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By: Florence Marino B.A., LL.B., TEP | Vice President, Tax & Estate Planning

The case of Carter v. The King 2024 TCC 71 is a family business succession story with a happy ending.  But it could have been a woeful tale.

The story of the family business

Brown’s Paving Ltd (BPL) was a family business started by Grandpa Brown and has been passed down through the generations since 1957.  After the death of Grandpa, Wallace and Calvin (the Sons) took over the business and when Calvin passed away in the 1990’s, Wallace became the sole shareholder.

Around that time, Wallace was thinking ahead.  He brought his sister’s son (Nephew) into the business, having graduated as a civil engineer and having previously worked for BPL.  Wallace’s daughter (Daughter – the Appellant in the tax case) also began working in the business starting at the bottom and learning every aspect of the business.  She studied alongside working part-time and returned to full-time each time after completing her studies in business and civil engineering programs.  

In 2007 both Nephew and Daughter spoke to Wallace about taking an ownership stake in BPL.  Wallace did an estate freeze taking back preferred shares and voting preferred shares (representing over 90% of the voting rights).  Wallace, Daughter and Nephew subscribed for 20%, 40% and 40% of the common shares respectively.

By 2013 BPL had grown.  Substantial investments were made in additional equipment, and it had doubled its workforce.  Revenues doubled too. Nephew was a big reason for the growth.  Wallace was “essentially semi-retired”, and Nephew was effectively managing and directing the operations of the company.  

Meanwhile Daughter was still also working in the business and as a shareholder, sharing in the profits of the business.  Starting in 2010 she had a long commute to work having moved in with her partner and eventually was married in 2013. 

In 2014 Nephew approached Daughter about buying her shares.  She was surprised and needed time to think about it.  On reflection, the idea appealed to her.  Although she enjoyed her work at BPL the commute was long and given that she and her husband were thinking about starting a family, she was not sure whether she’d be able to balance that against the demands of the business. 

Nephew and Daughter started negotiations.  Daughter offered to sell for $800,000.  Nephew was thinking something closer to $250,000.  They agreed to have the company valued. Although they both sought approval from Wallace (personally and due to his right of first refusal), Wallace stayed out of the negotiations.  They eventually agreed on a price of $600,000.

As is usually the case in these types of situations, Nephew didn’t have $600,000 in cash to buy Daughter’s shares.  He knew he’d have to borrow the money and he sought out professional advice.  Nephew was already in the process of setting up a Holdco to hold his BPL shares and would have done this even if the deal with Daughter did not proceed. 

What happened next was that BPL borrowed $600,000 from a bank secured by its assets and Nephew and Holdco guaranteed the loan with Holdco pledging its shares in BPL as security.  Holdco then purchased all of Daughter’s shares by issuing a demand promissory note.  BPL redeemed the shares held by Holdco for $600,000 which was used by Holdco to pay off the demand promissory note. 

Daughter didn’t pay attention to the details of the plan and the steps taken to carry out the purchase.  She was paid in full.  Wallace, although the controlling shareholder and a party to the Unanimous Shareholders Agreement, stayed out of it and simply did what was required of him to close the transactions.

BPL repaid the loan to the bank within two or three years.  The company continued to grow and in 2021, Nephew (or Holdco) purchased Wallace’s voting preferred and common shares for $1million.

All in all, a successful business transition.

Wasn’t this a tax case?

Yes.

Daughter reported a capital gain of $599,960.  The redemption of the BPL shares held by Holdco resulted in a deemed dividend.  Holdco claimed a deduction under section 112 resulting in no tax liability on the redemption.

The Minister reassessed Daughter under section 84.1 giving her dividend treatment instead of a capital gain.  For section 84.1 to apply, Daughter and Holdco had to be found to be factually not dealing at arm’s length since they were not related persons. The Minister argued they were not dealing at arm’s length and that BPL could have redeemed Daughter’s shares instead of carrying out this series of transactions but this way was chosen to give Daughter the best tax result.

The Tax Court found that Holdco and Daughter were dealing at arm’s length and were not acting in concert without separate interests.  So, section 84.1 did not apply.  (It also found that BPL was not connected to Holdco immediately after the sale and that Holdco did not control BPL since Holdco dealt at arm’s length with Wallace.) 

The Court found that Holdco and Daughter “engaged in hard bargaining relating to the terms of the sale.”  The Court also found that the transactions were structured not to find the most tax efficient way for Daughter to get out of the business but rather to benefit Holdco which needed a way to finance the purchase.  It saw these transactions in the context of Nephew’s long-term plan to eventually own BPL.  It was Nephew who approached Daughter and who actively carried out how the transaction was structured.  The Court stated, “there must be something more than sharing the same tax advisors and having a common interest in getting the deal done” for Daughter and Holdco to be seen as not acting at arm’s length.

Why we read this case with interest

This story is the story of many family businesses.  There are real tax impediments to family business succession.  Section 84.1 is a big one.  While it is valid for the government to seek to prevent “surplus stripping”, the reality of family business succession is that these impediments can prevent business transfers within a family.  The recent amendments to implement a regime for genuine intergenerational business transfers (See:  What does life insurance have to do with proposed intergenerational business transfers? – Lots – Tompkins Insurance) is a step in the right direction.  However, these rules come with more complexity and detailed requirements to meet.

FOOTNOTE:

This publication is protected by copyright. Tompkins Insurance is not engaged in rendering tax or legal advice. TOMPKINSights contains a general discussion of certain tax and legal developments and should not be construed as tax or legal advice.

Should you wish to discuss this or any other TOMPKINSights article, please contact
florence@tompkinsinsurance.com

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