Best Practices And Tax Planning Essentials
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The concept of corporate and personal tax planning over the last 10 years has become more complicated as the Canada Revenue Agency (CRA) continues to take steps to prevent avoidance of tax by taxpayers. Violation of the Income Tax Act can be triggered by taxpayers even in cases where there was no intent to avoid tax; unfortunately, however, such violations, albeit unintentional, may still result in expensive tax penalties imposed by the CRA
For this reason, it is very important that corporate shareholders and/or personal taxpayers understand the legitimate corporate and personal tax planning opportunities available to them so that corporate and personal financial and tax affairs can be structured in a tax efficient manner. At Burgess Kilpatrick, with effective personal and corporate tax planning strategies, you can secure financial order.
I have included here explanations of various corporate and personal planning opportunities that, depending on your situation, may result in tax savings compared to what one otherwise would have to pay if no tax planning preparations are undertaken.
We start with the situation of the family-owned business, where there exist several opportunities within the Income Tax Act to plan for the following:
- Transfer of wealth to the next generation
- Minimize tax exposure
THE CLASSIC ESTATE FREEZE
One strategy that is critical to business succession and that is invariably found in any carefully considered tax plan is the estate freeze. This concept allows for the succession of the future growth of the business from the owner-manager to the next generation. The concept also allows the owner-manager to bring children into the corporate structure without adverse tax consequences.
In a typical estate freeze, the children will subscribe for a new class of voting shares within the company (the growth shares), and the shares held by the owner-manager will be rolled over to a special “preferred” class of shares utilizing subsection 85(1) of the Income Tax Act. These preferred shares will retain their original cost, but can be redeemed for proceeds equal to their value at the time when they were rolled over. Although available for redemption at any time, these shares are normally redeemed only when there is sufficient cash within the company to warrant the redemption. Tax is payable only when the shares are redeemed and the owner receives the cash or similar personal benefit.
Additionally, with the use of a discretionary trust, this strategy allows the owner-manager to effectively retain control of the corporation while providing for multiplication of the Capital Gains Exemption to the beneficiaries of the trust (ie: where the growth shares are retained by the trust). It is one of the most feasible tax planning strategies for companies.
The following diagram illustrates this plan:
BEFORE
AFTER
In the before diagram, there was no provision for the owner-manager to be able to pass down ownership of the corporation to the children. In addition, if the owner wanted to take money out of the company, either as salary or as dividends, the amounts withdrawn would be subject to his/her marginal rates. In the after diagram, a freeze of the owner’s shares can be enacted, thereby passing on any future growth of the company to the children. The discretionary trust provides the added benefits of Capital Gains Exemption multiplication and protection of assets, since creditors are unable to penetrate the trust to retrieve value from the assets held within it. For more such viable tax planning strategies for small businesses or new business, feel free to reach out to us.
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REORGANIZING TO SPLIT INCOME
When an individual incorporates a business, the primary intention is to work as hard as possible to earn enough money to pay the bills. Hopefully, that effort will pay off and wealth will accumulate in the corporation. The preferred corporate tax rates in Canada allow income retained in the corporation to be taxed at a substantially lower rate than if it was taken out as a salary or dividends by the owner.
However, the issue now becomes how to take that wealth out of the company tax efficiently. The Income Tax Act allows the business owner to reorganize the corporate structure so that the owner can pass income and/or dividends to the spouse and children which is then taxed at their individual personal rates (assuming the children are over the age of 18). In the case of dividends, this is referred to as “dividend sprinkling”. The main planning issues related to such an income splitting arrangement are that:
- The owner must retain access to the Capital Gains Exemption
- There is provision to allocate inter-corporate dividends within the corporate structure.
In the preceding diagram, the owner has reorganized the corporate structure to include a holding company (Holdco), which allows dividends to be passed from Opco up to Holdco and then sprinkled out to the spouse and children at their respective personal tax rates. If the spouse and children are to be paid salary, then the Income Tax Act stipulates that a reciprocal amount of work must be performed to earn that salary. By maintaining the discretionary trust in the corporate structure (discretionary meaning that the owner/trustee has discretion as to how funds within the trust are allocated), there is provision to move non-business assets up to the trust and protect them from creditors.
MAXIMIZING THE CAPITAL GAINS EXEMPTION AND TAX PLANNING OBJECTIVES
A comprehensive tax plan will normally involve the following:
- Maximization of the Capital Gains Exemption.
- Ability to split income.
- Facilitate the movement of inter-corporate dividends.
- Separation of business vs. non-business assets to maintain qualified small business corporation (QSBC) status and protect against legal and creditor actions.
- Transfer of wealth.
- Estate planning and tax minimization on death.
Most business owners will concentrate on reorganizing tactics that will minimize their tax liability, either now or in the future. A main consideration in business succession planning is whether or not the business will remain within the family (ie: will the children want to take over the business). If not, tax planning takes on a different set of issues.
If not remaining within the family, the owner will want to make sure that the business is eligible for the Capital Gains Exemption upon the sale. This exemption is available to individuals only and is available on the sale of qualified farm property and upon the sale of shares of Canadian qualifying small business corporations (QSBC’s). Planning must be undertaken in order to ensure that the business establishes and maintains this qualification. At Burgess Kilpatrick, we offer expert tax advice Canada for such companies as well also in order to qualify, the business must meet the following:
- At the time of the sale, at least 90% of the assets held by the business must be used to earn business income
- During the 24 month period prior to the sale, at least 50% of the assets held by the business must have been used to earn business income.
Achieving and maintaining this criteria over the critical 24 month period becomes important when the business contains excess cash from operations. Cash reserves invested in fixed investments, for example, will not qualify under the business use criteria and may disqualify the business from the Exemption. Real estate investments paid for with business profits and held in the corporations name will also disqualify the business from the Exemption if the fair market value of the real estate is in excess of 50%/10% of the fair market value of the assets held by the business.
Meeting the criteria for the Capital Gains Exemption becomes a priority issue when the business begins to retain excess profits that are not re-invested into operations, either because such re-investment is unnecessary or because the owner-manager wants to retain a financial buffer to protect against future seasonal business fluctuations.
The importance of maintaining eligibility for the Capital Gains Exemption is heightened by the fact that the corporate structure can be situated to multiply the Exemption to in order to further minimize the tax liability upon sale.
For example, if the above diagram was altered slightly as follows:
The diagram is altered only to include the owner-manager as an additional shareholder in Opco. With this arrangement, when the shares of the business are sold, and assuming that these shares meet the criteria of qualified small business corporation shares, the shares owned by the owner-manager and by the trust will all be eligible for the Capital gains Exemption. Even though a trust is considered to be a separate entity, amounts flowing to each beneficiary up to the Exemption limit of $750,000 will be eligible for the Capital Gains Exemption.
This arrangement facilitates the maximization of the Capital Gains Exemption upon the sale of the business, although it must be noted that, since the Exemption is a one-time provision, the beneficiaries will not be able to use this exemption again. This is usually not a problem because great importance can be placed on the ability to take advantage of this tax saving when it is available (ie: there is always the possibility that this Exemption can be cancelled via legislation).
Having the Holdco in place in the corporate structure enables the “purification” of Opco by facilitating the transfer to Holdco of assets unnecessary to the operation of Opco and thereby maintaining qualified small business corporation status. The existence of Holdco also provides for the income splitting mechanism by allocating dividends through Holdco to its respective shareholders. Burgess Kilpatrick takes pride in offering such exemplary tax planning strategies for small businesses that would help shape your finances and keep your business afloat.
REORGANIZING THE BUSINESS STRUCTURE
When an owner-manager has been operating and building a business for a significant number of years, a significant amount of wealth may have accrued in the business. In order to protect the assets of the business and facilitate income splitting through salary issuance and dividend sprinkling, the above mentioned techniques can be incorporated to reduce tax liability and protect business assets.
However, in cases where 2 or more individuals previously came together to establish the business, either to utilize complementary skills or combine start-up financing resources, and now want to take their respective shares in the accumulated wealth of the business and continue on with their own individual businesses, the Income Tax Act contains provisions to enable the division of the corporation’s assets among its shareholders in a series of tax-deferred transfers. This technique of dividing the corporation’s assets among the respective shareholders is effectively called a “butterfly-type” reorganization, metaphorically termed to represent the “opening up” of the corporation’s assets and allocating them to its respective shareholders.
The objective of a butterfly-type transactions is to separate the interests of shareholders and in effect “demerge” the corporation. The usual procedure to do this is for each shareholder to create a holding company (Holdco) into which his/her interest in the operating company (Opco) would be transferred. The Holdco’s would then continue to operate as independent operating companies.
Unless the re-organization is effected the a tax-deferred manner, the application of subsection 69(5) of the Income Tax Act will deem the assets to be transferred to the holding companies at fair market value, which may result in punitive tax consequences if the assets have appreciated in value.
Consider the diagram below:
In this situation, there are 2 shareholders, A and B, each owning 50% of Opco. A and B would each create a holding company into which 50% o the assets of Opco would be transferred, and then Opco would be wound-up. The transfer of shares to the holding companies would create a deemed dividend under subsection 84(3) of the Income Tax Act; however, these dividends would be free of tax by virtue of the fact that they are flowing between connected corporations (meaning that the recipient of the dividend directly owned more than 10% of the voting shares of the payer corporation, the fair market value of which exceeded 10% of the fair market value of the total outstanding shares of the payer corporation at the time of the dividend issuance), and are therefore considered to be “inter-corporate” dividends.
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Ordinarily, subsection 55(2) of the Income Tax Act prevents this type of transfer as an inter-corporate dividend. The Canada Revenue Agency enacts sections of the Income Tax Act to ensure that the transfers of certain types of property at values different than their cost base are taxed in accordance with the provisions contained within the Act. In cases of the transfer of capital property this means that any increase in the transfer value normally is taxed at 50% of the increase between the cost and fair market value at the time of the transfer.
Subsection 55(3), however, prevents the imposition of subsection 55(2) on inter-corporate transfers in 2 cases:
- where the reorganization is internal (subsection 55(3)[a]))
- where the reorganization is a true “proportional” butterfly (subsection 55(3)[b])), meaning that the shares received by the holding companies are on a pro rata basis (ie: in proportion to the ownership levels held in Opco at the point in time immediately preceding the transfer).
Subsection 85(1) of the Income Tax Act allows this transfer to proceed on a tax-deferred basis (ie: there would be no tax imposed on the transfer of the assets even if the value at time of transfer was greater than the cost of those assets to Opco), provided that the transfer proceeds on a proportional basis (ie: in accordance to subsection 55(3)[b].
ESTATE PLANNING TECHNIQUES
The issue of estate planning takes on a greater level of importance when significant wealth accrues within the family. In cases where the owner-manager has built and established a business (or businesses) that have generated the family wealth, consideration must be given not only to the tax-effective distribution of financial resources to beneficiaries, but also to the liquidation of business assets and to the succession of the business either to the next generation or to an arms-length party.
The following discussion does not cover all the issues inherent in a situation as the one described above, but rather considers a few techniques that can be employed to reduce the tax burden upon the death of an individual. For a more extensive discussion on tax planning options to an estate, please contact our office.
- TAX TREATMENT AT DEATH
Consider the situation where a taxpayer of a private corporation dies. When this happens, he or she is deemed to have disposed of the shares in that corporation at fair market value (FMV) immediately prior to death, unless the shares are rolled over to a spouse, common-law partner, or a spousal/common-law partner trust.
The deemed disposition results (usually) in a capital gain, 50% of which is taxable and must be reported on the final tax return of the deceased. The estate acquires the shares for an adjusted cost base (ACB) equal to the FMV immediately before death. However, the paid-up capital (PUC) of the shares is unaffected, which will result in double taxation if the shares are later redeemed by the corporation to provide the estate with cash. Consider the following illustration:
If the shares are later redeemed by the corporation, there will be a deemed dividend under subsection 84(3) of the Income Tax Act and also a capital loss. The amount of the deemed dividend will be the difference between the paid-up capital on the shares and the fair market value at the time of redemption. Only if the shares are redeemed within the first year after death can the capital loss can be carried back and reduced against the capital gain originally reported on the personal return (under s164)(6) of the Income Tax Act). Otherwise, double taxation will result – first as a capital gain on the deceased person’s tax return, and a second time as a dividend, in the tax return of the estate or the beneficiaries.
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Consider the following example: At the time of his death Howard holds 1000 shares in ABC Inc. with an FMV of $2,000,000 and an ACB and PUC of $20,000. There will be a deemed disposition of $1,800,000 and a taxable capital gain at 50% of $900,000 which must be reported on his final tax return. Subsequently, and within the first year following death, the shares held by the estate are redeemed by ABC Inc. The redemption will trigger a deemed dividend. The tax liability is as follows:
- CAPITAL GAIN AT DEATH
Proceeds (FMV) $2,000,000
Less: ACB (20,000)
Capital Gain 1,800,000
Taxable (50%) 900,000
Tax (35%) $315,000
- REDEMPTION OF SHARES BY ESTATE (1st year)
Proceeds (FMV) $2,000,000
Less: PUC (20,000)
Deemed dividend [84(3)] 1,800,000
Tax (35%) $630,000
Dividend tax credit
(approx 13.5%) (85,050)
Tax paid $544,950
- CAPITAL LOSS CARRIED BACK TO PERSONAL RETURN
PUC $20,000
Less: Proceeds under
Deemed dividend (2,000,000)
(1,800,000)
Offset against capital
gain on personal return
s164(6) 1,800,000
Net capital gain 0
Tax refund received ($315,000)
The net tax paid under this scenario is $544,950, which is the amount of the deemed dividend under part B of the example. However, if the redemption is deferred until after the 1st anniversary of the date of death, then double taxation will result and the total tax paid on the set of transactions with be $859,950 – a tax rate of 43%.
II- UTILIZATION OF CONNECTED CORPORATION AND s.112(1) INTER-CORPORATE DIVIDEND
Although the election under s164(6) will reduce the tax paid to the deemed dividend amount, a second technique to further reduce the tax owing upon death is for the estate to transfer the shares to a holding corporation that is connected to ABC Inc. (connected meaning that the recipient of the dividend directly owned more than 10% of the voting shares of the payer corporation, the fair market value of which exceeded 10% of the fair market value of the total outstanding shares of the payer corporation at the time of the dividend issuance). The following diagram illustrates this technique:
In exchange for the transfer, the holding company will give the estate a note payable equal to the cost (ACB) of the shares to the estate. Once the shares are in the holding corporation, they are then redeemed by ABC Inc. Because the holding company and ABC Inc. are connected, the deemed dividend is considered inter-corporate and therefore non-taxable, except for any Part IV tax if the payer receives a dividend refund, The holding company then pays the $20,000 note to the estate.
In the above scenario, the only tax paid on the shares is the capital gain of $315,000, which is a reduction of $229,950, or just over 11 tax percentage points when compared to the net tax paid in the first scenario.
CONCLUSION
The above issues represent only a small aspect of potential tax planning techniques that can be implemented to legitimately minimize tax and implement a strategy to effect income splitting and asset protection. In most tax planning scenarios, consideration must be given to qualitative as well as quantitative, or monetary concerns, such as parity to beneficiaries, quality of life to the owner-manager and the spouse, philanthropic desires and vehicles available to realize those desires on a tax-efficient basis, etc.
Regardless of the situation, long-term planning and implementation of a well-considered strategy will result in legitimate tax minimization and the optimal allocation of resources among those involved in the tax planning process. We at Burgess Kilpatrick have been offering valuable assistance for corporate tax planning for companies Canada and aim to continue doing so.
If you have any questions or want to speak further about your corporation or estate planning matters, contact Nicholas Kilpatrick at nkilpatrick@burgesskilpatrick.com
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com or on Facebook at www.facebook.com/Burgess Kilpatrick for more information on our firm.
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