THE PERFECT PLANNING COMPANION EXCERPT #2. Canadian Estate Planning Guide. Excerpt: [ 4600] Internal Freezes and [ 4625] Stock Dividend Freezes

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1 THE PERFECT PLANNING COMPANION EXCERPT #2 Canadian Estate Planning Guide Excerpt: [ 4600] Internal Freezes and [ 4625] Stock Dividend Freezes

2 Canadian Estate Planning Guide A REAL LIFE EXAMPLE Determine for yourself whether or not the Canadian Estate Planning Guide is worth the investment. Check out the following pages that have been reproduced in their entirety from the Guide. You ll be impressed by their thoroughness and applicability. Written by Experts The Canadian Estate Planning Guide is the collaborative product of some of Canada s leading tax experts. David Louis JD, CA and Samantha Prasad Weiss BA, LLB, both with the law firm Minden Gross LLP, along with Robert Spenceley BA, MA, LLB, analyst with CCH Canadian, and Joseph Frankovic LLB, LLM, PhD, CFA, tax lawyer and member of the adjunct faculty of Osgoode Hall Law School, lead a host of contributors whose expertise make this Guide truly indispensable. David Louis JD, CA Samantha Prasad Weiss BA, LLB Robert Spenceley BA, MA, LLB Joseph Frankovic LLB, LLM, PhD, CFA Available in three user-friendly formats Print: $630 CD-ROM: $581 (single-user license) Online: $574 (single-user license) TRY BEFORE YOU BUY Take advantage of our free trial offer, available in print, on CD-ROM or over the Internet. For more information or to place an order, simply call the appropriate toll-free number below. Alberta: British Columbia: Ontario, Saskatchewan, Manitoba, Atlantic Canada and Territories: Toronto: Quebec: , ext. 267 Please quote Promo Code TA

3 CANADIAN ESTATE PLANNING GUIDE Virtually all practitioners will agree that an estate freeze is the cornerstone of estate and succession planning for a family business. There are several methods of implementing a freeze, most commonly, a holding company freeze, or an "internal freeze" i.e., reorganizing the corporation itself. The following excerpt From the Canadian Estate Planning Guide shows how the service presents a an extensive discussion of the tax issues and considerations pertaining to internal freezes, as well as a comparison of the benefits of this methodology vis-à-vis a holding company freeze. This excerpt is an example of how the Canadian Estate Planning Guide is a key tool to assist you in providing comprehensive and up-to-date estate planning advice to your clients. [ 4600] Internal Freezes to [ 4625] Stock Dividend Freezes The use of a holding corporation ( Holdco ) to implement a freeze is not the only method of achieving this objective in respect of a pre-existing corporation. An alternative approach is an internal freeze, whereby the shares of Opco are frozen directly by converting the pre-existing shares typically common into freeze shares. The diagram at 4750 illustrates a typical internal freeze configuration. As usual, the freezor ( Freezor ) holds shares of the corporation having the following attributes: redeemable/retractable at the value of the pre-existing shares at the time of the freeze; voting (either as an attribute of the redeemable/ retractable shares or with the voting shares sequestered in a separate class which has virtually no rights apart from the votes themselves); non-cumulative dividends either fixed or to a ceiling, usually based on the redemption/retraction amount (e.g., up to.75% per month); plus the usual preferences on dissolution, and so on (for a more detailed discussion of freeze share attributes, reference should be made to 4752 and 4850 et seq.). The growth shares are held either directly by one or more children, or as is more commonly the case, through a family trust, which will have the usual discretionary features, with the issue of Freezor (i.e., lineal descendants) as beneficiaries (see 4780et seq. for variations). Methodology There are a variety of ways to arrive at this configuration. The most common provision for effecting an internal freeze is Section 86 of the Income Tax Act. However, it is also possible to utilize Section 85 of the Act, e.g., by effecting a standard Section 86 reorganization, but also filing a Section 85 election form. (This is also known as an offside Section 86 reorganization or, even more simply, an offside 86.) In more unusual circumstances, an estate freeze could be effected through an amalgamation pursuant to Section 87 of the Act, e.g., where two corporations are involved in the freeze. It is also possible to effect an estate freeze via a stock dividend. Conceptually, at least, Section 51 (share and debt conversions) could also be used. [ 4605] Holdco versus internal freeze some considerations The most commonly-cited advantage to internal freezes is that they do not require the formation of a second corporation; accordingly, legal and accounting fees may be decreased. However, the following should also be considered: The use of a Holdco affords a degree of creditor protection, e.g., by allowing the payment of dividends to Holdco the proceeds can then be lent back to Opco if necessary, on a secured basis. 3

4 The use of a Holdco may facilitate continuation of Opco's status as a small business corporation on a tax-efficient basis. As noted at 4769, the basic test of small business corporation status is that substantially all of the corporation's assets must be devoted to Canadian active business activities. Accordingly, it is possible to implement freeze structures utilizing a Holdco, whereby excess cash or other assets can be jettisoned to the holding corporation as a tax-free inter-corporate dividend, leaving Opco pure. Of course, if a Holdco is already in place, and a freeze of Holdco is desired, it is probably preferable to effect an internal freeze in respect of Holdco itself. In general, implementing an internal freeze does not avoid any of the issues previously commented on.the valuation issues are similar; freeze shares received in exchange for common shares must have virtually the same attributes, and the implications of redeeming such shares do not change. [ 4610] Section 86 Freezes As stated previously, Section 86 of the Act is the most common method of effecting an estate freeze. Many rulings, technical interpretations, and articles have been written on Section 86 freezes, so that the technical issues pertaining to Section 86 freezes are, by and large, well settled. The following are prerequisites to the application of Subsection 86(1), which provides for the rollover: Reorganization of capital There must be a reorganization of the capital of a corporation. The meaning of this term is not specifically defined in the Income Tax Act, but pertains to corporate law principles. Accordingly, most practitioners follow relevant corporate law procedures, e.g., pertaining to fundamental changes (for example, provisions analogous to section 168 of the Ontario Business Corporations Act). Although it might be possible to have a reorganization of capital through other means, practitioners typically effect a section 86 reorganization by means of Articles of Amendment, the wording of which follows the corporate provisions relating to reorganizations. (For this reason, it is common to effect the conversion as a change of the common shares to freeze shares that is, following the wording of relevant corporate provisions.) The significance of the reorganization of capital requirement has lessened because of recent amendments to Section 51 of the Act, which allows a rollover for share conversions without the necessity of a pre-existing convertibility feature in respect of the shares which are exchanged. Accordingly, provided that no non-share consideration is received, an exchange which does not qualify under Section 86 may qualify under Section 51 of the Act. Disposition of all shares of a class The taxpayer must in the course of the reorganization of capital dispose of capital property that was all of the shares of a particular class of the capital stock owned by the taxpayer. In most estate freezes, status as capital property should not be problematic i.e., since Freezor is not in the business of trading these shares. However, it is also required that all of the shares of the particular class owned by the taxpayer be dis-posed of; Section 86 will not be available if the taxpayer disposes of only some of the shares of a class. However, it will be available if the taxpayer holds other classes of shares which are not included in the reorganization of capital. In this respect, a potential pitfall might arise if Freezor receives shares of the same class as a result of the reorganization. It could then be arguable that the taxpayer has not disposed of all of the shares of a particular class. An example of this problem could occur in respect of a partial freeze. Because of this, many practitioners will create a similar, but new class of share if this is a problem. This could be done, for example, by a variation of voting or dividend rights. Shares receivable Property must be receivable from the corporation which includes other shares of the capital stock of the corporation. [ 4612] Effect of Section 86 pro-rated cost base Most Section 86 estate freezes involve changing the preexisting shares to freeze shares, without the receipt of non-share consideration. Where no property other than shares is receivable, the adjusted cost base of the old shares immediately before the disposition carries over (subject to Subsection 86(2)) as the adjusted cost base of the new shares. However, if more than one class of new shares is received by the taxpayer, the adjusted cost 4

5 base of the old shares is apportioned between the classes of new shares on the basis of their relative fair market values. In some types of estate freeze reorganizations, this could be a suboptimal result. For example, if cost base is allocated to a class of shares, and this is followed by a spin-off reorganization, the reorganization could involve the cancellation of such shares (e.g., through an inter-corporate redemption), and the consequent disappearance of such cost base. Example Mr. Louis has previously crystallized the enhanced ($500,000) capital gains exemption by transferring his common shares of Opco into Holdco in consideration for Holdco common shares, so that Mr. Louis wholly-owns Holdco which in turn wholly-owns Opco, and the cost base of the shares of each corporation is $500,000. Mr. Louis now wishes to effect a spin-out reorganization whereby Holdco cash of $200,000 is to be spun out to Sisterco, which would also be wholly owned by Mr. Louis. To effect this result, the common shares held by Mr. Louis are changed (i.e., pursuant to Section 86) to freeze-type shares redeemable and retractable at $200,000 and common shares.the former are to be rolled into Sisterco in consideration for common shares of Sisterco and then redeemed, funded by the $200,000 cash. Two problems with this reorganization are: Part of Mr. Louis' cost base in respect of the pre-existing common shares will be allocated to the freeze-type shares, based on the relative fair market values of the two classes of shares. The cost base allocated to the freeze-type shares will be lost when these shares are redeemed. Furthermore, it may not be clear how much of the cost base is lost, i.e., if the fair market value of the new common shares is not clear. Arguably, Section 86 may not apply if the common shares of Holdco received by virtue of the Section 86 reorganization are the same class as the old common shares, on the basis that Mr. Louis has not disposed of all of the shares of a class. Hopefully at least, Section 51 would apply (which has a similar cost base prorating formula). Technical Note: Where property other than shares is received by the taxpayer as consideration (or part-consideration) for the old shares disposed of, the cost to the taxpayer of such property is deemed to be the fair market value, per paragraph 86(1)(a). Per paragraph 86(1)(c), the taxpayer is deemed to have disposed of the old shares for proceeds equal to the cost of all new shares, and other property receivable by the taxpayer for the old shares i.e., the fair market value of the non-share consideration, per paragraph 86(1)(a). Accordingly, if non-share consideration is received, this will trigger a gain to the extent of the excess over the pre-existing cost base. (Although, in most cases, a Section 86 reorganization involves a straight exchange of shares, conceptually, it might be argued that nonshare consideration could be received as part of the reorganization. An example of this could be intangible rights, e.g., from a shareholders' agreement implemented in connection with the freeze. Footnote Concerns along these lines have been expressed in respect of exchangeable share rollovers. (Obviously, however, the valuation of such rights would be debatable.) Other effects of Section 86 In addition to the foregoing, the following are other effects of a Section 86 reorganization, as compared with other internal freeze mechanisms: the CRA has taken the position that, pursuant to Subsection 84(9) of the Act, the corporate attribution rules will potentially apply in a Section 86 reorganization (see, for example, Question 42 of the 1986 Revenue Canada Round Table). For a detailed discussion of the consequences of the corporate attribution rules in the context of an estate freeze and how to avoid them, reference should be made to Where a Section 86 reorganization is effected, it is not necessary to file a tax election form with the CRA. The effects of Section 86 are automatic. [ 4614] Subsection 86(2) Benefit on Related Persons Subsection 86(2) limits the rollover provisions under Subsection 86(1) where a taxpayer has effectively gifted (loosely speaking see below) a portion of the value of his or her shares to a related person. The effect of Subsection 86(2) may be to force a recognition of the capital gain on the old shares and to alter the adjusted cost base of the new shares received on the reorganization. Subsection 86(2) may apply if the fair market value of the old shares before the reorganization is greater than the fair market value of share and non-share consideration 5

6 received and the difference can reasonably be considered to be a benefit that the taxpayer desired to have conferred upon a person related to him. For further discussion on minimizing the risk of the application of Subsection 86(2) and other benefit provisions, reference should be made to [ 4616] Subsection 86(2.1) Subsection 86(2.1) limits the paid-up capital in respect of a freeze. In general terms, the paid-up capital of the new shares issued on the exchange is limited to the paid-up capital of the old shares, less any non-share consideration. The provision contains a pro-ration formula in respect of paid-up capital where more than one class of share is received (unlike the cost base pro-rating formula in paragraph 86(1)(a), the formula subtracts the increase in paid-up capital, based on relative increases in paid-up capital, rather than fair market value). This provision applies only where the paid-up capital is increased over the pre-existing paid-up capital i.e., where the stated capital is increased pursuant to corporate law. (But for specific provisions such as Subsection 86(2.1), paid-up capital for tax purposes is dependent on stated capital under corporate law.) More often than not, the stated capital and therefore the paid-up capital for tax purposes will be limited under corporate law as part of the reorganization, thus pre-empting the application of Subsection 86(2.1). If the stated capital is limited, most corporate statutes appear to be silent as to the allocation of stated capital between classes. It appears that the CRA will usually accept an allocation by the taxpayer. However, the CRA has indicated that the General Anti-avoidance Rule could apply to a shift in paid-up capital i.e., if the purpose of this shift was abusive. (the CRA has stated that it is its general view that a shift of paid-up capital to restore each shareholder to the amount of paid-up capital that the shareholder would have had, had he originally purchased a separate class of shares would not be abusive.) In any event, for most estate freezes, the amount of paidup capital will be relatively nominal, so that the tax risks inherent in the shift will be modest. [ 4620] Section 85 Freezes ( Offside 86 ) Subsection 86(3) provides that Section 86 of the Act does not apply where Subsection 85(1) applies. In other words, the results of filing a Section 85 election in conjunction with the freeze can override the results of the rollover under Subsection 86(1), as described previously. Conceptually, the application of Section 85 in the context of a freeze involves the disposition of shares of the corporation to the corporation in return for other shares of the corporation.the CRA has indicated that if an estate freeze is effected directly through Articles of Amendment (i.e., the usual Section 86 mechanism), Subsection 86(3) applies, such that Subsection 85(1) election can be filed in connection with the reorganization. (See Question 20 of the 1992 Revenue Canada Round Table.) It also appears to be possible to effect an Offside 86 outside of the Articles by means of a share exchange agreement. Footnote Some years ago, a large accounting firm expressed some concern that the issue and allotment by a corporation of shares of one class in exchange for the surrender to the corporation by a shareholder of shares of another class might not be in compliance with the provisions of the Ontario Business Corporations Act. As many lawyers appear to be of the view that these concerns are not well founded, this issue seems to have been discounted. For an analysis, see B. Nichols Corporate Law Matters of Interest to Tax Practitioners, 1993 Ontario Tax Conference, Tab 2b, p Of course, shares having the proper freeze attributes must be in place. Potentially, one method of avoiding the necessity of filing Articles of Amendment is to create one or more classes of freeze shares in advance redeemable and retractable based on the value of the consideration received by the corporation in respect of the "first issuance" of the shares. Obviously, care must be taken not to reuse these shares. It is suggested that the authorized capital be restricted. Several different classes of first issuance shares could be created to facilitate future Section 85 rollovers. [ 4625] Section 86 vs. Offside 86 Considerations The following are instances in which offside 86 methodology is most commonly used and may be preferred over Section 86: Capital gains crystallizations The Section 85 methodology will, of course, allow a taxpayer to elect into a gain, thus bumping the cost base of the shares received. Pursuant to Subsection 6

7 85(1), where the taxpayer receives both common and preferred shares, the cost base would be allocated to the preferred shares as defined in the Act (see paragraph 85(1)(g) and (h)). Cost base sequestering As mentioned previously, the effect of the application of Section 86 is to average the pre-existing adjusted cost base amongst all classes of shares received, based on their relative fair market values. In many cases, this may not be a desirable result. (In fact, the allocation may be uncertain unless the value of all of the shares is known.) The Section 85 election mechanism sequesters the cost base in preferred shares in priority to common shares, to the extent of the value of the preferred shares received. (Note: the CRA has indicated that the use of Subsection 86(3) to sequester cost base in a class of shares such that the cost base is not proportional to the fair market value could trigger the General Anti-Avoidance Rule see, for example,window on Canadian Tax, However, since Subsection 86(3) specifically envisions the utilization of Subsection 85(1), the correctness of this interpretation may be debatable.) Of course, the normal restrictions in respect of Section 85 elections will apply if an offside Section 86 reorganization is effected. For example, where non-share consideration is received, the elected amount cannot be less than this, and so on. The commentary on this topic is current as of January 2nd, Just some of the reasons for making this Guide your planning partner. Feature: Detailed coverage of technical matters. Benefit: Provides a comprehensive review of issues, eliminating the need to consult other materials. Feature: Covers both tax and non-tax issues in estate planning. Benefit: Helps practitioners answer both tax and estate planning questions. Feature: Service is updated constantly. Benefit: Have access to current information that will help your clients. 7

8 CANADIAN ESTATE PLANNING GUIDE See inside for excerpts: [4600] Internal Freezes and [ 4625] Stock Dividend The Canadian Estate Planning Guide is available in print, on CD-ROM and online Other tax planning guides available from CCH Canadian Limited: Tax Planning for Small Business Guide Canadian Wealth Management Guide 95M3 The CCH design is a registered trademark of CCH Incorporated.

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