Avoid Double Taxation on Intergenerational Wealth Transfers

The baby boomer generation is reaching the retirement age, with the oldest in the cohort turning 77 and the youngest turning 59 in 2023. Many 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.

An intergenerational wealth transfer is often met by the challenge that the next generation may not have sufficient funds to buy the asset. In addition, the baby 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 one to help with the transition but should think twice before doing so as receiving an amount other than fair market value (FMV) consideration could result in double taxation.

The Income Tax Act (ITA) governs transactions between non-arm’s length individuals¹, and subsection 69(1) of the ITA 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:

Robyn started and incorporated her business, a flower shop, over 25 years ago. Her son, Jackson, has been actively engaged in the business and has expressed interest in one day taking over the flower shop from mom. 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 $2,000,000, however Jackson only has $1,000,000 saved up to buy the business. Robyn has other personal savings aside which would suffice for her retirement. She is eager to begin her retirement and wants to help her son, so Robyn agrees to provide Jackson a discount and sells the business for $1,000,000. She figures by providing her son a discount, she will also 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) of the ITA, Robyn would dispose of her shares with proceeds of disposition equal to $1,000,000 realizing a capital gain of $999,900² and resulting in taxes payable of $267,600³. As a result of this transaction, Jackson has received a business worth $2,000,000 for half price and Robyn’s capital gain was reduced by half, thereby resulting in less taxes paid.

However, since Robyn and Jackson are deemed not to deal at arm’s length as Robyn and Jackson are considered related persons as mother and son, subsection 69(1) of the ITA prevents such favourable tax results. Under paragraph 69(1)(b) of the ITA, Robyn is deemed to have received proceeds of disposition equal to the FMV of the shares of $2,000,000 and will realize a capital gain of capital gain of $1,999,900. Robyn’s taxes payable on the capital gain would be 535,300⁴ even though she only received $1,000,000 in cash.

Furthermore, 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 $1,000,000. The differential in the tax treatment between the transferor and transferee results in a double taxation on the $1,000,000 in which the proceeds strayed from the shares’ FMV. Similar punitive rules can apply under subsection 69(11) where an asset is transferred to a non-affiliated person⁵ 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 is 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 gift⁶. If Robyn had instead gifted the shares to Jackson, Robyn would be deemed to receive proceeds of disposition equal to $2,000,000 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 $2,000,000.

Whether a transaction occurs at arm’s length terms will ultimately depend on the facts and circumstances of the particular transaction. To determine whether individuals are dealing at arm’s length, the courts have developed a test based on 3 criteria:

1. Whether a common mind directed the bargaining for both parties to the transaction;
2. Whether the parties to the transaction acted in concert without separate interests; and
3. Whether any 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(s) to evidence that the sale did in fact occur at FMV. Furthermore, individuals could contemplate the addition of a price adjustment clause in their purchase and sale agreement. Where a price adjustment clause meets the requirements as provided by the CRA⁷, 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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¹ Related persons is a defined term under subsection 251(2) of the ITA and includes, but not limited to, those who are connected by blood relationship, marriage, common-law partnership or adoption. Subsection 251(1) of the ITA deems “related persons” not to deal at arm’s length.
² For illustrative purposes, the intergenerational business transfer rules and lifetime capital gains exemption were ignored.
³ Rounded and calculated based on the highest Ontario personal marginal tax rate of 53.53%.
⁴ Ibid.
⁵ Affiliated persons are defined under 251.1(1) of the ITA
⁶ Gift includes bequest, inheritance or a disposition that did not result in a change in beneficial ownership of the property.
⁷ Requirements as listed in Income Tax Folio S4-F3-C1.