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The transfer of family businesses: an economic and intergenerational challenge
In Canada, family businesses are a strategic component of our economy. They account for some 63.1% of private companies, generate almost half of the private sector’s real GDP and employ nearly 7 million people, demonstrating their influence on the entire national economic fabric.1
Despite their importance, succession poses a major challenge: less than 10% of Canadian SME (small or medium-sized enterprise) owners have a formal written succession plan.2 This lack of preparation exposes companies to major vulnerabilities during intergenerational transfers.
There are many causes: overly informal governance, unclear roles between family and company, inadequate communication and implicit conflicts. Tax and legal aspects, when neglected or misunderstood, can also compromise the success of the transfer.
A successful transfer goes far beyond maintaining the asset value. It is first and foremost based on intergenerational alignment: the family’s values must be reflected in the company’s vision, and this vision must be translated into a clear, shared governance strategy.
On an organizational level, this means defining the roles and responsibilities of family members, setting up conflict resolution mechanisms and establishing appropriate communication forums. Training successors and gradually integrating them into decision-making process are also key success factors.
Family Enterprise Continuity Framework developed by the Family Enterprise Canada illustrates this approach by underscoring five essential elements: business strategy, wealth integration, intrapersonal clarity, ownership alignment and governance formalization.3 The continuity of family businesses depends on balancing these five elements.
A successful transfer is more than just a transfer of securities or assets. It aims to pass on an intangible heritage: a shared identity, an entrepreneurial culture and accumulated know-how. In this sense, taxation and the law should not be seen solely as technical constraints, but as levers to support this process, easing the transition and minimizing friction.
When these conditions are met, the transfer of ownership becomes an act of sustainability that protects not only the family’s assets, but also the company’s contribution to society, whether in terms of jobs, innovation or regional economic vitality.
Thus, the success of a family business transfer depends as much on the strength of human relationships as on the coherence of the tax mechanisms used. When an owner plans to sell their shares to the next generation, certain tax provisions can inadvertently hinder this transition, even when it is motivated by a genuine concern for the company’s long-term future. This is where a tax rule comes into play, the scope of which can be decisive: section 84.1 of the Income Tax Act (ITA).
Section 84.1 of the ITA in the context of the transfer of a family business
The intergenerational transfer of a family business, while essential to economic and asset continuity, raises complex tax considerations. When a shareholder wishes to transfer their shares to a company controlled by their children, this desire, however natural in a succession process, may come up against section 84.1 of the ITA. This provision, originally designed to counter certain forms of tax avoidance, can have significant tax consequences if the specific conditions it imposes are not met.
Origin and scope of section 84.1 of the ITA
Section 84.1 of the ITA is designed to prevent taxpayers from converting accumulated corporate surpluses into capital gains for planning purposes, when they should normally be distributed as taxable dividends. This provision applies when shares of a corporation are sold to a purchaser corporation with which the seller does not deal at arm’s length, as in the case of a corporation controlled by family members. The realized gain is then reclassified as a deemed dividend.
The aim is to counter certain forms of surplus stripping, where a shareholder attempts to withdraw cash in a tax-efficient manner, without any real economic disengagement.
A barrier to intergenerational transfers
The strict application of this rule, however, had the effect of penalizing genuine intergenerational business transfers, by subjecting them to a less favourable tax treatment than a sale to a third party. This asymmetry, which was widely criticized in professional and entrepreneurial circles, was at odds with the intention of encouraging family succession in Canadian SMEs.
Assented to in June 2021, Bill C-208 initiated a reform by excluding the application of section 84.1 of the ITA in certain family transfer situations. It thus recognized the legitimacy of such transfers, while requiring certain conditions to be met. However, the rules initially introduced were soon deemed too vague to prevent abuse.
To ensure the integrity of the plan, the 2023 federal budget proposed major adjustments to these rules, clarifying the exclusion criteria in section 84.1 of the ITA for qualifying share sales in a family succession context. These adjustments came into effect on January 1, 2024.
Updated requirements
Since 2024, two types of transfers have been eligible for exemption under section 84.1 of the Income Tax Act: immediate transfer and gradual transfer. Each is based on distinct conditions, but certain general criteria apply in both cases:
- The purchaser corporation must be controlled by one or more of the seller’s adult children or grandchildren; the Act has broadened the definition of “child” to also include a niece or nephew.
- The shares must belong to an active business corporation in Canada.
- At least one child who controls the purchaser corporation must be actively involved in the business for a minimum period, either three years in the case of an immediate transfer, or five years for a gradual transfer.
Control and management considerations during company transfer
- Immediate transfer: the seller must transfer de jure and de facto control of the company at the time of the transaction. The child or next generation must ensure de jure control and active participation for a minimum period of 36 months, and management must be transferred within the same timeframe.
- Gradual transfer: the seller must transfer de jure control immediately. While they may stay on as an advisor or take on a transitional role, they must reduce their influence and no longer exercise de facto control at the end of the gradual period. The child or next generation must maintain de jure control and active participation for at least 60 months, and management must be transferred within this period. Lastly, the seller must have disposed of all common shares within 36 months of the disposition. Other statutory limitations also apply to prevent the former owner from retaining indirect control.
These rules are designed to encourage business transfers with a genuine family succession objective, while strengthening vigilance against planning abuses.
Conclusion
As we saw in the first part, the long-term future of family businesses depends on much more than the simple transfer of assets: it requires strategic preparation, intergenerational alignment, and a tax environment that does not unfairly penalize families engaged in a genuine succession process.
The relaxation of the rules in section 84.1 of the Income Tax Act reflects this reality. By facilitating planned intergenerational transfers, subject to certain conditions, the legislator is demonstrating its desire to support entrepreneurial continuity within families.
However, caution is still called for as these rules, while adapted since 2021, come with strict conditions that must be scrupulously observed. Otherwise, poor planning could result in the punitive effect of the original provision.
Ultimately, this reform illustrates the vital link between tax law and family dynamics, two spheres often perceived as distinct, but which in practice converge at the heart of the most crucial decisions for the future of family businesses in Canada.
1 https://www.conferenceboard.ca/product/the-economic-impact-of-family-owned-enterprises-in-canada/
3 https://familyenterprise.ca/resource/five-elements-of-continuity/