Planning for Taxation at Death

Transcription

1 TAX FUNDAMENTALS FOR THE ESTATE PRACTITIONER PAPER 5.1 Planning for Taxation at Death These materials were prepared by David R. Baxter of Thorsteinssons LLP, Vancouver, BC, for the Continuing Legal Education Society of British Columbia, February David R. Baxter

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3 5.1.1 PLANNING FOR TAXATION AT DEATH I. Introduction... 1 II. Fundamental Concepts: Deemed Disposition on Death and Mechanics of an Estate Freeze... 2 A. Internal Estate Freeze... 2 B. External Estate Freeze... 4 C. Freeze of Personally-Owned Assets... 5 III. Wasting Estate Freeze... 5 IV. Indirect Gift Rules and Price Adjustment Clauses... 8 V. Estate Freezes: When To Do It... 9 VI. Estate Freezes: When Not To Do It... 9 VII. Benefits and Risks and Utilization of a Trust A. Asset Management and Control B. Multiplying Capital Gains Exemptions C. Thawing a Freeze D. Minimizing Tax Consequences on Death E. Avoiding Corporate Attribution F. 21 Year Rule VIII. Refreezing IX. Tax Implications at Death A. Avoiding Double Taxation: Section 164(6) B. Section 40(3.6) C. Forego Redemption D. Life Insurance Funded Capital Dividends X. Post-Mortem Wind-Up Bump XI. Alter Ego Trust and Joint Spousal or Common-Law Partner Trust XII. Other Considerations A. Attribution Rules (Sections 74.1, 74.2 & 74.3) B. Non-Share Consideration on Freeze C. Inter-Generational Transfers of Farm Property D. Inter-Generational Transfer of Fishing Property I. Introduction This paper focuses on the principal income tax considerations in respect of estate freezes which are implemented in advance of death, and related matters. The matters discussed herein are of particular relevance to high net-worth individuals and owner-managers of Canadian-controlled private corporations.

4 5.1.2 Although the provisions of the Income Tax Act (Canada) (the Act ) are not unduly complicated in relation to estate freezes, advisors need a general understanding of the overall taxation system to fully appreciate the planning opportunities. This provides advisors with the requisite insight in order to identify planning opportunities which can result in significant tax savings over prolonged periods. Unless otherwise stated, all statutory references are to the Act, the Canada Revenue Agency is referred to as the CRA and stated tax rates apply to a high-rate individual taxpayer residing in BC and a Canadian-controlled private corporation ( CCPC ) earning BC-sourced income. II. Fundamental Concepts: Deemed Disposition on Death and Mechanics of an Estate Freeze For income tax purposes, a taxpayer is generally deemed to have disposed of property owned immediately prior to death for proceeds equal to its prevailing fair market value (subject to rollover treatment on bequests to a surviving spouse or common-law partner or a trust settled for a spouse or common-law partner). 1 As a result of this deemed disposition, the taxpayer becomes taxable on any unrealized capital gains which have accrued on such property up to the time of death. In the context of an owner-manager of a private corporation, this deemed disposition can have significant consequences where the owner s shares are worth significantly more than the historical cost. The shares will frequently not be marketable and readily convertible into cash (as the shares will not be listed on a stock exchange) and there may be insufficient funds in the deceased s estate to fund the resulting income tax liability. Furthermore, any distribution of corporate funds by way of a subsequent redemption or repurchase of shares will have additional tax implications. The primary objective of an estate freeze is to limit the tax liability that arises on death by limiting the size of the owner s estate. Specifically, the owner s economic interest in his or her corporation is fixed or frozen at current values, with future corporate growth thereafter accruing to the holders of newly-issued common shares (who are often the owner s children, grandchildren or other heirs, or a trust established for their benefit). By undertaking the freeze, the gain triggered on the death of the freezor (or, in the case of a spousal or common-law partner rollover on the freezor s death, the death of the freezor s spouse or common-law partner) is limited to the unrealized gains which have accrued up to the time of undertaking the freeze. A. Internal Estate Freeze In the context of an owner-manager of a private corporation, an internal estate freeze would typically be undertaken as follows: 1. The freezor would exchange his or her common shares for newly-issued, fixed-value, nonparticipating preferred shares. The exchange would occur on a tax-free rollover basis under s. 51 or 86 (or, if the freezor wished to crystallize all or a portion of the accrued capital gain in respect of his or her common shares, by filing an election under s. 85 so as to designate specific proceeds of disposition). 2 The preferred shares must have the following qualities in order to comply with longstanding administrative positions of the CRA regarding estate freezes: 1 Sections 70(5) and 70(6) of the Act. 2 A s. 85 election might be filed to trigger a gain on the exchange if the owner has available capital losses to offset that gain or is able to utilize the capital gains exemption for qualified small business corporation shares, shares of a family farm corporation or shares of a qualified fishing corporation. The amount specified in the election determines the proceeds of disposition of the common shares and the cost of the preferred shares received in exchange therefor. The owner s cost of investment is bumped by the amount of the gain triggered so that a smaller taxable gain will be realized on a later disposition (or deemed disposition at death) of the preferred shares.

5 5.1.3 redeemable at the option of the holder; carry voting rights in respect of matters which pertain to such class of shares; have first preference on any distribution of assets of the issuing corporation on its liquidation, winding-up or dissolution; have no restriction on transferability (other than as is required by the governing corporate law); and restrict the issuing corporation from paying dividends on all other classes of shares if doing so would result in the corporation having insufficient assets available to pay the redemption amount on the preferred shares. 2. With all of the economic value of the corporation s shares now allocated to the redemption amount of the freezor s preferred shares, the common shares of the corporation should have nominal value. The freezor s children, grandchildren or other heirs (or a trust established for their benefit) can then subscribe for new common shares at a nominal subscription price. Gains accruing on the common shares after the freeze accrue to the freezor s heirs to be recognized when they dispose of the shares. As such, an estate freeze should be viewed as a mechanism to defer a portion of the tax that otherwise would have been payable on the freezor s death (i.e., because the freezor divests himself or herself of common shares to which ongoing growth in the equity value of the corporation will accrue). In effect, the tax on the future growth in value of the corporation s shares is deferred until the holder(s) of common shares dispose of such shares. Example: Death of Freezor freezor children P/S C/S FMV = 500,000 FMV = 250,000 ACB = 100 ACB = 10 Holdco A freezor implemented an internal estate freeze at an earlier time when the net asset value of Holdco was $500,000. At the time of the freeze, new common shares were issued from treasury to the freezor s children for a nominal amount (say $10). At the time of the freezor s subsequent death, the common shares are worth $250,000. Assuming the freezor does not bequeath shares to a surviving spouse or partner (or trust for such spouse or partner), there will be a deemed disposition of the freezor s preferred shares as a consequence of death and a capital gain of $499,900 is realized (giving rise to an income tax liability of approximately $110,000 if the effective tax rate on capital gains is 22%). However, the unrealized capital gain on the common shares owned by the freezor s children is not triggered, thereby deferring an additional tax liability of approximately $55,000. On the eventual disposition the common shares, that additional tax liability will be realized (although, to the extent that the common shares are owned by several children who are subject to lower marginal tax rates, the tax payable may be reduced).

6 B. External Estate Freeze There are a number of circumstances where an external freeze may be preferred (for example, where there are several owners of a corporation and only one is undertaking a freeze). In those circumstances, the freezor would exchange his or her common shares for newly-issued preferred shares of a holding corporation (which have similar rights and restrictions as the preferred shares discussed in step #1 of the internal estate freeze). The exchange could occur on a tax-free rollover basis by filing an election under s. 85. Common shares of the holding corporation would be held by the freezor s heirs (or a trust established for their benefit). Example: Mrs. F owns 100 common shares of Opco worth $500,000. Her cost of the common shares is $100. Mrs. F s cousin also owns 100 common shares. Mrs. F wishes to cap her economic interest in Opco so as to minimize tax consequences at death. Mrs. F has adult children who are her sole heirs. Mrs. F has no capital losses and her common shares do not qualify for any capital gains exemption. Mrs. F s cousin does not wish to undertake a similar freeze. Mrs. F transfers her common shares of Opco to a newly-formed holding corporation ( Holdco ) in consideration for non-participating preferred shares of Holdco with a fixed redemption amount of $500,000. An election is filed under section 85 so that Mrs. F is deemed to dispose of, and Holdco is deemed to acquire, the common shares for $100. Mrs. F s cost of the preferred shares becomes $100 (i.e., being the elected amount under section 85). Mrs. F s children subscribe for common shares of Holdco for $10. Mrs. F children preferred common Holdco cousin 100 C/S 100 C/S Opco

7 C. Freeze of Personally-Owned Assets A freeze may be similarly undertaken in respect of personally-owned capital property (or other select properties). In that case, the individual owner would transfer such property (for example, rental real estate) to the corporation in consideration for fixed-value preferred shares. To avoid realizing a gain in respect of such transfer, an election would be filed pursuant to section 85 of the Act. Common shares of the corporation would be separately issued to the freezor s heirs such that future growth in the property would accrue to such shareholders. III. Wasting Estate Freeze Although an estate freeze is primarily a technique for capping taxes at death, in certain circumstances it may be structured to reduce tax on death for the freezor. If, after the estate freeze, the freezor redeems his or her preferred shares received on the freeze so that there are fewer (or no) preferred shares remaining at the time of death, the freezor s income tax liability at death is consequently reduced because a smaller (or no) capital gain will be realized on the deemed disposition at death. The redemption, however, typically gives rise to a deemed dividend under s. 84(3) of the Act (given that the preferred shares normally have a nominal paid-up capital for tax purposes), which must be considered in determining the overall tax efficiency of the wasting freeze. The effectiveness of a wasting estate freeze is dependant upon the nature of the corporate earnings used to fund the redemption of the freezor s preferred shares. If the aggregate of the tax payable: by the CCPC on its corporate income, and the freezor on the deemed dividend arising on the redemption of preferred shares, approximates the amount of tax that the freezor would have otherwise paid if the income were earned directly by the freezor (or if it was paid out of the CCPC as a salary or bonus), then the redemption of preferred shares has the advantage of reducing the size of the freezor s estate with little or no extra tax costs. The overall result is the reduction of taxation at death. The following chart summarizes integrated tax rates as of January 1, 2011 for a top-rate individual taxpayer resident in BC who is a shareholder of CCPC that earns different types of income from sources within BC. ACTIVE BUSINESS INCOME UP TO $500,000 SPECIFIED INVESTMENT BUSINESS INCOME (& RDTOH REFUND) CAPITAL GAINS (& RDTOH REFUND) Corporate Income $1,000 $1,000 $1,000 Net Corporate Tax Redemption Proceeds Total Personal Tax Total Corporate and Personal Tax Personal Income 1,000 1,000 1,000 Personal Tax Benefit/(Penalty) $10 ($19) ($9) 3 Of the $910 shown, $500 could be distributed as a tax-free capital dividend. The $410 balance would be treated as a taxable dividend.

8 5.1.6 This chart shows that there is slight over-integration in respect of low rate active business income and reasonable (albeit imperfect) integration with other sources of income. This has not always been the case. Prior to the introduction of an enhanced dividend tax credit for eligible dividends (being taxable dividends paid from corporate retained earnings which are derived from active business income taxed at the ordinary corporate tax rate), there were significant costs associated with earning high rate active business income and then paying dividends (or, in the case of a redemption of shares, deemed dividends) to shareholders. This has been largely remedied with the introduction of the enhanced dividend tax credit, although disintegration can still apply in certain circumstances. Generally, a wasting estate freeze is most effective in respect of a CCPC earning specified investment income. This requires an understanding of the refundable dividend tax on hand ( RDTOH ) concept. To prevent individual taxpayers from deferring tax on investment income earned through a CCPC, the Act initially imposes a high corporate tax rate (44.7%) on such income, which is intended to approximate the top marginal tax rate for individual taxpayers (43.7%). However, upon paying (or deeming to pay) taxable dividends to its shareholders, the CCPC is entitled to a refund of over half of the corporate tax (so that the effective corporate tax rate decreases to 18%). Of course, the recipient shareholder is subject to tax on the taxable dividend. The amount of the corporate tax refund is determined by the RDTOH mechanism. For each dollar of specified investment income earned by the CCPC, RDTOH is refunded at a rate of $1 for every $3 of dividends paid. This refund rate is designed to approximate the top marginal tax rate applicable to dividends, which is currently 33.7%. Accordingly, RDTOH can be thought of as the prepayment of tax by a CCPC on behalf of the individual shareholder. But for this regime, there would be great incentive to incorporate an asset which produces investment income. Instead, this RDTOH regime largely achieves its goal of making such incorporation tax neutral. Specified Investment Income CCPC 44.67% (26.67%) 18.00% Dividen Individual Total Tax 44.67% (26.67%) 18.00% 27.64% 45 64% Investment Income Individual 43.7%

9 5.1.7 The following integration chart is an expanded version of the previous chart as it applies to specified investment income earned through a CCPC and shows how the RDTOH refund mechanism works. SPECIFIED INVESTMENT INCOME AND RDTOH REFUND CAPITAL GAINS AND RDTOH REFUND Income $1,000 $1,000 Initial Corporate Tax RDTOH (267) (133) Net Corporate Tax Redemption Proceeds Total Personal Tax Total Corporate and Personal Tax It is worth noting that the RDTOH refund to the CCPC is approximately equal to the personal tax payable by the recipient shareholder on the dividend. Accordingly, there is no significant disincentive to trigger the refund of RDTOH by way of the payment (or, in the case of a redemption of shares, the deemed payment) of taxable dividends. As earlier noted, a redemption of shares has the ancillary benefit of reducing the size of the freezor s estate (and thereby reducing the tax consequences arising on the freezor s death). Notwithstanding that a wasting estate freeze is most effective when a CCPC earns specified investment income, there may be other circumstances when it is equally appropriate. For example, if a freezor is otherwise receiving salary from the frozen corporation (in order to finance personal expenditures) and is prepared to forego salary in consideration for redemption proceeds, 4 a wasting freeze may also be effective to reduce taxation otherwise arising on death, especially where the corporation is earning active business income to which it is entitled to the small business deduction. Furthermore, where a CCPC earns both specified investment income and high rate active business income (the latter of which is credited to the corporation s general rate income pool, or GRIP for short), then the CCPC can designate its taxable dividends paid (or deemed to be paid) as eligible dividends so as to reduce personal taxation (while concurrently triggering the RDTOH refund). In effect, this accelerates the personal tax savings in respect of GRIP. 4 This strategy may result in a reduced entitlement to make RRSP contributions where the freezor foregoes salary in consideration for the redemption of shares. This is because salary qualifies as earned income for RRSP purposes while dividends do not.

10 5.1.8 Example: Wasting Estate Freeze Joe s preferred shares of ABC Ltd. are worth $500,000 in aggregate and have a total paid-up capital and adjusted cost base of $100. ABC Ltd. earns $100,000 of specified investment income, which is subject to an initial corporate tax of approximately $44,670 (44.67%). ABC Ltd. uses the after-tax investment proceeds (including the corporate tax refund on the deemed payment of dividends) to redeem some of Joe s preferred shares with a total redemption amount of $82,000. The redemption gives rise to a deemed dividend of approximately the same amount (given the nominal paid-up capital of the preferred shares). If Joe is subject to tax at the highest marginal rate, his personal tax on the deemed dividend will be approximately $27,634 (33.7%). Concurrently, ABC Ltd. will be entitled to a refund under subsection 129(1) equal to $26,666. The corporate tax refund (which could be assigned to Joe in part payment of the redemption price) approximates the personal tax payable by Joe on the deemed dividend arising from the redemption of his preferred shares. It is important to note that the tax advantages associated with a wasting estate freeze will be undermined if the holders of the common shares of the frozen corporation (typically the freezor s heirs) sell their common shares shortly after the freezor s death. By doing so, accrued capital gains (i.e., on the common shares) which were not realized on the freezor s death are triggered, giving rise to further income tax liability. This is amplified later. IV. Indirect Gift Rules and Price Adjustment Clauses Estate freezes normally involve the issuance of fixed-value preferred shares for common shares of the corporation or for assets transferred to the corporation. These transfers can normally be done on a tax-free basis under the rollover provisions in ss. 51(1), 85(1), 86(1) and 87(4). However, there are indirect gift rules in ss. 51(2), 85(1)(e.2), 86(2) and 87(4) which provide that if the property that is to be frozen is valued too low, and it is reasonable to regard that the freezor desired to confer a benefit on a related person, then the rollover can be undermined in whole or in part. If there is no attempt to complete a proper freeze and common shares are issued to family members at a bargain, then the existing shareholders who waived their pre-emptive right to acquire the new shares at a bargain could be taxed on the basis that they disposed of an economic interest in the company. Further, if a spouse or common-law partner of a shareholder acquires new shares at a bargain, then the normal attribution rules could apply to the shareholder. Concerns regarding the indirect gift rules are commonly addressed using reasonable valuations and price adjustment clauses, in addition to ensuring that the freeze shares have appropriate rights and restrictions. In Interpretation Bulletin IT-169, the CRA states that each of the following conditions must be met before it will accept a price adjustment clause: the agreement reflects a bona fide intention of the parties to transfer the property at fair market value and arrives at that value for the purposes of the agreement by a fair and reasonable method; each of the parties notifies the CRA by a letter attached to the party s tax return for the year in which the property was transferred that:

11 5.1.9 i. the parties are prepared to have the price in the agreement reviewed by the CRA pursuant to the agreement; ii. the parties will take the necessary steps to make any adjustment; and iii. a copy of the agreement will be filed with CRA if demanded; and any required adjustment is actually made. Further, the parties must agree that, if the CRA s value is different from theirs, they will use the CRA s value in their transaction. The CRA s position on price adjustment clauses is not sustainable and few tax practitioners follow it. For instance, most price adjustment clauses do not automatically adopt the CRA s determination of value and most practitioners do not formally advise the CRA of the existence of price adjustment clauses. The CRA s position reflects the notion that price adjustment clauses are an administrative concession on its part. This may arise from a misunderstanding of the Federal Court of Appeal decision in Guilder News Co. (1963) Ltd. v. MNR, 73 D.T.C (F.C.A.), aff g 72 D.T.C (F.C.T.D.). In that case, a price adjustment clause was ignored because the parties had not reasonably and in good faith attempted to determine the value of the property. However, the decision implies that the courts will accept the validity of a price adjustment clause where a bona fide effort has been made to determine a value. V. Estate Freezes: When To Do It It makes sense to consider estate freezes in terms of 21 year intervals based on the following four-step analysis: For a variety of compelling reasons (as amplified later), it rarely makes sense to issue common shares directly to children. Those shares should generally be issued to a family trust. An inter vivos family trust is generally subject to a deemed realization of its assets every 21 years. However, a family trust can generally transfer its property to Canadian-resident beneficiaries on a tax-deferred basis (in satisfaction of their capital interests in the trust) pursuant to s. 107(2). The recipient beneficiaries acquire such property at a cost equal to the trust s historical cost. By issuing common shares as a part of an estate freeze to a family trust, rather than directly to family members, the ultimate decision about who should actually own those shares can be effectively deferred for 21 years. Accordingly, a good rule of thumb for determining whether a freezor is too young to undertake an estate freeze is to add 21 years to the age of the freezor's youngest heir (for example, a child). For example, if the freezor's youngest child is two years old, then absent other persuasive reasons (like facilitating income-splitting on a future sale of the frozen corporation) it may be premature to implement a freeze. VI. Estate Freezes: When Not To Do It The greater the likelihood that the frozen assets will be sold prior to the death of the freezor or shortly after the death of the freezor, the more likely that an estate freeze should not be undertaken. Principal factors to be taken into account include the following:

12 The greater the financial need of the freezor s children and other heirs, the more likely that the frozen assets will be disposed of before or shortly after the freezor s death. For example, it would generally make sense for an impecunious child to liquidate the freeze in order to pay down a mortgage on a principal residence given that interest payable on a mortgage used to acquire a principal residence is not deductible. The greater the disharmony among the children and other heirs, the more likely that the frozen assets will be disposed of before or shortly after the freezor s death. Non-resident children or other heirs can complicate the tax planning related to an estate freeze (especially when they reside in, or are citizens of, the US). This is not to say that an estate freeze should never be done in these circumstances, but rather that careful consideration of all Canadian and foreign tax implications must first be undertaken. Furthermore, the nature of the freezor s assets might suggest that an estate freeze should not be undertaken. For example, it generally does not make sense to freeze an asset that wastes in value, such as a leasehold interest in real estate. VII. Benefits and Risks and Utilization of a Trust While the principle benefit of an estate freeze may be the reduction of income tax payable on death of the freezer (or, in the case of a rollover, on the later death of his or her spouse or common-law partner), other significant benefits include the following: allowing the freezor s heirs to acquire an equity interest in closely-held corporation for a nominal investment, thereby facilitating a smooth inter-generational succession; reducing estate duties and probate fees by capping the size of the freezor s estate; and providing a means of income-splitting with adult children or other heirs in respect of future earnings generated from the corporation s business and/or capital gains realized on any subsequent disposition (or, in the case of death of a shareholder, the deemed disposition) of the shares of the corporation. 5 However, there are also risks associated with an estate freeze where new common shares are issued directly to the freezor s children or other heirs. The most significant risks include the following: the freezor relinquishes at least some control over the corporation as a result of the introduction of new shareholders (since, as a matter of corporate law, even non-voting shareholders have rights in respect of the administration of the corporation and dealings with respect to shares of various classes) 6 ; the holders of newly issued common shares (who are commonly the freezor s children or other heirs) acquire direct economic and legal interests in the corporation which 5 This can be particularly advantageous where the shares are eligible for the $750,000 capital gains exemption for qualified small business corporation shares, shares of a family farm corporation or shares of a qualified fishing corporation. 6 Rights which vest in a shareholder under corporate law include the right to contest the manner in which the corporation is being managed where the affairs are conducted in a manner that is oppressive to a particular shareholder, or where there has been an act that is unfairly prejudicial to the particular shareholder. In some circumstances, a dissenting shareholder may apply to court for an order that it would be just and equitable to wind-up the corporation. Whether conduct is oppressive or unfairly prejudicial to a particular shareholder is a highly fact-dependent determination which can lead to considerable uncertainty in the ongoing management of the corporation.

13 may not be freely alterable in the event of significant changes of circumstances (e.g., health problems, drug dependencies, mental breakdowns, marital breakdowns, etc.); the freezor may suffer from a lack of financial resources in the future when a nonreversible freeze is undertaken prematurely (especially if the freezor incurs unforeseen liabilities after the freeze, such as unexpected medical costs); taxable gains may be prematurely realized on an unanticipated death of one or more heirs prior to the death of the freezor; and adverse corporate attribution 7 can arise where the beneficiaries of the freeze are the freezor s spouse or common-law partner, or the freezor s minor issue, nieces or nephews. These risks can be managed by introducing a trust as part of the estate freeze. Specifically, a trust could be created in order to hold the common shares which would otherwise be issued to the freezor s children, grandchildren or other heirs. Some of the principal advantages are noted below. A. Asset Management and Control A discretionary trust can be a very convenient vehicle through which dividends on the common shares, and gains ultimately realized on the sale of the common shares, can be distributed amongst one or more of the beneficiaries on a discretionary basis, while the freezor (in his or her capacity as a trustee or co-trustee) can retain control over the shares. Since the beneficiaries do not directly own shares, their economic entitlements are not fixed and can be reconsidered from time to time as circumstances dictate. Furthermore, oppression rights of a disgruntled beneficiary are significantly restricted since he or she is not a shareholder of the corporation. B. Multiplying Capital Gains Exemptions If it is anticipated that the common shares of the frozen corporation would qualify for a capital gains exemption (for example, because they will be qualified small business corporation shares), holding such shares in a discretionary trust can provide an opportunity to maximize the capital gains exemptions without diluting share ownership among numerous family members. On a subsequent sale of the common shares, the trust can make a designation under s. 104(21.2) in order to allocate the resulting capital gain among the beneficiaries (so that they, in turn, can claim their respective capital gains exemptions). C. Thawing a Freeze An estate freeze can be effectively thawed (i.e., reversed) by having the common shares of the frozen corporation issued to a discretionary trust of which the freezor is (or may be subsequently appointed as) a beneficiary. In such circumstances, the freeze may be thawed if the trustee subsequently exercises his or her discretion to distribute income or capital from the trust to the freezor (as one of the beneficiaries of the trust). The CRA considered this type of reversible freeze in question 22 of the 1990 Revenue Canada Round Table and concluded that the fact that a discretionary trust was formed as part of an estate freeze (of which the freezor was a beneficiary) would generally not, in and of itself, result in the application of the general anti-avoidance rule. 8 The CRA did, however, refer to the 7 Section 74.4(2) of the Act. 8 It seems highly unlikely that the CRA would be able to successfully assert GAAR in the context of a properly implemented estate freeze in favour of a discretionary trust of which the freezor is one of the beneficiaries.

14 possible application of the indirect payment rule in s. 56(2), the attribution rules and the indirect gift rule found in s. 86(2). Practically speaking, those additional risks can be adequately addressed if the trust is carefully settled and managed. However, if the freezor is both a beneficiary and trustee of a discretionary trust, an inherent conflict of interest could arise. While this alone would not undermine the validity of the trust, it could give rise to trust law complications (including the possibility that the other beneficiaries could seek to challenge the manner in which the trustee s discretion is exercised). To mitigate against that risk, it is generally advisable for an independent third person to be appointed as a co-trustee and stipulate that the trustees only act with unanimous approval (or in the case of multiple independent trustees, by way of a majority consent). D. Minimizing Tax Consequences on Death In respect of the value of a beneficiary s discretionary interest in a trust, practitioners have generally adopted the position (based on long established case law) that such discretionary interest is of nominal value at the time of death of the beneficiary. This position has been acknowledged by the CRA in an unbinding technical interpretation. 9 The CRA has, however, more recently suggested that significant value may be attributed to an interest in the discretionary trust in certain circumstances. 10 Specifically, in the absence of any term of the trust that would direct the trustees to favour one beneficiary over another, the CRA was of the view that the even-handed principle would suggest that the value of each beneficiary s interest was approximately equal. The CRA comments were premised on a court decision which valued a husband s capital interest in a discretionary trust in a pro rata manner for the purposes of a matrimonial division of property under the Ontario Family Law Act (notwithstanding that the court specifically acknowledged that such a pro rata valuation was incongruent with trust law). 11 In rendering its decision, the court was undoubtedly swayed by the underlying principle that, for family law purposes in Ontario, division was predicated on a fair and equitable split of assets between spouses. The applicability of such an appraisal method in determining the value of a beneficiary s discretionary interest in other circumstances is questionable. For absolute certainty, a formal appraisal from a qualified appraiser should be obtained. E. Avoiding Corporate Attribution Utilization of a trust as part of an estate freeze may mitigate against the application of the corporate attribution rule found in s. 74.4(2). Generally stated, the corporate attribution rule can apply where property (for example, common shares) are transferred to a corporation and one of the main purposes for the transfer was to reduce the income of the freezor and to benefit (either directly or indirectly through a trust) a designated person who owns, or is deemed to own, 10% or more of the shares of any class of capital stock of the corporation. 12 In the context of an estate freeze, designated persons include the freezor s spouse or common-law partner, and the freezor s issue, nieces and nephews who 9 Technical Interpretation # (September 1, 1992). 10 Technical Interpretations # (November 27, 2002) and # (April 3, 2003). 11 Sagl v. Sagl, [1997] O.J. No (Ont. Gen. Div.). 12 The corporate attribution rule only applies while the freezor is resident in Canada and the corporation is not a small business corporation (being a corporation where at least 90% of its gross asset value is attributable to active business assets). Where the corporate attribution rule applies, the freezor is deemed to have received a taxable interest benefit each year computed by reference to the prescribed rate under the Act, less 125% of non-eligible taxable dividends (and 145% of eligible dividends) but not deemed dividends received by the freezor in the year on the preferred shares.

15 are under 18 years of age. The corporate attribution rule will not apply to an estate freeze if the new common shares are issued to a trust established for the benefit of one or more designated persons where: the only interest that each designated person has in the corporation is held through the trust; by the terms of the trust, a designated person may not receive or obtain any use of the income or capital of the trust while he or she is a designated person in respect of the freezor 13 ; and the trust is administered in accordance with its terms and no deductions are made under s. 104(6) or (12) in computing the trust s income on account of amounts paid or payable to a designated person. 14 A trust that satisfies these conditions is extremely useful in undertaking an estate freeze where the freezor wishes to include minor children, grandchildren or other issue as part of the group which benefit from the future growth in the frozen corporation. F. 21 Year Rule A trust is generally deemed to have disposed of its property every 21 years for proceeds of disposition equal to the prevailing fair market value of such property (i.e., so that accrued gains are then realized and taxable). To avoid this deemed disposition, the terms of the trust should permit the distribution of trust property (e.g., common shares of a frozen corporation) to one or more beneficiaries of the trust on the eve of the 21 st anniversary. If properly structured, such distribution will occur on a rollover basis under s. 107(2) so that the realization of taxable gains is deferred until such time that the recipient beneficiary disposes of such property. While beyond the scope of this paper, there are a number of other strategies that can be considered to address the 21 year problem where there is a reluctance to distribute trust property directly to the beneficiaries. VIII. Refreezing If there has been a devaluation of a frozen corporation s assets or going concern value after a freeze, it is possible that the value of preferred shares issued in connection with the freeze have a redemption amount that is significantly greater than the current net asset value of the corporation. To accelerate the benefits which are intended to be conferred to the benefactors of the freeze (i.e., the freezees), a refreeze should be considered whereby the preferred shares are exchanged for new preferred shares having a reduced redemption amount. For many years, the CRA took the position that refreezes (i.e., exchanging preferred shares which have a redemption amount in excess of their fair market value for preferred shares which have a lower redemption amount) could not be accomplished without adverse tax consequences. There was no logical basis for this position and it has since been abandoned: see Technical Interpretations # (June 3, 1997) and # (November 17, 2000). So long as the decrease in value of the preferred shares does not arise as a consequence of the stripping out of corporate assets (for example, paying dividends on other shares), the CRA has confirmed that a benefit would not ordinarily be conferred on the common shareholders or preferred shareholders on the re-freeze. 13 In the case of a child, niece or nephew or other issue, he or she ceases to be a designated person in respect of the freezor upon attaining the age of 18 years. 14 Section 74.4(4).

16 IX. Tax Implications at Death A. Avoiding Double Taxation: Section 164(6) The potential for double taxation arises when the deceased freezor s preferred shares are redeemed after death by his or her estate. To the extent that the redemption price exceeds the paid-up capital of the redeemed shares, the deceased s estate will realize a deemed dividend which is subject to tax in the hands of the estate (notwithstanding that the deceased may have also realized a capital gain on the deemed disposition of the same shares immediately prior to his or her death). The estate will concurrently realize a capital loss on the redemption equal to the difference between the estate s cost of the shares (being equal to the deceased s deemed proceeds of disposition) and the paid-up capital of the shares (which is frequently nominal). The Act recognizes the potential for double taxation and provides a limited solution by permitting a deceased s estate to make an election under s. 164(6) in respect of the disposition of the shares on redemption by the estate. By making the election, the capital loss realized by the estate on the redemption of shares can be carried back to the deceased s last taxation year (i.e., for the year of death) and offset against the capital gain realized by the deceased on such shares. The net result is that tax is only paid by the estate on the deemed dividend arising on the redemption. The s. 164(6) election can only be made in respect of a capital loss arising in the first taxation year of the estate. Therefore, the redemption of shares or wind up of the company must occur in the estate s first year. The election must be filed before the earlier of the dates specified in Regulation 1000(2) A late election may be filed with the consent of the Minister of National Revenue on payment of a penalty of $100 per month that the election is late, to a maximum of $8,000: see ss. 220(3.2), (3.3) and (3.5) and Regulation 600(b).

17 Example: Avoiding Double Taxation on Death Assume: 1. the deceased died without a surviving spouse; 2. the deceased owner was at the top marginal tax rate (say 44%); 3. no capital gains exemptions or losses are available; 4. the deceased died owning preferred shares having a fair market value of $1,000,000 immediately before death; 5. the paid-up capital and adjusted cost base of the preferred shares was nominal (assume nil); and 6. dividends and capital gains are taxed at rates of 33% and 22%, respectively. On death, the owner would realize a capital gain of $1 million, or a $500,000 taxable capital gain. This would result in a personal tax liability of $220,000. The estate would have an adjusted cost base for the shares of $1,000,000 but the shares would continue to have nil paid-up capital. Therefore, if the shares were subsequently redeemed by the estate for $1,000,000, the estate would be taxed on a deemed dividend of $1 million (being the difference between the redemption proceeds and the paid-up capital of the shares) which would result in tax payable by the estate of about $330,000. The estate would also realize a capital loss of $1 million 16 on the redemption of the shares by virtue of their high cost base. In the absence of s. 164(6), the estate s capital loss could not offset the deceased owner s capital gain realized at death. The result would be that aggregate tax of $550,000 would be payable on shares having a gain on the deceased s death of only $1 million. This result is easily avoided by making the s. 164(6) election, with the result that the estate s capital loss offsets the deceased s capital gain, leaving only the tax on the deemed dividend ($330,000). B. Section 40(3.6) Section 40(3.6) is a stop-loss rule that denies a capital loss otherwise arising on a redemption of shares of a corporation that is affiliated with the redeeming shareholder immediately after the redemption. 17 It historically presented a potential trap that could prevent the recognition of a capital loss by an estate on the redemption of shares received from a deceased freezor, and thereby result in double taxation. That potential trap was removed with the introduction of s. 40(3.61). Pursuant to s. 40(3.61), the stoploss rule in s. 40(3.6) does not apply to an estate s loss arising from a s. 164(6) election. 16 The capital loss may be denied if the stop-loss rules in s. 112(3.2) applied (as discussed below). 17 Affiliated persons are defined in s

18 C. Forego Redemption In light of reductions in the capital gains tax rates, tax on capital gains is generally less than tax on dividends. 18 Accordingly, a deceased s estate may consider foregoing a redemption of shares so as to avoid greater taxation on the deemed dividends that would be triggered on that redemption. Instead, the deceased s estate (or the beneficiaries thereof, if the shares have been distributed from the estate) could transfer the shares to a holding company in exchange for a promissory note (which, subject to s. 84.1, would not be a taxable transaction), with the shares thereafter being redeemed from the holding company. The redemption proceeds could be distributed to the holding company as an inter-corporate tax-free dividend, and the promissory note then repaid with the redemption proceeds without further tax consequences. This is commonly referred to as the pipeline method and is illustrated in Scenario 1 of the following example. However, as illustrated by Scenario 2 of the following example, the tax advantages sought by such a post-mortem transfer of the deceased s shares to a holding company can be undermined by s where the deceased has claimed his or her capital gains exemption on a earlier disposition or deemed disposition of the shares (or shares for which the shares were substituted) or the cost of the shares (or shares for which the shares were substituted) is based, in whole or in part, on a V-day value. 20 The most tax efficient post-mortem plan will depend on a number of factors, including: Whether the subject corporation has significant refundable dividend tax on hand ( RDTOH ) at the time of death of the deceased shareholder or, in the event of an anticipated sale of corporate assets, in the foreseeable future. Whether the subject corporation has a significant balance in its capital dividend account ( CDA ), either at the time of death or in the foreseeable future (again, due to an anticipated sale of capital assets in the corporation or as a result of the receipt of life insurance proceeds, as discussed in the next section). Whether the shares owned by the deceased shareholder are eligible for the capital gains exemption. The optimal post-mortem plan will wholly depend on the particular facts and circumstances at hand. 18 Due to the dividend tax credit, low-rate taxpayers may have less tax on dividend income compared to capital gains. 19 If applicable, s can deem non-share consideration realized on such an exchange to be recharacterized as dividends. 20 Generally speaking, the V-day value is the fair market value of the shares at December 31, 1971 (being immediately before the implementation of capital gains taxation under the Act).

19 Example: Post-Death Transfer to a Holding Company Mary owns preferred shares of XYZ Ltd. worth $500,000. The shares have a nominal adjusted cost base and paid-up capital (say $1). On death, Mary realizes proceeds of disposition from the deemed disposition of her shares of $500,000 (assuming no spousal rollover) and her estate acquires the shares at a cost of $500,000 (but still nominal paid-up capital). Assume the preferred shares qualify for Mary s $500,000 capital gains exemption for qualified small business corporation shares and, after Mary s death, her estate transfers the shares to a newly-formed holding company ( Holdco ) for a $500,000 promissory note. Scenario 1: Mary does not claim her capital gains exemption. Mary would realize a capital gain of $499,999 on the deemed disposition of her preferred shares immediately prior to her death. Assuming a 22% tax rate, her tax liability would be approximately $110,000. When her estate subsequently transfers the shares to Holdco for a $500,000 promissory note, the estate realizes no capital gain (or dividend under section 84.1). On the subsequent redemption of the shares by XYZ Ltd., an inter-corporate tax-free dividend of $499,999 would be payable to Holdco. Holdco could use the redemption proceeds to pay off the $500,000 note due to Mary s estate without further tax consequences. Overall, the only tax paid is the $110,000 capital gains tax payable by Mary. Scenario 2: Mary claims her $500,000 capital gains exemption. The capital gain realized by Mary on the deemed disposition of her preferred shares is fully sheltered from tax by virtue of claiming Mary s capital gains exemption. However, when her estate transfers the shares to Holdco for a $500,000 promissory note, the estate would be deemed to have received a $499,999 taxable dividend from Holdco under ss. 84.1(1)(b) and 84.1(2)(a.1) if Holdco was connected with XYZ Ltd. immediately after the transfer. While the subsequent redemption of the shares by XYZ Ltd. would give rise to an intercorporate tax-free dividend to Holdco which could, in turn, be used to pay off the promissory note due to Mary s estate without further taxation, the estate s overall tax liability would be approximately $168,500 (assuming a 33.7% tax rate on the dividend). D. Life Insurance Funded Capital Dividends Life insurance is commonly used to finance an insured deceased s tax liability at death. Prior to April 27, 1995, the use of corporate-owned life insurance provided an opportunity to eliminate the tax payable both on the deemed disposition of the shares of a deceased owner and on the redemption proceeds subsequently received by the estate. After April 26, 1995, the tax advantages associated with corporate-owned life insurance is more modest (subject to significant grandfathering treatment, as discussed below).

20 Insurance proceeds received by a private company (net of the adjusted cost basis 21 of the policy immediately before the insured person s death) are added to the company's capital dividend account. If the appropriate election is made, 22 the redemption proceeds can then be treated as a capital dividend and distributed to the estate on a tax-free basis. Prior to April 27, 1995, the estate would concurrently realize a capital loss on the redemption of the shares which could be carried back to the deceased owner's terminal taxation year pursuant to s. 164(6) to offset the capital gain realized on the deemed disposition at death. As a consequence, no tax was payable by either the deceased owner or the estate. In effect, the tax on death was deferred through the use of corporate-owned life insurance. As the remaining shareholders did not receive any increase in the cost base of their shares, they essentially inherited the tax liability of the deceased shareholder since the value of their shares was enhanced (by funding the redemption of the deceased s shares with tax-free life insurance proceeds) without any increase in the cost of such shares. In that regard, it should be noted that, in determining the deemed proceeds of disposition of the deceased s shares at death, the fair market value of any life insurance policy owned by the corporation is deemed to be the cash surrender value of the policy (being nil in the case of a term life insurance policy) pursuant to s. 70(5.3) of the Act. Historically, corporate-owned life insurance was an excellent tool for family succession because, where the insurance was used to buy out a parent and the remaining shareholders were the children, the obligation to pay tax on the parents deemed disposition on death was deferred until either the children disposed of their shares or died. The surviving shareholders could arrange to defer the tax arising on their deaths if they set up a similar arrangement insuring their lives with corporate-owned life insurance. This tax deferral opportunity was significantly curtailed when s. 112 was amended with general effect after April 26, As amended, the stop-loss rules in s. 112(3), (3.1) and (3.2) can apply to reduce the capital loss otherwise arising on a disposition of shares by individuals, partnerships and trusts (including estates) by the amount of tax-free capital dividends received on such shares. 23 Applied to life insurance-funded redemptions, 50% of the capital loss that would otherwise be realized by the deceased s estate is denied. As such, only half of the loss would be available to carryback (i.e., by filing a s. 164(6) election) to apply against capital gains realized on the deceased s death. The stop-loss rules in s. 112(3), (3.1) and (3.2) are all subject to detailed grandfathering rules for plans or policies in existence on April 26, The grandfathering rules can be summarized in the following table. 21 The adjusted cost basis of a policyholder s interest in a life insurance policy is defined in s. 148(9) of the Act. By way of over-simplification, it is the aggregate premiums paid by the policyholder less the net cost of pure insurance (determined by reference in rules in Regulation 308) and any outstanding policy loans. 22 The election is due to be filed before the capital dividends are paid and must be in respect of the entire dividend: see s. 83(2). 23 The stop-loss rule would not apply where: 1. the vendor owned the shares throughout the 365 days preceding the disposition; and 2. the vendor and persons with whom the transferor does not deal with at arm s length did not own more than 5% of the shares of any class.