Avoid double taxation on wealth transfers to the next generation

The baby-boomer generation is reaching retirement age, with the oldest in the cohort turning 77 this year and the youngest turning 59. Many boomers may be thinking about how to transfer their wealth and businesses to their children and family, including whether to transfer the assets during their lifetime.

One challenge in transitioning wealth to the next generation during a person’s lifetime is that the next generation may not have sufficient funds to buy the asset. In addition, boomers must be prepared to pay the large tax bill due to the capital gain from the sale or gift of the asset. Parents may consider providing a discount to their children or other loved ones to help with the transition. But they should think twice before doing so, as receiving an amount other than fair market value (FMV) could result in double taxation.

The Income Tax Act (ITA) governs transactions between non-arm’s-length individuals, and subsection 69(1) aims to deter taxpayers from manipulating tax results by entering into transactions, with non-arm’s-length individuals, that may stray from FMV.

Consider the following hypothetical scenario:

Robyn created and incorporated her business, a flower shop, more than 25 years ago. Her son, Jackson, has been actively engaged in the business and has expressed interest in one day taking over the shop. As Robyn approaches retirement, she begins to think about selling the business to Jackson.

Robyn received a formal valuation that the business has a FMV of $2 million; however, Jackson has only $1 million saved. Robyn is eager to retire, and she has other personal savings that would suffice for her retirement. She also wants to help her son.

So, Robyn agrees to sell the business to Jackson for $1 million. She figures that, by providing her son a discount, she will get the added bonus of minimizing her capital gain and therefore taxes due. The adjusted cost base (ACB) of the shares of the corporation is $100.

Without subsection 69(1), Robyn would dispose of her shares with proceeds of disposition equal to $1 million, realizing a capital gain of $999,900^* and resulting in taxes payable of $267,623 (53.53% in Ontario). As a result of this transaction, Jackson would receive a business worth $2 million for half price, and Robyn’s capital gain would be reduced by half, thereby resulting in less tax.

However, since Robyn and Jackson, as mother and son, are deemed not to deal at arm’s length, subsection 69(1) prevents such favourable tax results. Under paragraph 69(1)(b), Robyn is deemed to have received proceeds of disposition equal to the FMV of the shares of $2 million and will realize a capital gain of $1,999,900. Robyn’s taxes payable on the capital gain would be $535,273 even though she received only $1 million.

Further, although Robyn’s proceeds of disposition were bumped up to the FMV, there is no similar provision that would deem Jackson to acquire the shares equal to FMV. As such, Jackson’s ACB on the shares is equal to the amount he paid of $1 million. The differential in the tax treatment between the transferor and transferee results in double taxation on the $1 million in which the proceeds strayed from the shares’ FMV. Similar punitive rules can apply under subsection 69(11) when an asset is transferred to a non-affiliated person for less than FMV (including tax-deferred rollovers).

Subsection 69(1) can also apply in circumstances where a transaction occurs at a value higher than the FMV. In this case, the rules deem the transferee to have acquired the asset with a cost equal to the FMV at the time of the sale even if they received an amount greater than the FMV. There is no similar adjustment for the transferor’s proceeds of disposition, and therefore they are still expected to report their capital gain and pay taxes in accordance with the amount paid, including the amount in excess of FMV.

These punitive rules generally do not apply on transfers made by way of a gift. If Robyn had instead gifted the shares to Jackson, Robyn would be deemed to receive proceeds of disposition equal to $2 million and pay taxes accordingly. Similarly, Jackson would be deemed to acquire the shares at FMV and, as such, his ACB for the shares would be equal to $2 million.

Whether a transaction occurs at arm’s length terms will ultimately depend on the particular facts and circumstances. To determine whether individuals are dealing at arm’s length, the courts have developed a test based on whether:

• a common mind directed the bargaining for both parties to the transaction;
• the parties to the transaction acted in concert without separate interests; and
• either party could exercise de facto control, influence or authority over the other with respect of the transaction.

As such, transactions with unrelated persons such as friends and business partners could also be caught under these rules. The CRA has also commented in Folio S1-F5-C1 that a failure to carry out a transaction at FMV may be indicative of a non-arm’s-length transaction; however, such failure is not conclusive.

Given the above punitive results, it is important to ensure that all transactions occur at FMV. In most cases where related parties are involved, it may be prudent for clients to get formal valuations of the transferred asset to demonstrate that the sale did in fact occur at FMV.

Further, individuals could contemplate the addition of a price adjustment clause in their purchase and sale agreement. Where a price adjustment clause meets the requirements provided by the CRA, the property is considered to be transferred at FMV and may prevent subsection 69(1) from applying to the vendor if the transaction strays from the FMV.

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* For illustrative purposes, the intergenerational business transfer rules and lifetime capital gains exemption were ignored.