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CALU has begun consultations with the Department of Finance concerning proposals which would extend the affiliated persons rules to trusts and which, if enacted, would affect the estate of a deceased taxpayer, where the estate's assets include shares that are redeemed. CALU's submission to the Department, dated June 18, 2004, also posted to this website, serves as the basis for future consultations to resolve concerns. In this article, posted in August 2004, CALU member Kevin Wark reviews the potential applications of the proposals in greater detail and comments on their possible impact on the tax advantages of corporate share redemption in certain family succession situations.
For a historical perspective on this issue, readers may wish to refer to the December 1996 INFOexchange; the July 1999 CALU Report, Question 2; and the December 2000 CALU Report.
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Prior to the introduction of the stop-loss rules(1) (the "stop-loss rules"), there were significant tax advantages to redeeming the shares of a deceased shareholder using corporate-owned insurance. While the stop-loss rules created new planning complexities and diminished the tax benefits of these arrangements, there continue to be valuable tax benefits associated with the use of corporate-owned insurance to fund the redemption of shares on the death of a key shareholder.
However, the March 2004 federal budget (the "2004 Federal Budget") contains proposals that if ignored, may eliminate the tax advantages of corporate share redemption in certain family succession situations. In fact, for the unwary client and advisory, these new rules can create onerous tax consequences. This article will use a case study to review the impact of the stop-loss rules on share redemption arrangements, and how the proposals contained in the 2004 Federal Budget will further complicate the area of insured family succession arrangements.
Mr. Roberts is the controlling shareholder in RobCo, which is worth approximately $4 million. Mr. Roberts is married to Sandra and has two children, John (age 23) and Janice (age 30). Janice is active in the business while John has indicated he wishes to pursue a career as an architect. As a result, Mr. Roberts has made plans that would have Janice eventually take over RobCo as the controlling shareholder. Mr. Roberts has just completed an estate freeze(2) and capital gains crystallization(3) under which he has converted his common shares into two classes of voting preference shares. One class of shares has an adjusted cost base (ACB) and redemption value of $500,000 and nominal paid-up capital(4) (the PrefA shares). The other class of shares has nominal ACB and paid-up capital, and a redemption value of $3.5 million (the PrefB shares). As part of the estate freeze Janice was issued new common shares with nominal value.
Mr. Roberts has also entered into a buy-sell arrangement with Janice. On Mr. Roberts' death Janice is to purchase the PrefA shares for $500,000. The PrefB shares are to be redeemed by the corporation. The purchase of the PrefA and PrefB shares is to be funded by a $4 million insurance policy owned by RobCo on Mr. Roberts' life.
In addition to his interest in RobCo, Mr. Roberts owns personal insurance, a principal residence, vacation property and RRSPs currently valued at over $3 million. He has arranged his affairs so that these properties will go directly to Sandra on his death, passing outside of his estate.
Mr. Roberts recently updated his will, under which his lawyer and close friend, John, is the executor. The remainder of Mr. Roberts' estate (consisting primarily of cash from the disposition of his shares in RobCo) will be held in a trust under which Sandra, John and Janice are both discretionary income and capital beneficiaries. The trust also has provision for any grandchildren of John and Janice as discretionary capital beneficiaries.
Shortly after implementing this plan Mr. Roberts meets an untimely death as a result of a car accident.
On Mr. Roberts' death he is deemed to have disposed of his shares in RobCo at their fair market value.(5) Since the PrefA shares have an ACB equal to their redemption value, no gain or loss will arise with respect to those shares. However, Mr. Roberts will realize a capital gain of $3.5 million in respect to the PrefB shares since they have a nominal ACB. Mr. Roberts' estate will inherit those shares with an ACB equal to their fair market value ($500,000 for the PrefA shares and $3.5 million for the PrefB shares).(6) As specified under the buy-sell agreement, Janice purchases the first class of preference shares for $500,000 and provides a promissory note to Mr. Roberts' estate. There is no gain or loss to the estate on this transaction.
RobCo, as beneficiary of the insurance policy on Mr. Roberts' life, receives insurance proceeds of $4 million on a tax-free basis. For the purposes of this example we will assume the full amount of the death benefit is credited to RobCo's capital dividend account.(7) Pursuant to the terms of the buy-sell agreement, RobCo declares a tax-free capital dividend(8) of $500,000 on the PrefA shares and Janice uses these proceeds to repay the promissory note to the estate.
RobCo uses the remaining $3.5 million of insurance proceeds to redeem the PrefB shares from the estate. This will trigger a deemed dividend to the estate of $3.5 million.(9) RobCo elects that this dividend be paid out of its capital dividend, with the result that the estate receives it tax-free.(10)
In addition, the redemption constitutes a disposition of the shares by the estate for tax purposes. The proceeds of disposition ($3.5 million) are reduced by the deemed dividend of $3.5 million arising on the redemption of the shares.(11) As a result, the estate realizes a capital loss of $3.5 million. Assuming the redemption takes place in the first taxation year of the estate, this loss may be carried back to Mr. Roberts' terminal return.(12) As a result, the gain in the estate of $3.5 million is fully offset by the capital loss of $3.5 million realized by Mr. Roberts' estate on the redemption of the PrefB shares.
The net impact is that there is no taxable capital gain in Mr. Roberts' terminal return with respect to his shares in RobCo. As well, the estate has received $4 million on a "tax-free" basis. Janice now has 100% ownership of RobCo, represented by the PrefA shares and common shares received on the estate freeze. Janice has inherited a capital gains tax liability of $3.5 million, as the adjusted cost base of her common shares has not been increased by this transaction even though those shares now represent $3.5 million of value in RobCo. So in effect the capital gain that would otherwise have been taxable to Mr. Roberts has been deferred and shifted into the hands of his daughter.
The tax advantages of the above-noted planning strategy has been significantly eroded by the enactment of the stop-loss rules.(13) These rules were designed to prevent an individual (including an estate) from claiming a capital loss on shares to the extent the shareholder has previously received tax-free capital dividends in respect of those shares.
As originally proposed, there were limited exceptions to the stop-loss rules and no grandfathering for arrangements in place prior to the introduction of these proposals. As a result of vigorous lobbying efforts by insurance and tax advisors, the final legislation offered some respite for share redemptions arising on death, as well as fairly generous grandfathering for arrangements in place before April 27, 1995.(14)
The relieving rule for estates generally ensures that the capital loss in the estate is only reduced by the amount by which capital dividends received on the share exceeds 50% of the lesser of the:
(i) capital gain on the deemed disposition at death; and (ii) capital loss in the estate otherwise determined.(15)
While the relieving rule for estates does not restore all the tax benefits that existed prior to the introduction of the stop-loss rules, they do provide room for planning to reduce the tax bill to both the deceased's estate as well as the surviving shareholders.
As a consequence of the stop-loss rules, the redemption process would be modified as follows. RobCo would still redeem all the PrefB shares from Mr. Roberts' estate. However, RobCo would only elect that 50% of the deemed dividend of $3.5 million be treated as a tax-free capital dividend.(16) The remaining deemed dividend of $1.75 million would be fully taxable and would result in a tax liability to the estate of approximately $540,000.(17) The estate would use part of the redemption proceeds to cover this tax liability and distribute the remainder in accordance with the terms of the will. The stop-loss rules would not apply because of the 50% relieving rule discussed above, with the result that the full $3.5 million capital loss could be carried back by the estate to offset the capital gains on death. Absent this transaction the combined tax payable by the estate would be $805,00(18), so there is a resulting tax savings of $265,000. This liability would be funded through the proceeds received on the sale and redemption of Mr. Roberts' shares.
Janice's common shares will again have increased in value from nil to $3.5 million without any corresponding increase in the ACB of those shares. However, she also has access to the remaining capital dividend account in RobCo of $1.75 million arising from the insurance proceeds. She can declare a dividend equal to this amount on a tax-free basis and secure the payment of this amount against other corporate assets. By doing so she has reduced the value of RobCo by $1.75 million, which in turn reduces the capital gains tax liability with respect to her common shares.
In summary, by utilizing the 50% relieving provision for estates we have reduced the tax bill for Mr. Roberts' estate by $265,000. In addition, the deferred capital gain on Janice's common shares that normally arises from a corporate redemption transaction has been reduced by $1.75 million (which is a savings of approximately $400,000 in tax).(19) So while the revised structure under the stop-loss rules does not totally eliminate taxes in Mr. Roberts' estate, they have been reduced from what would otherwise have been incurred at death. As well, leaving 50% of the capital dividend in RobCo for use by Janice has eliminated the potential for double tax in respect to her common shares.
As part of the same technical bill that introduced the stop-loss rules discussed above, another stop-loss rule was also introduced into the Act (the "affiliated corporation stop-loss rules")(21). The intent of these rules is to prevent a taxpayer (including a trust or estate) from claiming a loss on the disposition of shares to a corporation if that person is "affiliated" with that corporation after the disposition. Instead, the amount of the loss arising on the disposition will be added to the ACB of the remaining shares owned by the taxpayer in that corporation. The loss will therefore be deferred until the subsequent disposition of those shares in circumstances where the affiliated corporation stop-loss rules do not apply.
Until the 2004 Federal Budget, the term "affiliated persons" did not apply directly to trusts (including estates). Instead, the term was applied to the trustees of the trust. So it was relatively easy to avoid the affiliated corporation stop-loss rules with respect to losses arising from the redemption of a deceased shareholder's shares. This was accomplished by ensuring that the individual trustees did not control the corporation in their personal capacity after the shares were redeemed.
However, the 2004 Federal Budget has proposed rules specific to trusts and their beneficiaries.(22) After March 22, 2004, a trust (including an estate) will be affiliated with any beneficiary who is entitled to a majority interest in the trust income or capital, and to any person affiliated with that beneficiary. In the case of discretionary trusts, the new rules will apply as if any discretion has been fully exercised with respect to each person who is a discretionary beneficiary of the trust.
Applying these new affiliation rules to our case study, Janice will be affiliated with the trust as she is a "majority interest beneficiary" under Mr. Roberts' will.(23) Jane is also affiliated with RobCo after the redemption of the shares from the estate, as she is the controlling shareholder.(24) After the redemption of the PrefB shares by the estate, the estate would be affiliated with RobCo because Jane is affiliated with both the estate and RobCo.(25) Therefore, the affiliated corporation stop-loss rules would apply to the estate.
As a consequence, the estate would not be able to carry back the $3.5 million loss that would otherwise be available due to the 50% relieving provision under the stop-loss rules.(26) This would result in the full capital gain of $3.5 million being taxable in the terminal return as a result of Mr. Roberts' death. Furthermore, the estate would be required to pay tax on the deemed dividend of $1.75 million. To make matters worse, there would be no future relief from this double taxation. This is due to the fact that the estate would not own any shares after the redemption, so the denied loss could not be added to the ACB of any shares.(27)
These new proposals can result in very punitive tax results for family owned businesses. Furthermore, as currently proposed, these rules apply after March 22, 2004, without any grandfathering for arrangements currently in place. If these proposals are enacted, it will add significant complexity and uncertainty, as well as potentially expose the owners of shares in private corporates to double taxation on death.(28) It is hoped that, in addition to the consultative effort currently underway through the Conference for Advanced Life Underwriting, advisors to small business owners will convey their concerns regarding the negative outcomes of the proposals to the Department of Finance.
Kevin Wark, LL.B., CFP, was recently appointed to the position of Senior Vice-President, Business Development, with PPI Financial Group. A well-known speaker and author in the insurance industry, Kevin has written and spoken extensively in the areas of estate and tax planning and is the author of the consumer book "Everything You Need to Know About Estate Planning" published by Key Porter Books. He is also the editor-in-chief of the publication "Insurance Planning" distributed by Federated Press. He is a member of the Canadian Tax Foundation, Canadian Bar Association, the Conference for Advanced Life Underwriting, and the Society of Trust and Estate Practitioners, as well as a member of the Board of Advisors for the Toronto Community Foundation. Kevin can be contacted at (416) 349-6474 or firstname.lastname@example.org.