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1 ADVANTAGES & DISADVANTAGES OF VARIOUS FORMS OF ESTATE FREEZE TRANSACTIONS Stephanie Daniels, Farris, Vaughan, Wills & Murphy LLP Kay E Gray, Grant Thornton LLP Vancouver Young Practitioners Group Overview Why do we do estate freezes? ITA rules usually used to implement estate freezes Commonly-used structures pros and cons Additional considerations tips and traps 2 Vancouver Young Practitioners Group 2

2 Background: Why do an Estate Freeze? Key motivations of estate freezes: Income splitting Capital gains tax deferral Restrictions re shifting of value/income amongst nonarm s length parties Key judicial decisions: McClurg & Neuman Kieboom & Romkey 3 Vancouver Young Practitioners Group 3 Income Tax Act Rules Applied to Implement the Freeze Section 51 Convertible property Rollover of shares/debt to new shares where: shares or debt of the corporation that are capital property of the taxpayer are exchanged, only consideration received by the taxpayer is one or more new shares issued by the same corporation, then the exchange is deemed not to be a disposition by the taxpayer (some exceptions to this), and the exchange is deemed to be a transfer of property for purposes of sections 74.4 and Vancouver Young Practitioners Group 4

3 Income Tax Act Rules Applied to Implement the Freeze Section 85 Transfer of property to a taxable Canadian corporation by shareholders Rollover of property to new shares where: eligible property of the taxpayer is disposed of to the corporation, consideration received by the taxpayer must include shares issued by the same corporation, taxpayer and the corporation jointly elect in prescribed form, then taxpayer's PoD and the corporation's cost of the property is deemed to be the 'agreed amount' per the joint election, and taxpayer's cost of shares received equals PoD ('agreed amount') less the of any non-share consideration received 5 Vancouver Young Practitioners Group 5 Income Tax Act Rules Applied to Implement the Freeze Section 86 Exchange of shares by a shareholder in course of reorganization of capital Rollover of shares to new shares where: shares of the corporation that are capital property of the taxpayer are disposed by the taxpayer to the corporation, all of the shares of the particular class must be disposed, consideration received by the taxpayer must include shares issued by the same corporation, taxpayer's PoD deemed to equal his cost of shares disposed taxpayer's cost of new shares received equals his PoD less the of any non-share consideration received 6 Vancouver Young Practitioners Group 6

4 Income Tax Act Rules Applied to Implement the Freeze Section 85.1 Share for share exchange Cannot use 85.1 for an estate freeze where, immediately before the exchange, the taxpayer disposing of shares is dealing at non-arm's length with the corporation acquiring the shares. 7 Vancouver Young Practitioners Group 7 Income Tax Act Rules Applied to Implement the Freeze Subsection 97(2) Rollover to partnership Rollover of property to interest in partnership where: property of the taxpayer is disposed of to a partnership, immediately after the disposition, the partnership is a Canadian partnership of which the taxpayer is a member, taxpayer and all the members of the partnership jointly elect in prescribed form, then taxpayer's PoD and the partnership's cost of the property is deemed to be the 'agreed amount' per the joint election, and taxpayer's cost of his partnership interest is adjusted by an amount by which the PoD ('agreed amount') exceeds or is less than the of any consideration received other than an interest in the partnership 8 Vancouver Young Practitioners Group 8

5 Internal Freeze 0% + growth in ITA 85(1) or 86 9 Vancouver Young Practitioners Group 9 Valuation Issues and Price Adjustment Preventing the application of indirect gift rules Valuation of Shares CRA: What would a hypothetical arm s length purchaser be willing to pay? Skinny shares for purposes of 70(5), no premium for voting rights in an estate freeze Price Adjustment Clauses New Folio S4-F3-C1 Changes to the CRA s requirements for PACs 10 Vancouver Young Practitioners Group 10

6 What are Freeze Preferred Shares? Freeze Share Attributes Fixed value preferred shares Must have the same as property for which exchanged, less value of any non-share consideration provided by corporation on exchange Redeemable/retractable Dividend entitlement? Voting rights? Consider timing of issuance of shares 11 Vancouver Young Practitioners Group 11 Holding Company Freeze OTHER S/H OTHER S/H OPCO of Opco HOLDCO 0% + growth in Holdco OPCO of Opco ITA 85(1) 12 Vancouver Young Practitioners Group 12

7 The Corporate Attribution Rule Subsection 74.4(2) An imputed income rule, where: Canadian-resident individual Transfers or loans property either directly or indirectly, by means of a trust or by any other means whatever, To corporation not a small business corporation, Where one of main purposes of transfer or loan is: to reduce the individual s income, and to benefit (directly or indirectly) a designated person who would be a specified shareholder 13 Vancouver Young Practitioners Group 13 The Corporate Attribution Rule Subsection 74.4(2) (cont d) Exceptions: Small business corporation must continuously qualify Springing trusts 74.4(4) Consequences: Annual deemed interest income 1% (current prescribed rate) of aggregate redemption value of shares held by Freezor or outstanding debt Reduced by taxable dividends actually received by Freezor (other than on redemption of shares) 14 Vancouver Young Practitioners Group 14

8 Drop-Down Freeze Investment + Business Assets HOLDCO Investment Assets of Freezeco Business Assets ITA 85(1) 0% + growth in Freezeco 15 Vancouver Young Practitioners Group 15 Stock Dividend Freeze 0% 0% + % growth + % growth in in 16 Vancouver Young Practitioners Group 16

9 Preferred Shares Rules Part IV.1 and VI.1 tax Both determined based on the dividend recipient VI.1: paid by dividend payor IV.1: paid by dividend recipient Exception: Dividend allowance 191.1(2) No Part VI.1 tax payable on first $500,000 of dividends paid on taxable preferred shares Decreases if more than $1 million in dividends paid in prior year Dividend allowance is shared among associated corporations 191.1(4) 17 Vancouver Young Practitioners Group 17 Preferred Shares Rules (cont d) Exception: Excluded Dividends subsection 191(1) Exempt from application of Part VI.1 tax Common in estate freezes: recipient has a substantial interest in the dividend payor Taxable Canadian corporation and SH is related or owns > 25% of votes & value Exception: Excepted Dividends section Exempt from application of Part IV.1 tax Common in estate freezes: recipient is a private corporation or has a substantial interest in the dividend payor 18 Vancouver Young Practitioners Group 18

10 Preferred Shares Rules (cont d) Exception: Specified amount 191(4) No Part IV.1 or VI.1 tax on deemed dividends on acquisition, redemption or cancellation of certain shares, if Terms of share (or agreement in respect thereof) specify amount for which share can be acquired, redeemed, or cancelled, and Specified amount does not exceed of consideration for which share received (cannot include a taxable preferred share) Must be actual dollar value 19 Vancouver Young Practitioners Group 19 Control and Change of Control Limitations on use of deductions, losses and credits realized prior to an acquisition of control Consider whether change in control However: estate freezes often saved by 256(7) Deems no acquisition of control for purposes of certain provisions Rely on exceptions for changes amongst related parties 20 Vancouver Young Practitioners Group 20

11 Hybrid Freeze INVESTCO INVESTCO Investment Assets 0% + growth in Investco & Freezeco Business Assets Investment Assets Business Assets ITA 85(1) 21 Vancouver Young Practitioners Group 21 Whether to use a Family Trust Income-splitting flexibility Flexibility for partial or full thaw of freeze (if Freezor a beneficiary) Potential creditor-protection Protection in event of marriage breakdown...maybe Reduced valuation concerns No acceleration of capital gains if family member dies 22 Vancouver Young Practitioners Group 22

12 Family Trusts Drafting Considerations Ultimate distribution of trust assets on termination: Power of appointment as to distribution? Set distribution provisions? Fully discretionary? Power to appoint trustees Power to remove trustees Power to vest interests indefeasibly Power to transfer to another trust Power to amend Power to add/remove beneficiaries 23 Vancouver Young Practitioners Group 23 Corporate Beneficiary Freeze One sided OPCO 0% OPCO + growth FAMILY TRUST HOLD CO 24 Vancouver Young Practitioners Group 24

13 Corporate Beneficiary Freeze Two sided OPCO 2 HOLD CO FAMILY TRUST 11% common shares 39% common shares 39% Common Shares FAMILY TRUST 11% common shares HOLD CO 25 Vancouver Young Practitioners Group 25 ADVANTAGES & DISADVANTAGES OF VARIOUS FORMS OF ESTATE FREEZE TRANSACTIONS Thank you. Kay Gray Stephanie Daniels 26 Vancouver Young Practitioners Group 26

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