Ch. 17: Review Questions 1, 2 and 8 to 14, Multiple Choice 4, 5, 6, Exercises 1 & 5
Ch. 18: Review Questions 7 to 10, Multiple Choice 4
Problem Set – (s. 84.1 and Estate Freezing and Trusts) (a separate document)
1SECTION 84.1 AND THE QSBC CAPITAL GAINS EXEMPTION
S. 84.1 applies (regardless of whether subsection 85(1) applies or not) if all of the following are met:
1. An individual resident in Canada is transferring…
2 Shares of a taxable Canadian corporation, e.g., S, that are capital property…
3. To a non-arm's length corporation, e.g., P…
4. And immediately after the two companies are connected (e.g., P and S are connected) Non-arm’s length, in addition to rules learned previously (i.e., related persons are non-arm’s length), for purposes of section 84.1, a corporation is deemed to be a non-arm’s length corporation if: (a) immediately before the disposition the individual was one of a group of fewer than 6 persons that controlled the taxable Canadian corporation (e.g., S); and (b) immediately after the disposition the individual was one of a group of fewer than 6 persons that controlled the purchaser corporation (e.g., P) [paragraph 84.1(2)(b)]
And for purposes of section 84.1: a group means 2 or more persons [paragraph 84.1(2.2)(b)]; a corporation that is controlled by one or more members of a particular group of persons is considered to be controlled by that group of persons [paragraph 84.1(2.2)(c)]; and, a corporation can be controlled by more than one person or group of persons at the same time [paragraph 84.1(2.2)(d)]
Connected is defined in s. 186 for Part IV tax and means
> 10% of the votes and value of the shares of the corporation
or control Control for the purposes of s. 186 includes the extended meaning of control under s. 186(2)
You are considered to own any shares of related persons (for purposes of determining if two companies are “connected” because one company controls another).
This extended meaning of control only applies for the purpose of determining if two (or more) companies are connected.
Typical Scenario when s. 84.1 applies: An Individual is trying to realize and strip out accrued tax-free capital gains in private company shares by transferring it to another company he (or a related person) owns. The gains are tax-free because (a) they are sheltered by the capital gains exemption (CGE) or (b) they represent capital gains accrued to V-day. If these tax-free gains are stripped out (in the form of boot) on an 85(1) rollover, s. 84.1 converts them to dividends. We will not discuss V-day in this course.
Effect of s. 84.1
84.1 deemed dividend[84.1(1)(b)] = Boot minus the greater of
(a) the PUC of the S shares transferred in or
(b) the modified ACB* of these S shares.
* The modified ACB excludes any increase in ACB that occurred on a tax-free basis (such as any increase in ACB from V-Day or from a prior transaction that utilized the CGE).
2. 84.1 PUC reduction of P shares [84.1(1)(a)]
= Increase in LSC minus [(greater of PUC or modified ACB of S shares) – boot]
The PUC = the Increase in LSC minus PUC reduction
s. 84.1 and s. 85(1) – things to note
1. s. 84.1 rules are automatic. S. 84.1 will always apply when the four s. 84.1 conditions are met… with or without an s. 85(1) election.
2. Normally you can take boot = your elected amount and if the EA is > ACB, you will have a capital gain (CG). When the four s. 84.1 conditions are met and the EA is > the greater of PUC and modified ACB, you will have a deemed dividend (not a capital gain).
3. The s. 84.1 PUC reduction is more severe than the s. 85(2.1) PUC reduction and will always apply when the four s. 84.1 conditions are met. The 84.1 PUC reduction is based on the difference between the “greater of PUC or modified ACB of S shares”. The s. 85(2.1) PUC reduction is based on the elected amount.
1.1 Test Yourself on 84.1
1. Does this mean that you can't make an s. 85(1) election to recognize capital gains on shares like you can on other assets?
Answer: No- you can but you just can't take boot > the greater of (a) PUC of the shares transferred in and (b) modified ACB of the shares transferred in
2. Would s. 84.1 generally apply when shares of public companies are transferred to investment holding companies?
Answer: Not usually - because the shares transferred probably wouldn't amount to > 10%, the amount required to be connected. However if all 4 conditions described above are met than 84.1 will apply)
3. What are the other implications of being connected?
Answer: No Part IV tax on dividends received from payer except to the extent of the recipient's % of the payer’s dividend refund)
4. Christine owns all the shares of D Ltd. The shares have a PUC and (modified) ACB of $1,000 and a FMV of $300,000. The shares are QSBC shares and she plans to recognize her capital gains exemption on these shares. W Ltd. is a CCPC controlled by her father. Christine will sell all her D Ltd. shares to W Ltd. for FMV, receiving a $300,000 note. Which of the following statements is correct?
(a) Christine will realize a capital gain of $299,000 that will be fully sheltered by the QSBC capital gains exemption
(b) There will be no tax consequences since Christine can transfer her shares to W Ltd. by electing under s. 85(1)
(c) Christine will have a deemed dividend of $299,000 on the transfer of her D Ltd. shares to W Ltd.
(d) Christine will have a deemed dividend of $300,000 on the transfer of her D Ltd. shares to W Ltd.
The correct answer is (c).
Note: 84.1 applies since: all of the following conditions are met:
Christine, an individual resident in Canada, is transferring;
Shares of D Ltd., a taxable Canadian corporation;
The D Ltd. shares are capital property;
The purchaser, W Ltd., is a non-arm's length corporation; and
Immediately after the two companies, D Ltd. and W Ltd. are connected.
Christine is related to W Ltd. since her father controls W Ltd. and she is related by blood to her father.
D Ltd. and W Ltd. are connected since W Ltd. controls D Ltd. after the transfer.
S. 84.1 will lead to a deemed dividend of: boot ($300k) less the greater of: PUC ($1k) and modified ACB ($1k) = $300k - $1k = $299k.
There will not be a capital gain and hence Christine cannot use her QSBC CGE. Christine’s capital gain is:
P of D ($300k) less deemed div. ($299k) = adjusted P of D = $1k
Less: ACB (1k)
Capital gain nil
5. Joe transferred all the shares (PUC $100, Original cost $100, FMV $125,000) of his wholly owned corporation Profits Inc. to Amber Inc., a corporation whose common shares are 100% owned by Joe's brother. The transfer took place under s. 85(1). Joe wanted to trigger a capital gain of $99,900 so he and Amber Inc. elected a transfer price of $100,000. As consideration Joe took back $100,000 of debt and 25 preference shares with a redemption amount of $1,000 each.
(a) How much income will Joe have to report in the year of the transfer relating to this transaction?
(a) Capital gain of $100
(b) Capital gain of $99,900
(c) Dividend of $100
(d) Dividend of $99,900
The correct answer is (d).
(b) Calculate the PUC of Joe’s 25 preferred shares of Amber Inc.
Since 84.1 applies (make sure you can explain why) and shares are issued the paragraph 84.1(1)(a) PUC reduction applies:
PUC reduction = Increase in legal stated capital $25,000 (A)
Minus: The greater of: PUC ($100) and modified ACB ($100) = $100
Less: boot $100,000
Excess, if any, (note: there is no excess) $0 (B)
PUC reduction (A – B) $25,000
PUC = increase in legal stated capital ($25,000) less PUC reduction ($25,000) = $0
6. Ying owns 100% of the shares of Tax Ltd. and Holdco Ltd. Ying purchased her shares of Tax Ltd. in 1975 for $10,000 – the PUC of the shares is $8,000 and their FMV is $975,000. The shares of Tax Ltd. are QSBC shares and Ying would like to recognize her $800,000 QSBC capital gains exemption by transferring her shares of Tax Ltd. to Holdco Ltd for cash and Holdco Ltd. common shares. The total FMV of the consideration taken back is $975,000. Ying and Holdco Ltd. will elect a transfer price of $810,000 under s. 85(1). What is the maximum amount of cash that Ying can receive on the transfer without adverse tax consequences?
The correct answer is (b).
7. Amanda would like to recognize her $800,000 QSBC CG exemption on shares of OPCO that she owns by transferring her shares of OPCO to Holdco (an arm's length corporation) for cash and Holdco common shares. The PUC and ACB of her OPCO shares is $5,000. The FMV of the shares is $900,000. The total FMV of the consideration received by Amanda from Holdco will be equal to $900,000. Amanda has selected an elected transfer price of $805,000 under 85(1). If Holdco and Amanda are dealing at arm's length, what is the maximum cash that she can receive on the transfer without any adverse tax consequences?
The correct answer is (a).
8. Ann would like to recognize her $800,000 QSBC CG exemption on shares of OPCO that she owns by transferring her shares of OPCO to her brother for cash. The PUC and ACB of her OPCO shares is $5,000. The FMV of the shares is $805,000. What will be the tax consequences to Ann of the sale?
(a) Capital gain of $800,000
(b) Capital gain of $0
(c) Dividend of $800,000
(d) Dividend of $5,000
The correct answer is (a).
Note: There will be a capital gain (of $800,000) and a CGE can also be claimed (which is a division C deduction).
The 2013 federal budget has increased the CGE to $800,000 starting in 2014. In 2015 and thereafter it will increase further based on inflation.
The previous questions have tested your conceptual knowledge of s. 84.1. Do the Problem Set question 1 for a good example of a freeze that we cover later in these notes.
2 Corporate Reorganizations which are Automatic Rollovers
Most corporate reorganizations occur on a tax-free rollover basis. The S. 85(1) rollover is an exception.
There is no GST/HST on these automatic rollovers because they are exempt transactions involving shares.
The two main golden rules you learned with respect to s. 85(1) will apply to individuals using these automatic rollovers:
FMV in = FMV out
Cost in = Cost out
2.1 Convertible securities (Section 51)
Legislative intent/major use: to facilitate conversions of securities on a tax-free basis
Automatic tax-free conversion of bonds or shares, that are capital property, to new shares (s. 51)
No cash (or other assets) can be received. Only share consideration can be received
No disposition is reported, instead the old ACB becomes the new ACB [51(1)(d)] and the old PUC (if shares are converted) becomes the new PUC [51(3)]
The section 51 rollover does not apply if subsection 85(1) or section 86 applies to the transaction
There is also an automatic tax-free conversion of bonds to new bonds. The principal of the new bonds must equal the principal of the old bonds (s. 51.1)
2.2 Section 85.1 Arm's Length Share for Share Exchange
Legislative intent/major use: Allows public company takeovers where a deal is done for shares (not cash) between arm’s length persons (occurs as an automatic rollover).
1. Why doesn’t s. 85.1 apply when I transfer shares to a holding company?
Answer: Because the parties are typically not dealing at arm’s length.
2. You own one share of the Hudson’s Bay Company (HBC) which is being taken over by another Canadian company (Canco). The takeover is a share for share exchange and each shareholder is being offered one share of Canco for each HBC share they own. This is a fair deal based on the FMV of each HBC share, which is $15. Your ACB of each HBC share is $10 and the PUC of each HBC share is $1. You deal at arm’s length with Canco. (a) Will you use the automatic Section 85.1 rollover or Subsection 85(1)? Answer: I will use 85.1 if Canco and I don’t want to be bother with an election form. I will use 85(1) if want to recognize a gain or want Canco to have a higher ACB of HBC shares (see (b) below). A s. 85(1) election will override s. 85.1.
(b) What is your ACB of the Canco shares and Canco’s ACB of the HBC shares after the exchange?
Answer: S. 85.1(1)(a) states that the shareholder/vendor acquires new shares with the same ACB as the old shares. Therefore your ACB of the Canco shares is $10. A rollover.
S. 85.1(1)(b) states that the corporation/purchaser acquires the old shares with an ACB = lesser of PUC and FMV of old shares. Therefore Canco’s ACB of the HBC shares is only $1. Not good. Canco would prefer the result of a s. 85(1) rollover. The PUC of the HBC shares (now owned by Canco) is unchanged i.e., it’s still $1.
S. 85.1(2.1) limits PUC of new shares to PUC of old shares. Therefore the PUC of the Canco shares issued on the takeover is $1. Seems fair.
3. What are the differences between s. 85(1) and s. 85.1
Compare and Contrast
Non-share consideration is allowed subject to the rules in s. 84.1 and 85(1).
No non-share consideration permitted: s. 85.1(2)(d)
Assets to be transferred
Any eligible property under s. 85(1.1).
Shares that are capital property.
Elect any amount between cost and FMV.
Automatic rollover at cost
No restriction on relationship of taxpayers.
Parties must deal at arm’s length immediately before the exchange: s. 85.1(2).
After exchange vendor cannot control purchaser or own > 50% of FMV of shares immediately after the exchange; S. 85.1(2)(b)
Transferor of shares may control purchaser company afterwards.
Transferor of shares cannot control purchaser company immediately afterwards.
2.3 Section 86 Share Capital Reorganizations
A lawyer files articles of amendment to effect a reorganization of share capital. When a shareholder exchanges his shares for a new class of shares in the course of a reorganization of capital, section 86 provides an automatic tax-free rollover (if all conditions, mentioned below, are met).
WHY REORGANIZE SHARE CAPITAL?
1. Estate freeze: Where a common shareholder exchanges his/her shares for preference shares so that new common shares can be issued for a nominal or reduced amount to the next generation.1
2. To reorganize shares into shares with different voting, dividend and/or liquidation entitlements.2
1. Shares must be capital property to the shareholder
3. Shares must be received. (Some boot can be received as well)
1. Generally an automatic rollover. Taxpayer has a disposition at ACB (as long as no boot is taken) [86(1)].
2. Deemed dividend if the PUC of the new shares and any boot received is > than the PUC of the old shares. * [ITA 84(3) and 84(5)]
3. The s. 86(2) benefit (gifting) rule will apply if FMV in > FMV out - this results in a capital gain.*
1. Boot is not generally taken back. If boot is taken back, it cannot exceed the lesser of the PUC or the ACB of the old shares, of this will result in problems (i.e., a deemed dividend)*
2.* PUC in (i.e., PUC of old shares) = boot out and PUC out (i.e., PUC of new shares) [86(2.1)]. If not there will be a deemed dividend. The ACB of the new shares = ACB of old shares – boot [86(1)(b)].
3.* FMV in = FMV out. If FMV in > FMV out and it is reasonable to regard the excess as a benefit that the taxpayer wished to confer, s. 86(2) applies and there will be a capital gain.
* For the purposes of this course, you only need to know these conceptual, simplified versions of the detailed complex rules discussed in FIT.
If a section s. 85(1) election is made, it overrides s. 86.
Which of the following is true with respect to a tax-free share capital reorganization under section 86(1)?
Shares must be received although boot can also be received.
No election can be made under subsection 85(1).
All shares held by a shareholder of a particular class must be exchanged.
All of the above
The correct answer is (d).
3ESTATE FREEZES & TRUSTS
Estate freezing is an estate planning technique that uses s. 85(1), s. 86 and preference shares (and plans around various anti-avoidance provisions such as s. 84.1). Estate freezing is a technique whereby the current FMV of growth assets (common shares or other assets) is "frozen" by exchanging them for a corporation's fixed value preference shares (fixed value preference shares are non-growth assets because they don't grow in value). Fixed value preference shares are redeemable and retractable at a certain (i.e., fixed) value. The corporation issues new common shares (which can grow in value) at a nominal value (typically) to the next generation. Freezing the value of assets freezes the accrued capital gain at death [s. 70(5)]. You can also utilize any unused CGE at the same time as doing an estate freeze.
When doing an estate freeze, as is typical in many tax planning scenarios, you want to avoid the negative tax consequences that can apply with non-arm’s length transfers and the attribution rules (including the kiddie tax). Non-arm’s length transfers and the attribution rules (including kiddie tax) are covered in ADMS 3520 lecture 6. These notes should be reviewed. Some attribution rules and corporate attribution were covered in ADMS 4562 lecture 5. In the examples below it is important to: (1) transact at FMV; and (2) have the person buying the common shares (e.g., spouse, related minor, minor niece or nephew, or trust established for the benefit of such persons) use their own money to buy the common shares.
Notice how with a successful estate freeze the future growth will be taxed in the hands of the (younger) person who buys the common shares (often a child or grandchild). This (younger) person should live longer than the taxpayer doing the estate freeze and hence tax is deferred. Note also that the child or grandchild can, in the future, do their own estate freeze.
Advantages of a successful estate freeze are as follows:
1. no tax costs
2. can maintain control (if take back voting & retractable shares)
3. can retain income source if shares pay dividends
4. can usually use QSBC CGE on the transfer
EXAMPLE: Mr. X owns 100% of the common shares of CCPC (cost and PUC - $1,000, FMV - $1 M).
OBJECTIVES: Mr. X has 4 objectives. He wants to:
1. Transfer the CCPC shares to his children (who will ultimately be the beneficiaries of his estate).
2. Freeze the value of his interest in CCPC (and the related tax liability), to allow future growth in value from today onwards to accrue to his children (rather than having this future growth taxed on the deemed disposition on his death).
3. Avoid any taxes when he freezes.
4. Retain control of CCPC.
OPTIONS: Mr. X has several options.
1. GIFT TO HIS CHILDREN This meets only objectives 1 and 2. S. 69 treats gifts as dispositions at FMV (he could claim his CGE). And he loses control.
2. INSTALMENT SALE Same problems as with a gift. The tax is deferred somewhat (because a 5 or 10 year reserve can be claimed under s. 40(1) and 40(1.1). And Mr. X can get some cash by selling rather than gifting (but where are the children going to get the cash? from him?)
3.1 ESTATE FREEZE
(3 types: Holdco Freeze, Internal Freeze, Reverse or Asset Freeze)
(a) Holdco freeze (85(1))
Mr. X transfers all of his common shares to Holdco using 85(1) by electing at his ACB there would be no tax on the transfer. As consideration he could take back voting preference shares of Holdco that are redeemable/retractable for $1,000,000 (gives him control). Common shares of Holdco would be issued to his children for a nominal value. The preference shares of Holdco will not appreciate because if the value of the CCPC shares increase due to earnings or market conditions the increased value will be reflected in an increase in the value of the common shares of Holdco which are now held by the children. There is no GST/HST on sales of shares.
Question #1 - The entire value of Holdco is contained in the preference shares - how would you improve this?
Answer: Take maximum boot – but s. 84.1 will apply – so must limit boot to the greater of CCPC’s PUC and "modified ACB" (i.e., $1,000 in this example).
Question #2 - Why should the preference shares be voting and redeemable/retractable?
Answer: All three features help to control the company, particularly the voting rights. Having a FMV redemption amount ensures that FMV in = FMV out rule is complied with. Having the shares retractable (i.e., redeemable at the shareholder’s option) ensures liquidity.
Question #3 - What should he do if he wants to crystallize his $800,000 CGE?
Answer: Elect $800,000 higher than ACB (but boot should not exceed the greater of modified ACB and PUC)
Question #4 - Can a Holdco freeze be done on assets other than shares? (e.g., real estate which is capital property?)
Answer: Yes. Any “eligible property” can be transferred using s. 85(1)
(b) Internal Freeze (s. 86 or 85(1))
Mr. X exchanges his common shares for voting redeemable/ retractable preference shares on a tax-free basis under section 86. His children subscribe for new common shares.
As discussed earlier, the s. 86 rollover is automatic. This type of freeze has the following advantages: no election, no Holdco to set up & maintain, there is no GST/HST on sales of shares; simpler & cheaper than Holdco freeze. It will be a tax-free rollover if Mr. X gives up all his common-shares & other s. 86 conditions met (usually take only preference shares).
But Mr. X is unable to crystallize his accrued gain and utilize his capital gains exemption with an internal freeze unless he and the corporation jointly elect under s. 85(1). If Mr. X elects under s. 85(1), s. 86 does not apply
- s. 85(2.1) PUC reduction will apply [reduction = increase in L.S.C. minus (elected amount - boot)] if s/ 85(1) election made
or 84.1(1) PUC reduction, if required s. 84.1 conditions are met)
(c) Reverse or Asset Freeze (85(1))
Mr. X causes Opco to transfer selected Opco assets under 85(1) to new Opco ("Newco") in exchange for maximum boot & voting, redeemable/ retractable preference shares - children subscribe for Newco common shares. Old Opco effectively becomes the holding company. An 85(1) election must be filed – it can be a tax-free rollover or a TCG can be recognized (but there is no utilization of CGE because OPCO is the transferor – not Mr. X)
A reverse asset freeze is appropriate when you want to freeze only certain assets or want selected assets (e.g., active business assets vs. real estate) to be transferred to different people.
Disadvantages of a reverse asset freeze:
- Real estate inventory cannot be transferred under s. 85(1)
- provincial land transfer tax is payable (by the purchaser) on the purchase of land
- GST/HST is payable on the sale of assets. There is an election not to have GST/HST apply if all or substantially all of the assets (90% or more) of a business are transferred to a GST/HST registrant (i.e., should register Newco for GST/HST prior to the sale of assets)
Mr. X owns 100% of the common shares of X Ltd. X Ltd. owns a bakery (FMV $1M) and the land and buildings that the bakery uses (FMV $1M). Mr. X is interested in freezing his estate in favor of a trust (or trusts) for his children. Bert is a baker who works in the business and Roger is a rock star who lives in California. Mr. X wants to leave 50% of X Ltd.’s value to each child. He may want to use a trust to separate beneficial ownership from control.
Mr. X would transfer all his common shares in X Ltd. to a newly-incorporated company (“Newco”) under subsection 85(1), electing at the ACB of the common shares (or electing at a higher amount if he wants a CG on the transfer). As consideration he would receive $2 M of fixed-value, voting, redeemable, retractable preference shares of Newco. New common shares of Newco would be issued to (a trust for) his children for a nominal amount.
Mr. X exchanges his common shares in X Ltd. for $2 M fixed-value, voting, redeemable, retractable preference shares of Newco on a tax-free share capital reorganization under section 86. (A trust for) his children subscribe(s) for new common shares of X Ltd. for a nominal amount. He and X Ltd. could elect under s. 85 if Mr. X wants to trigger a capital gain on the transfer.
Reverse or asset freeze
X Ltd. would transfer the bakery to a newly incorporated company (i.e., Bakeco Ltd.) and the land and buildings to a newly incorporated company (i.e., Realco Ltd.) under subsection 85(1), electing at their tax values. In exchange, X Ltd. would receive $1M fixed-value, voting, redeemable, retractable preference shares of each corporation (i.e., $2M in total). New common shares of Bakeco would be issued to (a trust for) Bert for a nominal amount. New common shares of Realco would be issued to (a trust for) Roger for a nominal amount. (Note that X Ltd. has turned into a holding company.)
A trust is a relationship, documented in writing in the trust deed, between 3 parties:
(1) the settlor who: (a) sets up the trust and has the trust deed drafted to meet his/her wishes; and
(b) who transfers assets to the trust;
(2) the trustee who legally owns the trust’s assets and manages those assets, following the instructions in the trust deed, for the benefit of the beneficiaries; and
(3) the beneficiaries, who are chosen by the settlor and listed in the trust deed, who benefit from the assets and/or income of the trust.
A beneficiary can be an income beneficiary meaning he/she can get income* earned by the trust; a capital beneficiary meaning he/she can get capital (i.e., assets) of the trust; or both an income and capital beneficiary.
* Capital gains realized in the year are considered income under Canadian tax law. Income earned and capital gains realized in a year and retained in the trust (i.e., not paid out to beneficiaries) become part of the capital (i.e., assets) of the trust after year-end.
A trust can be an inter vivos trust or a testamentary trust [s. 108(1)]. A testamentary trust is one created upon the death of a taxpayer (i.e., as per the deceased person’s will). All other trusts are inter vivos.
A trust can be either discretionary or non-discretionary. A discretionary trust is one where the trustee can decide which beneficiary gets what amount of income and/or capital (including getting nothing) from the trust. A non-discretionary trust is one where the trust deed specifies which beneficiary gets what amount of income and/or capital from the trust.
Tax Consequences of Trusts When the settlor transfers property to a trust, he/she has a disposition (typically at FMV). Hence income or loss (or capital gains or capital loss) will result. The trust acquires the property with a cost equal to what was paid or equal to FMV if no consideration was paid [s. 69(1)(c)]. A transfer to a spousal trust is at cost.
A trust is taxed as an individual and must file a tax return due 90 days after year-end [s. 150(1)(c)]. An inter vivos trust must have a calendar year-end but a testamentary trust can have an off-calendar year-end (typically 1 year after the date of death). The February 11, 2014 federal budget has proposed the following change for testamentary trusts effective in 2016 and thereafter: testamentary trusts will only be able to have an off-calendar year-end for the first 36 months (then they will need to have a calendar year-end).
Trusts do not get basic personal tax credits. Inter vivos trusts are taxed at the top marginal tax rate but testamentary trusts are taxed at the same marginal tax rates as individuals. The February 11, 2014 federal budget has proposed the following change for testamentary trusts effective in 2016 and thereafter: testamentary trusts will only get graduated marginal tax rates for the first 36 months (then they will be taxed at the top marginal tax rate).
One major difference with a trust is that a trust can allocate income including taxable capital gains earned in the year (and certain income allocated keeps its form) to a beneficiary and the allocated income is not taxable in the trust [s. 104(6)(b)]. Capital gains, dividends and foreign income allocated to a beneficiary keep its form. Any other income allocated is taxed as property income [s. 108(5)].
Any income allocated to a beneficiary in the year is taxable to the beneficiary.
Another major difference with a trust is the 21-year deemed disposition rule. If a trust has existed for 21 years, and on each additional 21 year anniversary, the trust is deemed to dispose of and reacquire all its capital assets at FMV [s. 104(4)]. This triggers any accrued capital gains or capital losses and triggers any accrued recapture [s. 104(5)].
If an income beneficiary disposes of his/her income interest in a trust the proceeds received will be taxable as income (and not as a capital gain). The cost of an income interest is typically nil (i.e., $0) [s. 106].
If a capital beneficiary disposes of his/her capital interest in a trust the proceeds received will be taxable as a capital gain. The ACB of a capital interest is typically nil (i.e., $0) [s. 107].
If a trust distributes an asset (i.e., capital) to a capital beneficiary the asset is typically disposed of at cost (for tax purposes) and acquired by the capital beneficiary at cost (i.e., a rollover) [s. 107(2)].
3.3 OTHER (NON-TAX) ESTATE FREEZE CONSIDERATIONS
(The answers depend on the actual fact situation and the parents' wishes.)
1. When should a trust be used to hold the common shares owned by the children?
A trust should be used in situations where you want to separate beneficial ownership from control (trusts are discussed in ADMS 3520 and reviewed in the teach test questions at the end of these notes).
2. Should a 40 year old parent freeze a company in favor of a trust for his or her children.
Normally freezors are older than 40 because they forfeit future growth. It could be possible that the 40 year old parent has enough other wealth. If not, the parent could do a partial freeze: i.e., where the parent also subscribes for some common shares and therefore participates in some of the future growth of the corporation.
3. How to provide parents (i.e., the freezor) with sufficient income during retirement years?
Answer: The dividend yield on the preference shares provides income and the dividends could be cumulative. There could also be a planned series of share redemptions to provide income and liquidity. A shareholders’ agreement could be drafted in such a way as to allow the parents to step in if the children weren’t managing the company properly.
4. When should parent(s) give up controlling shares?
Answer: It depends on their wishes. The shares could convert to non-voting shares at some time in the future.
5. Should the parent who is not active in the business hold voting shares after the death of the freezor?
Answer: Probably not. After the death of the freezor, the shares could (a) transfer to a spouse trust or (b) convert to non-voting shares and/or (c) be redeemed or (d) sold.
Any sale or redemption will likely have tax consequences.
4 Possible Double Tax on Death/Post-Mortem Planning for Private Company Shares
If an individual owns shares of a private corporation on the date of death, there can be double tax if a spousal rollover is not available to defer the CG on death. Using the example of a private company owning investment assets, D Ltd.,3 this could happen because:
1. The deceased will have a deemed disposition of the shares of D Ltd. triggering tax on any accrued CG (resulting in the D Ltd. shares having a high ACB)
2. A second layer of tax will result when the assets owned by D Ltd. are sold and the funds are distributed by D Ltd. to shareholder(s). This second layer of tax consists of
(a) D Ltd.’s corporate tax on CG (because its assets still have the historical low ACBs4)
(b) personal tax on D Ltd.’s distribution to shareholder(s). The distribution could be done by redeeming some D Ltd. shares or winding up D Ltd.: both would trigger a deemed dividend and capital loss: see s. 84(3) and 84(2), discussed in Lecture 6. Remember that D Ltd.’s dividend will be taxable, unless it is a capital dividend.5 But even if it is a capital dividend, there will be a capital loss that the estate6 or beneficiary may not be able to use unless they have capital gains.7
Liquidating the assets of D Ltd. may be necessary because
2. the beneficiaries will have a need for cash (either immediately or in the future).
4.1 Planning – The S. 164(6) election
The s. 164(6) election allows any losses that occur in the first year of the estate to be carried back to the terminal tax return of the deceased individual. Hence, this election can eliminate double tax that would otherwise result if the capital loss can’t be used. In a sense, this election allows the tax paid on the CG in the deceased’s return to be replaced by tax paid by the estate (if any) on a dividend received in its first year. If the dividend is a capital dividend there will of course be no tax. But if the dividend is a taxable dividend there will be tax.8 Example:
An individual who owns shares of D Ltd. (a private corporation) with a FMV of $1M and an ACB and PUC of nil (i.e., $0) dies. On the individual’s terminal tax return he/she will have a deemed disposition of the D. Ltd. shares at FMV. Hence a capital gain of $1M (i.e., $1M - $0) will be realized. Capital gains are half-taxable. The individual’s estate will acquire the D Ltd. shares with a new ACB equal to FMV (i.e., $1M).
As discussed in Lecture 6, the redemption of the D Ltd. shares by the estate will lead to:
1) deemed dividend (d.d.) = proceeds ($1M) less PUC ($0) = $1M d.d.; and
2) capital loss = adjusted proceeds of disposition ($1M less d.d. of $1M) = $0 less ACB of $1M = $1M capital loss.
Notice how without s. 164(6) there is double tax since the deceased individual pays tax on half of the $1M capital gain (triggered on death) and the estate pays tax on a $1M deemed dividend.
If the estate trustee makes the s. 164(6) election, the capital loss realized in the estate can be carried back and reported on the deceased individual’s T1 return for the year of death (as opposed to being reported on the estate’s T3 return) as long as the loss occurs in the first taxation year of the estate. Hence after the s. 164(6) loss carryback election, the deceased individual will have a capital gain on death of $1M - $1M loss carryback = $0 and there will not be double tax. There will be tax on the $1M dividend to the estate (i.e., 1 layer of tax not 2). Note: you must ensure that the loss in the estate occurs within its 1st year in order to use the s. 164(6) election.
4.2 The Pipeline
One of the disadvantages with s. 164(6) is that the effective tax rate on a dividend received by the estate may be higher than the effective tax rate on the CG that would otherwise have been paid by the deceased. The pipeline strategy is an aggressive strategy that leaves the CG in the terminal return and attempts to avoid the tax on the dividend by using a sale and a s. 88(1) windup and bump. Because the pipeline strategy has been widely written about (even in the Globe and Mail), it is suspected that many taxpayers have it in place as part of their estate plan. It is aggressive because
(a) the CRA has stated that it would apply s. 84(2) in cases where D Ltd. does not carry on business and the strategy is implemented shortly after death and
(b) a 2013 Federal Court of Appeal decision applied s. 84(2) in a situation where a taxpayer sold his investment holding company to brother-in-law rather than winding it up.9 The story is not over on this issue because this case is being appealed to the Supreme Court of Canada but it is a good reminder of how risky tax planning can be and how the CRA has other rules besides GAAR that it can apply.
These are the steps to the pipeline. Each step uses rules that we have learned in this course:
1. Have a private company owned by the beneficiaries or another family member (e.g., B Ltd.) purchase the D Ltd. shares from the estate for their FMV ($1M) using a $1M promissory note.10
Result: no tax to estate because no capital gain
2. Use a s. 88(1) windup to have B Ltd. acquire the assets of D Ltd. and bump the assets owned by B Ltd. to their FMV ($1M): see Lecture 8.
Result: Assets now owned by B Ltd. and have ACB = FMV = $1M.
3. B Ltd. sells assets for $1M and pays off $1M promissory note owned by estate.
Result: Estate now has $1M cash to distribute tax-free to beneficiaries. No tax paid on redemption of promissory note.
5 TEACH TEST
1. Give 2 scenarios in which Section 86 reorganizations are commonly used.
2. What are the 3 conditions for a Section 86 reorganization?
3. S. 86 reorganizations result in deemed dividends when the Boot received and the PUC of the new shares > ______
4. The Subsection 86(2) gifting rule applies if FMV in > _____ .
5. When a person dies, his capital property is deemed disposed of at _______if it is left to a spouse or spousal trust.
6. Why would a person leave property to a spousal trust rather than directly to a spouse?
7. What is estate freezing?
8. What are the three types of estate freezes?
9. Why are redeemable, retractable, voting preference shares commonly taken back by the freezor?
10. Why are estate freezes used rather than just gifting the property?
11. Does s.84.1 apply to estate freezes?
12. What is the most commonly used type of estate freeze? Why?
13. If I owned 50% of a company and the other 50% was owned by an unrelated person, what kind of estate freeze should I use to freeze the value of my interest in the company?
14. Why are trusts used?
15. What is meant by the following terms: trustees, beneficiaries, settlor, capital beneficiary, income beneficiary, discretionary powers, testamentary, inter vivos
16. Explain why there may be double tax on the death of a shareholder of a private company and how this tax can be minimized.
17. See Question 16 above. Why is this not a concern on the death of a shareholder of a public company?
TEACH TEST ANSWERS
1. Estate freeze (convert common to pref.), to reorganize common into > 1 class)
2. Shares must be capital property to shareholder, shareholder must exchange all shares of that class, new shares must be received.
3. PUC of old shares
4. FMV out
5. Tax cost (ACB or UCC)
6. Because spouse may be unable to manage assets, to maintain control over ultimate beneficiary when spouse dies or for income splitting using 104(13.1) and 104(13.2).
7. Conversion of growth asset to pref. shares which do not grow in value while maintaining control and not paying tax
8. Holdco, Internal, Reverse or Asset
9. Voting gives control. Redeemable, retractable feature fixes FMV (FMV in = FMV out), gives liquidity and control.
10. To defer tax, maintain control (and maintain income stream with dividends)
11. Yes, where the s. 84.1 conditions are met (see notes above for the conditions)
12. Probably either holdco (can freeze any asset) or internal (simple, no holdcos created)
13. Probably holdco, because the other shareholder would not want my children owning shares of the company.
14. To separate beneficial ownership from control
15. Trustees manage the trust
Beneficiaries receive income and capital of the trust
Capital beneficiary receives the original capital and capital gains of the trust
Income beneficiary receives income not capital
Discretionary powers allow the trustee to choose the amount (if any) of payments to the beneficiaries
Testamentary trust is created on death
Inter vivos trust is created during the settlor's lifetime
16. There may be double tax on a windup or redemption because the estate or beneficiary will have a deemed dividend and capital loss if the shares have a high ACB from the deemed disposition at FMV on death. This can be minimized either by
(a) having the estate repurchase the shares in its first taxation year and electing to carryback the capital loss under s. 164(6) to eliminate the CG in the deceased’s return or
(b) doing the pipeline strategy which leaves the CG in the deceased’s return and has the estate or beneficiary sell the shares (no CG because ACB = FMV) to a second company for a promissory note. The second company uses the s. 88(1) windup and bump to increase the ACB on the first company’s non-depreciable property to FMV and sells it (without a CG because ACB = FMV) to pay off the promissory note. The pipeline strategy is a more aggressive strategy and may not work: see links to discussion of the MacDonald case in section 4 of these notes.
17. Public company shares are more liquid assets that are often easily sold for cash and a repurchase of public company shares is taxed as a capital gain.
1 A partial freeze is a variation on this: i.e., where the original common shareholder also subscribes for some new common shares and therefore participates in the future growth of the corporation. A partial freeze is often used when a parent doing an estate freeze is relatively young or when a key employee or other new shareholder is subscribing for an interest in the business.
2 Canadian corporations used to do this before going public (the original owners received voting shares and non-voting shares were issued to the public). If you or your spouse were common shareholders you might reorganize the capital to do income-splitting (so that dividends could be declared independently). If different investors bought in at different times, they might want separate classes to keep their PUC separate (instead of being averaged).
3 The investment assets could be after-tax retained earnings from a business or professional practice that was sold or discontinued.
4 If the D Ltd. owned business assets (e.g. inventory, equipment, goodwill, etc.), there could be business income.
5 If the private company has a positive balance in its capital dividend account then it could elect to pay a tax-free capital dividend.
6 The estate is the trust established on the death of an individual until all assets are distributed to beneficiaries.
7 The estate may be wound up and the loss may never be used. The beneficiary may be able to use it eventually.
8 The amount of tax will depend on whether it is an eligible or non-eligible dividend.
9 Queen v. MacDonald, 2013 FCA 110. For a discussion of this case and the pipeline strategy, see, for example
http://www.ey.com/CT/en/Insights/Insights_Case_Comment_2013-013 and http://www.moodysgartner.com/the-federal-court-of-appeal-decision-in-macdonald-the-best-things-in-life-are-worth-waiting-for/
10 Or by issuing redeemable preference shares with PUC = $1M (i.e., = FMV). Redemption of preference shares with PUC = FMV also would result in no deemed dividend or capital loss at the end of step 3.