Many farmers may have heard about the “tax rollover” rules and the Capital Gains Exemption (“CGE”) rules in the Income Tax Act (Canada) (the “Act”). If applicable, these rules may create beneficial tax positions when a person transfers shares of a farming corporation to their child or to a third party. The use of these rules is dependent on whether certain conditions are satisfied.
This article will not explore the specifics of the “tax rollover” and the CGE rules. Rather, the focus of this article will be on one method – the Discretionary Family Trust – which may permit farmers to take advantage of these beneficial tax rules. For more information on these rules, see the following articles (which were previously prepared by our firm):
- “Transferring the farm to the kids is tax free – or not” https://www.producer.com/opinion/transferring-the-farm-to-the-kids-is-tax-free-or-not/
- “Transferring the farm to the kids now has new tax rules” https://www.producer.com/opinion/transferring-the-farm-to-the-kids-now-has-new-tax-rules/
To start, to qualify for the tax rollover rules or the CGE rules, the shares of the relevant farming corporation must be “shares of the capital stock of a family farm or fishing corporation” (an “FFC”).
For a share of a corporation to be qualified as an FFC, one of the requirements at the time the determination is being made is that all or substantially all of the fair market value of the property owned by the corporation must be attributable to assets used principally in the course of carrying on a farming business in Canada. The Canada Revenue Agency has taken the position that “all or substantially all” means 90% or more. Therefore, if the corporation has more than 10% of the fair market value of its assets not used principally in farming, the shares might not qualify for the tax rollover rules or the CGE rules.
One asset that may cause a corporation to be offside, which may not be readily apparent, is cash. A farm may have extra cash on hand for an operating cushion or to fund upcoming equipment or land purchases. While cash may still qualify as an “active” asset (meaning it was used principally in the business of farming), any cash not actively used in the operating season may be viewed as a “non-farming” asset. If the farming corporation has too many “non-farming” assets, this will prevent the shares from qualifying for the tax rollover rules and the CGE rules. The process of removing assets of a farming corporation that are not used in the business of farming is often referred to as “purifying”.
With this background, the question then becomes – How is a farming corporation purified?
One answer includes the Discretionary Family Trust. A trust is a relationship in which one person (known as the settlor) gifts property to another person or persons (the trustees) for the benefit of certain other persons (the beneficiaries). A typical discretionary family trust is drafted to have the parents as trustees. The beneficiaries would include the parents, children, grandchildren and other corporations controlled by the parents. The settlor gifts property (usually a small amount of cash – for example three $10 bills) to the trustees for the benefit of the beneficiaries which creates the trust. Note that if the settlor is also a beneficiary, adverse tax consequences can arise. The discretionary aspect of the trust gives the trustees absolute discretion in allocating the income and capital of the trust to the beneficiaries as they see fit.
Once a discretionary family trust is settled, the shares of the farming corporation can be restructured to issue to such trust participating shares in the corporation that are entitled to dividends. The farming corporation can then pay a dividend out of its future profits to the family trust by distributing the “non-active” cash to the family trust. The family trust would then allocate this dividend and transfer this cash to an existing (or new) holding corporation controlled by the parents.
This removes the “non-active” cash from the farming corporation, which allows its shares to continue to qualify for the “tax rollover” and CGE rules. In addition, the dividend paid by the farming corporation should be received tax free by the holding corporation. If the farming corporation needs the cash in the future (e.g. to buy land or equipment), the holding corporation can loan the cash to the farming corporation.
The family trust has an additional advantage regarding the CGE rules. Consider a situation where there is a family of four and the parents are desiring to sell their farming corporation to a third party. Since the family trust owns shares in the farming corporation, the capital gain realized on the sale of the shares can be split among the four family members allowing each to claim their CGE (provided the shares meet the 90% asset test and the other conditions present in the Act).
The current CGE rules permit each individual transferring shares in an FFC a $1,000,000.00 exemption when transferring such shares. This means (provided the individual has not otherwise used their CGE) that an individual selling/transferring shares of an FFC will not have to pay tax on the first $1,000,000.00 of gain associated with the sale of such shares. For a family of four, this would be $4,000,000.00 of gain that would be protected from tax.
It is important to consider whether a family trust can improve your corporate structure or assist in your retirement and/or succession planning.
Kade Kehoe
STEVENSON HOOD THORNTON BEAUBIER LLP
500 – 123 2nd Avenue South, Saskatoon, SK S7K 7E6
Telephone: 306-244-0132
Email: kkehoe@shtb-law.com
Michael J. Deobald
STEVENSON HOOD THORNTON BEAUBIER LLP
500 – 123 2nd Avenue South, Saskatoon, SK S7K 7E6
Telephone: 306-244-0132
Email: mdeobald@shtb-law.com
This article is provided for general informational purposes only and does not constitute legal or other professional advice and does not replace independent legal or tax advice.
This article was originally published in The Western Producer on February 9, 2023.