© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Business succession planning Tax considerations Paul Deighan, CA Tax Partner Grant Thornton LLP

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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)

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Paper Transactions

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Traditional structure Service Co Parents

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. My father wanted me to be a partner in his business, but Revenue Canada got there first!

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Estate freeze Arrangement to permit future appreciation in asset values to be transferred to others, without loss of control or current income tax Restrict amount of capital gains on death and allow others to participate in growth of assets Income splitting, capital splitting and "freeze" ultimate tax exposure Concept Benefits Purpose

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Traditional freeze Service Co Parents Children P/S C/S

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Freeze using a family trust Service Co Parents Trust P/S C/S Super voting Children (future growth)

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Corporate beneficiary freeze Service Co Parents Trust P/S C/S Super voting Children (future growth) Corp Beneficiary Co

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Estate freeze with a holding company Parents Hold Co Trust Children (future growth) common shares non-voting growth Service Co debt obligation voting control

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. What is a trust? A vehicle that separates legal ownership from beneficial ownership

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Non-tax reasons to consider a family trust control and decision making creditor protection secrecy parents' cash requirements marriage children's cash requirements

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. "Purchase" succession plan

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to family Section 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to family Section 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to family Use 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to family Use of child company 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to family Use of child company Child Child Co Service Co Parents Sell Dividend Note

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to family Use of child company Caveats: section 84.1 – Parents cannot use capital gains exemption General Anti-Avoidance Rules (GAAR) potential agency issue Ensure proper documentation!

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to third parties if no family members capable of or interested in taking over the business sale of shares versus assets

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to third parties Shares versus Assets Shares 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to third parties 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Selling to third parties 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Sale to third parties Concluding comments Don't let the tax tail wag the commercial dog

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Management buyouts (MBO) 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Management buyouts (MBO) LBO

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Management buyouts (MBO) Reducing the size of the deal bonus strip consulting fees other payments to vendor

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Management buyouts (MBO) 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Management buyouts (MBO) Estate Freeze

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. Management buyouts (MBO) 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

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. 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.

© 2008 Grant Thornton LLP. A Canadian Member of Grant Thornton International Ltd. All rights reserved. For more information ….. Contact: Paul Deighan, CA Tax Partner Grant Thornton LLP (902) 892 – 6547