Protecting Your Wealth For The Next Generation: Provisions To Transfer Wealth Efficiently.
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If a taxpayer owns shares in a corporation that was built over the years and that now contains substantial value, he/she probably anticipates leaving this value to a future generation. However, without a tax-planning strategy involving the wealth in the company, that wealth will be exposed to double taxation and that future generation will see much less of that wealth than if some time was taken to plan the taxpayer’s estate before death.
Subsection 70(5) and the Potential for Double Tax
When an individual dies and own shares in a private corporation, the shares are deemed to be disposed of at Fair Market Value (FMV)[1]. This deemed disposition can only be avoided when the shares can be rolled over to a spouse or a spousal trust. Those shares are then deemed to be purchased by the deceased’s estate at a cost equal to the FMV. However, the deemed disposition does not change the Adjusted Cost Base (ACB) of the assets in the corporation.
Normally, the executor of an estate will wind up the company in order to accomplish distribution of estate proceeds. Doing this, however, results in a deemed dividend under subsection 84(2) equal to the difference between the FMV and the Paid-up Capital (PUC) of the shares, thereby resulting in double taxation on the value of the corporation.
For example, if Mr. X started a business and had 100 shares issued to him for $1 each, the paid up capital (PUC) of those shares is $100. These constitute the total issued shares of the corporation. Through the years he has grown the business and today the value of his shares is $1,000,000.
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Upon the death of Mr. X, his shares are deemed to be sold for $1,000,000; 50% of this amount will be taxable. Then when the executor winds-up the estate, there will be a deemed dividend on the estate equal to the same amount, as follows,
| Upon death | |
| Value at death | $1,000,000 |
| Less: PUC of shares | -100 |
| Capital Gain | 999,900 |
| Taxable capital gain (50%) | 499,950 |
| Tax (30%) - A | 149,985 |
| Upon wind-up of estate | |
| Deemed dividend under ss. 84(2) | 999,900 |
| Tax (35%) - B | 349,965 |
| Total tax paid (A + B) | $499,950 |
| Combined tax on sale | 50.00% |
Assumptions:
Capital Gain tax = 30%; Deemed dividend tax = 35%
Techniques to Relieve Against Double Tax
The two main techniques to relieve against this form of double taxation are:
- Capital loss carry-back under subsection 164(6) of the ITA, to create a loss in the deceased’s estate within the first tax year of the estate, which can be carried back to the final return of the deceased to offset the capital gain reported on that return.
- Pipeline Planning, in which a new corporation is used to convert that value in the corporation to debt so that the value can be extracted by the estate tax-free
- Capital loss carry-back under subsection 164(6) of the ITA
For this technique to be executed correctly, the executor of the estate must be organized and begin administering the estate soon after the death of the taxpayer, because this provision is only available in the first year of the estate.
This subsection of the ITA allows for the value of the deemed dividend triggered upon the wind-up of the corporation to be deducted from the value of the shares of the corporation. Once the deemed dividend has been paid and all of the value of the corporation has been considered extracted as a result of that dividend, the value of the shares are nominal. The ITA allows for the value of the deemed dividend to be deducted from the value of the shares at wind-up, thereby resulting in a loss which can be carried back to the final return of the taxpayer, as follows:
The taxpayers’ estate is established upon the death of the taxpayer and begins on the day after the taxpayer’s death. An estate tax return must be filed by the end of the tax year (ie: the first tax year ends on the day that is the day before the same date of the year following the year of the taxpayers’ death), and this carry-back must be claimed in the form of an election on that first return.
Tax planners should be consulted as soon after the death of the deceased as possible in order to determine materials needed to calculate the deemed disposition and subsequent capital loss to carry back. All information and administration necessary to facilitate this carry-back can be time-consuming, and so it is best to begin this process early.
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Some resources on this topic may reference a “Circularity” issue that prevents the execution of a loss carry-back in a situation like this. This circularity issue is embedded within Section 40 of the ITA, which determines a taxpayers gain or loss from the disposition of property. Specifically, subsections 40(3.4) and (3.6) defer a taxpayer’s loss where, despite a disposition by the taxpayer, the loss property remains within – or the property is acquired by – a person within the population of persons affiliated with the taxpayer.
However, subsection 40(3.61) specifically ensures that these subsections will not apply to any portion of the capital loss carried back that is in excess of the capital gain claimed on the deceased’s final tax return.
In the event that, from the time of the deceased’s death to the end of the first year of the estate, the value of the shares of the corporation have declined, the value of the capital loss carried back to the final return will be less than the capital gain reported on the final return. However, additional planning can be executed to take advantage of any possible tax benefits inherent in notional accounts of the corporation such as the CDA, RDTOH, NRDTOH, or GRIP accounts to further reduce tax exposure.
As you can tell, if we can carry back the capital loss on the first estate return to the final return of the deceased, then the only tax exposure remaining (assuming the capital loss is equal to the capital gain claimed on the final return of the deceased) is the dividend that was reported on the estate’s first tax return. The second technique, if applied correctly, can further reduce tax exposure in this estate planning cycle to that of a capital gain. This second technique is referred to as “Pipeline Planning” as discussed below:
- Pipeline Planning
The Pipeline plan simply involves incorporating a new company which, through a series of transactions, will convert the increase in value in the shares of the corporation from a capital gain to a loan receivable to the estate. To create a Pipeline, assume that the taxpayer, Mr. X owns XCo:
- X’s estate incorporates a new corporation, Newco, for nominal consideration.
- The estate sells the shares of XCo to Newco for $1,000,000 (assuming no accrued gain or loss on the shares since Mr. X’s death)
- The sale proceeds payable by Newco would be a non-interest bearing demand promissory note payable by Newco in the amount of $1,000,000
- XCo would be wound up into Newco on a tax-deferred basis.
- Newco would use cash on hand (ie the cash that was in XCo) to repay the loan to the estate.
By using this method, what was as deemed dividend under the carry-back method is no a loan that has been repaid tax-free, resulting in the shares having only a capital gain exposure.
One of the concerns that has for a long time prevented the application of the Pipeline method in some estate plans is the possibility of the Canada Revenue Agency (CRA) assessing a deemed dividend under subsection 84(2)of the ITA on the sale of the shares to Newco for $1,000,000. Section 84 (paraphrased) is a deemed dividend provision of the ITA which, when certain fact patterns exist, assesses distributions from corporations to non-arms length individuals as deemed dividends. However, there have been many cases in which the CRA ruled favourably in prior advance rulings on the non-application of subsection 84(2), when the following applied:
- That the corporation in question (ie: XCo in our example) would remain a separate and distinct entity for at least one year.
- That during this one year period, the corporation would continue to carry on its business in the same manner as before, and
- Only thereafter would the note be repaid on a progressive basis.
One point to consider is that, when the above points exist, subsection 84(2) should not apply to the transaction because the money is being paid to cancel a debt (ie: the $1,000,000 loan) rather then being paid for the benefit of shareholders, and the continuance of the operation of the business further qualifies the loan as an operating one, the repayment of which benefits the corporation and contributes to it’s working capital resources.
In summary, the Pipeline plan, if executed correctly and if sufficient planning is done, results in the lowest tax exposure (ie: capital gain). This plan also involves the most time and financial resources to correctly implement. Consideration should be given to the costs versus the ta benefits of implementing such a plan.
The carry-back plan, by contrast, is easier to implement, but results in tax exposure equal to that paid on the deemed dividend reported on the estate’s first tax return. Organization and proactive administration of the estate is necessary to ensure that the carry-back can be effected in the first year of the estate’s tax filing. Note that the deadline to filing an estate’s T3 tax return is 90 after the end of the tax year of the estate. Either method, however, is preferred to the onerous tax consequences realized if no planning is done at all.
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.
[1] Falk, Chris; Morand, Stefanie, “Income Tax Developments in Estate Planning and Administration”, Law Society of Upper Canada 15th Annual Estates and Trusts Summit
