arm’s length person

• if parents sell shares to a company controlled by their children, section 84.1 would change the parents capital gain into a taxable dividend

Selling to familySection 84.1 trap

• instead, if the parents sell the shares directly to their children, the sale would be tax free by virtue of the CGE but the children would have to pay for the shares with after-tax $$

• in contrast, if the parents sell their shares to an arm’s length CCPC that has accumulated funds then the corporation would need less pre-tax earnings to net the amount required to pay the purchase price

Selling to familyUse of child company

Facts:• parents are looking to exit from Service Co. in

favour of child but need cash flow to fund their retirement

• parents are not using their capital gains exemption• buy out over 10 years

Steps:• parents sell Service Co shares to children• children sell Service Co shares to Child Co• Service Co pays dividends to Child Co• repayment of promissory notes to children by Child

Co• repayment of promissory notes to parents by

children• use of Capital Gains Reserve

Child Co

Service Co

ParentsSell

Dividend

Caveats:• section 84.1 – Parents cannot use capital gains

exemption• General Anti-Avoidance Rules (GAAR)• potential agency issue

Ensure proper documentation!

Capital gains exemption planning

• QSBC – three criteria to meet

– 24 month holding period

– asset test at time of disposition (90%)

– asset test over immediately proceeding 24 months (50%)

• need to review for prior ABIL, CNIL and unclaimed exemption balance

• potential alternative minimum tax implication

• purification transaction – watch subsection 55(2)

• multiplying the exemption

Selling to third parties

• if no family members capable of or interested in taking over the business

• sale of shares versus assets

Shares versus AssetsShares• acquisition of control – deemed year-end, impact on losses• capital gains tax, avoids recapture on depreciable assets• $750,000 capital gains exemption on QSBC shares• relatively simple from a commercial perspective• liability issues – need to manage carefully (warranties and

representations)• no GST and PST implications, no property transfer taxes• lost tax shield to purchaser - cost "trapped" in shares,

therefore no immediate write-offs

Shares versus Assets

Assets• step up in cost base of assets – future tax savings

from tax depreciation• avoids contingent or undisclosed liabilities• allocation of purchase price

Safe income strip • may provide opportunity to strip excess cash and / or

passive investments from subject corporation immediately prior to share sale to third party

• to extent that a safe income dividend is paid, value of the shares is reduced

• safe income dividend paid to a Canadian corporation results in no immediate tax payable on that inter-corporate dividend

• hence, beneficial for vendor to strip out all safe income before selling shares to an arm’s length purchaser

Sale to third partiesConcluding comments

Don't let the tax tail wag the commercial dog

Business succession planning - multiple shareholdings scenario

• shareholders’ agreement is a must• right to sell shares may be subject to a right of first

refusal or buy / sell arrangement • the triggering event for a right of first refusal is often

an offer from a third party• a buy / sell arrangement provides that either the

remaining shareholders or the corporation agree to purchase the disposing shareholder’s interest upon the occurrence of a defined triggering event, such as death, incapacity, or bankruptcy

Business succession planning - multiple shareholdings scenario

• the sale price for shares sold under the terms of a shareholders’ agreement may not always be equivalent to the FMV of the shares in an arm’s length sale. Proper structuring is required to ensure that the sale price falls within the CRA policies

• in certain circumstances, a shareholders’ agreement may adversely affect the control of a corporation

Management buyouts (MBO)

Instalment sales• simple - payment over fixed period of time• complex – timing determined by criteria such as

gross revenue, cash flow or earnings

Leveraged buy-out (LBO)• a "management LBO" envisions that management

incorporates new company which borrows funds to complete the purchase

• tax planning required to determine optional allocation of borrowing between the management acquisition company and the management to maximize adverse deductibility

• further planning required to merge management acquisition company and target company

Management buyouts (MBO)LBO

Reducing the size of the deal• bonus strip• consulting fees• other payments to vendor

Estate freeze• can be used if buy-out is over time or to set the

stage for an earn-in• freeze and allow management to subscribe for

common shares (nominal cash requirement) • owner may retain voting control through preferred

shares

Management buyouts (MBO)Estate Freeze

Estate freeze• allows owner a reserved entitlement to receive

funds from the company equal to FMV of the owners' position over time

• no immediate tax to owners – defer to when preferred shares are redeemed

• mechanism for preferred shareholders to take over should circumstances change

In Conclusion …..

Despite all the tax and non-tax hurdles, business

succession can be a piece of cake with proper planning

and a strong team of professional advisors.

For more information …..

Contact:Paul Deighan, CATax Partner Grant Thornton LLP(902) 892 – 6547

pdeighan@GrantThornton.ca

© 2008 grant thornton llp. a canadian member of grant thornton international ltd. all rights...

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