How can I sell to my child’s company without a deemed dividend?

Section 84.1 of the Income Tax Act can recharacterize what an individual takes from selling shares to a corporation the individual does not deal with at arm’s length, which can include a corporation controlled by the individual’s child. Cash or notes above the greater of the shares’ paid-up capital and adjusted cost base can become a deemed dividend rather than a capital gain.

How the exception works

If subsection 84.1(2.31) or (2.32) is met, paragraph 84.1(2)(e) deems you and the buying corporation to deal at arm’s length at the time of the sale, so the deemed dividend rule no longer applies. Both subsections require that you are an individual other than a trust, that the buyer is controlled by one or more children aged 18 or older, and that the shares are qualified small business corporation shares or shares of a family farm or fishing corporation. Each also asks that you have not already sought this exception, at any time after 2023, for shares deriving their value from the same active business. The Act’s “child” includes nieces and nephews and some of their relatives.

The immediate route

Under subsection (2.31) you and your spouse or common-law partner must not, at any time after the sale, control the subject corporation, the buyer or any other entity carrying on the relevant business, or own more than a limit the Act sets of any class of their shares other than non-voting preferred shares; within 36 months and from then on you must own none of their shares except non-voting preferred shares as the Act defines them. For 36 months a child must control the buyer, and at least one child must be actively engaged on a regular, continuous and substantial basis in the business, which must stay active. Within 36 months, or a greater period that is reasonable in the circumstances, you must take reasonable steps to hand over management to a child and permanently stop managing.

The gradual route

Subsection (2.32) allows a staged exit with longer periods: the child’s control and involvement run for the later of 60 months and the final sale time, you must take reasonable steps to hand over management within 60 months or a greater reasonable period, and within 10 years you must reduce your remaining debt and equity interests below limits the Act sets. The bar on control and the 36-month rule on holding only non-voting preferred shares also apply.

The election and the catch

You and the child must jointly elect in the prescribed form and file it by your filing-due date for the year of the sale. If the conditions turn out not to be met, subsection 160(1.5) makes those who elected jointly and severally liable for the extra tax. The CRA also describes a longer capital gains reserve period for intergenerational business transfers. For the general rule, see selling shares to your own holding company.