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The death of a shareholder of a private company often means the implementation of one or more post mortem planning arrangements to minimize the tax arising on the shareholder's death. Some relatively recent legislative changes and proposals have changed, or at least caused a re-thinking of, plans that should be put into place. In this CALU Report, member Chris Ireland of PPI Financial Group focuses on a number of key issues that must be considered when dealing with the death of an owner of private company shares. CALU thanks Chris for sharing his expertise on this complex topic.
Paul McKay, CAE
Table Of Contents
The death of a shareholder of a private company often means the implementation of one or more post mortem planning arrangements to minimize the tax arising on the shareholder's death. Some relatively recent legislative changes and proposals have changed, or at least caused a re-thinking of, the plans that should be put into place. These legislative changes include the reduction in the capital gains inclusion rate to 50% (a change that has now been in place for over six years), changes to the affiliated stop-loss rules, and the proposed reduction in the tax rates applicable to the receipt of certain dividends.[1] This article will not review all of the issues and changes, but will focus on a number of the key areas that must be considered when dealing with the death of an owner of private company shares.[2] Specifically, the following issues will be reviewed:
To review these issues, let's start with the following simple example:
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The death of Mr. Jones will result in a deemed disposition of his shares of ABC Co., with a capital gain of $6 million in his final, or terminal, personal income tax return. Assuming the highest marginal rate of 46.4% for a resident of Ontario, there would be $1,392,000 of capital gains taxes payable on death. If capital loss planning was undertaken after Mr. Jones' death, with the provisions of subsection 164(6)[4] utilized on a timely basis,[5] the capital gain could be eliminated and replaced by a dividend taxed in the first taxation year of Mr. Jones' estate.[6] Assuming that none of the dividends are "eligible" dividends, the dividends are subject to tax at the highest marginal tax rate (31.1%), the affiliated stop-loss rules in subsection 40(3.6) do not apply, and there is no balance in ABC Co.'s capital dividend account, the tax liability would be $1,878,000, an increase of $486,000. From a tax perspective, there would be no reason, in this example, for the capital loss planning to be completed. Instead of the capital loss planning, the so-called pipeline planning could be implemented which would preserve the capital gains rate.
The following steps could be completed to implement this planning:
If ABC Co. owned non-depreciable capital property at the time of Mr. Jones' death, "bump" planning could be completed in conjunction with the pipeline planning to reduce the future corporate tax on the non-depreciable capital property that is designated. The reduction in the corporate income tax would be achieved by making an election to increase the cost base of the non-depreciable capital property (subject to limitations contained in the bump rules). In addition to the three steps listed for pipeline planning, ABC Co. would be wound up into, or amalgamated with, Newco.[7] These steps could be illustrated as follows:
The following chart shows the difference in the 2007 capital gains and dividend rates for all of the provinces, comparing the highest marginal rates.
The May 2, 2006, Federal Budget will impact this analysis if ABC Co. has a balance in its general rate income pool ("GRIP").[8] A dividend paid and designated out of a company's GRIP balance (an "eligible" dividend) will mean the recipient of the dividend, if a Canadian resident individual, will be taxed at a lower rate. This next chart adds to the previous one by comparing the highest marginal rates (federal and provincial) for eligible dividends, non-eligible dividends and capital gains.
In those provinces where eligible dividends are taxed at a lower rate than capital gains, and where there is sufficient GRIP balance in the corporation, it will be more advantageous to "convert" the capital gain into an eligible dividend through the use of subsection 164(6), rather than use the pipeline/bump strategy.
The availability of capital dividends must also be considered when determining the appropriate post mortem plans. The potential post mortem planning, in order of priority, can be summarized as follows:
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The fair market value deemed disposition on death rules can also apply to certain trusts when a particular beneficiary dies.[10] For a spouse or partner trust, the death of the spouse/partner beneficiary will result in the fair market value deemed disposition rules for the trust; for an alter ego trust, the deemed disposition rules will be triggered by the death of the alter ego beneficiary; for a joint spousal/partner trust, the second to die of the spouses/partners will cause the trust to have a fair market value deemed disposition of certain assets. Therefore, the post mortem planning arrangements and issues that must be considered for an individual owning private company shares, must also be considered for these types of trusts. Instead of Mr. Jones owning the shares of ABC Co., assume that an alter ego trust for the benefit of Mr. Jones owns the shares, as follows:
The $6 million capital gain would still be realized on Mr. Jones' death, but the taxpayer reporting the gain would be the alter ego trust. Unfortunately, although the capital gain realized has not changed, not all of the post mortem rules that are available to an estate of an individual are available to spousal/partner trusts, alter ego trusts, and joint partner trusts.
This section will examine the following areas:
i) Capital loss planning As discussed earlier, when Mr. Jones owned the shares of ABC Co. as an individual at the time of his death, subsection 164(6) planning could be implemented to deal with the potential double tax to the estate/beneficiaries. However, this provision is not available to a trust Ð for example, in the preamble to subsection 164(6), the wording includes references to "... the estate of a deceased taxpayer ...", and "... the first taxation year of the estate...". If the shares are owned by an alter ego trust at the time of Mr. Jones' death, the requirements in the preamble would not be satisfied.
For the purposes of the Act, though, the alter ego trust (as well as a spousal/partner trust and a joint partner trust) is considered a separate taxpayer[11] and, therefore, the loss carry back rules could potentially be utilized to eliminate the deemed gain on death realized by the alter ego trust. Specifically, any net capital losses realized in the same taxation year as the deemed gain, and the next three succeeding taxation years of the trust, could be used to offset the deemed gain. As an alter ego trust is required to have a calendar year end,[12] if Mr. Jones died in 2007, the trust (assuming it is still in existence) could implement capital loss planning in 2007, as well as for 2008, 2009 and 2010.[13] It is essential that the same taxpayer (i.e., the alter ego trust) realize the capital loss. The Act does not presently have any special rules to allow the carry back of a loss to the relevant tax return of the trust from another taxpayer (in other words, no equivalent section to subsection 164(6)).
The wording of the trust deed must be reviewed by legal counsel to determine if the trust will be in existence for a sufficient period of time after the death of the relevant beneficiary, and if the assets that could be used to create a capital loss (the ABC Co. shares in our example) are still owned by the trust and not otherwise required to be distributed. Planning for these types of trusts must include a properly worded trust deed to ensure the potential use of capital loss planning after the death of the particular beneficiary.
It is also important to note that all income in the alter ego trust will be taxed at the highest marginal rate, including any net deemed gain, and that subsection 75(2) will no longer apply to any income of the alter ego trust after the death of the particular beneficiary. In addition, any capital or non-capital losses that the deceased individual may have available cannot be used to offset the capital gain in the trust nor can the alter ego trust use the capital gains exemption.
ii) Pipeline and Bump Planning Considerations The other post mortem planning alternatives discussed above for individuals are also applicable to these trusts, but additional steps may be necessary. For example, the trust will have an increased adjusted cost base of its shares because of the fair market value deemed disposition and subsequent reacquisition, of shares pursuant to subsection 104(4), and could therefore complete the pipeline planning alternative. However, in order to implement the bump planning there must be an acquisition of control (of ABC Co. in the example) as a consequence of the death of the relevant beneficiary.[14] This acquisition of control requirement would not be satisfied if the trust owned all of the shares of ABC Co. before and after the death of Mr. Jones. If voting shares are transferred from the trust to beneficiaries as a result of Mr. Jones' death, the acquisition of control should be met.[15]
iii) The Affiliated Stop Loss Rules and Subsection 40(3.61)The affiliated stop loss rules must be considered whenever post mortem capital loss planning is to be implemented although the recent addition of subsection 40(3.61) will usually result in the affiliated rules not applying to capital loss planning for shares owned by an individual's estate. This relatively new provision[16] only has application to losses that are to be carried back under subsection 164(6), and therefore is not available to post mortem capital loss planning for spousal/partner trusts, alter ego trusts and joint partner trusts.[17]
A typical example of when these rules could apply is when the controlling shareholder of the relevant company is also the majority interest beneficiary in a trust. Consider our alter ego trust example for Mr. Jones, and assume that the shares of ABC Co. are controlled after the death of Mr. Jones by his son, who is also the residual beneficiary of the trust. This situation is illustrated as follows:
Pursuant to the definition of majority interest beneficiary in subsection 251.1(3), Son would be the majority interest beneficiary of the trust (and therefore affiliated with the trust under subparagraph 251.1(1)(g)(i)), and he would also be affiliated with ABC Co. as the controlling shareholder (subparagraph 251.1(1)(b)(i)). ABC Co. would then be affiliated with the trust because of subparagraph 251.1(1)(g)(ii). Any capital losses that are created with respect to the trust's shares of ABC Co. could be denied under the affiliated stop-loss rules.[18] Consequently, planning must be considered to avoid the application of these rules.
Planning alternatives for Son and the trust include the following:
The winding-up of ABC Co. could be relatively straightforward Ð the assets of the company would be distributed to the trust, with the company realizing any gains inherent in the assets and the trust realizing a deemed dividend on the distribution,[19] and a capital loss on its shares of ABC Co.[20] This capital loss would not be subject to the affiliated stop loss rules because of the rule in paragraph 69(5)(d) and, therefore, would be used to offset the deemed gain arising on the death of Mr. Jones (assuming the capital loss was realized in the same taxation year as the deemed gain, or the loss carry back rules have been used, as discussed above).
However, the wind up of a company that has significant assets can have income tax and other implications. If ABC Co. is an operating company, or a company with accrued gain assets, there could be corporate income tax realized on the winding up, resulting in a prepayment of tax that may not otherwise have to be incurred for several years. Also, if the company owns real estate, depending on the location of the real estate, there could be land transfer tax realized on the wind up. Any other shareholders of the company would not want a wind up as it would result in deemed dividends and/or capital gains to those shareholders. These potential other implications must be considered before implementing a winding up.
An alternative to the wind up of the corporation in which the trust owns shares is to utilize a new company, which would become the owner of the shares (the ABC Co. shares in the example), with the new company eventually being wound up to allow the trust to realize the capital loss.
The steps to implement this alternative could be as follows:
CRA has stated in a number of written interpretations and rulings that the general anti-avoidance rule would not apply to this type of transaction.[21] Given that the result is the elimination of double tax by allowing the capital loss, the lack of application of the general anti-avoidance rule is appropriate.
iv) Donation Planning A donation made pursuant to an individual's will is allowed to be claimed on that individual's terminal return because of subsection 118.1(5). This provision specifically deems the gift to be made immediately before the individual dies. Another rule allows for donations made in the year of death to be available to be carried back to the immediately preceding year.[22] However, these provisions, or similar ones, are not available to trusts. For example, if an alter ego trust, under its terms, was to make a gift to a registered charity after the death of the alter ego beneficiary, there is not a provision that deems such a gift to be made in the same taxation year as the deemed realization of the capital gains (or a provision that deems the gift to qualify as one for donation purposes). The necessary tax result can still be obtained but this type of planning is another example of making sure the trust deed or will is properly drafted.
As a general rule, the trust deed or will must be drafted so that the trustees have the power to make the gift. In document 2000-0056625, CRA stated that "where the trust agreement empowers the trustees to make a gift and the trustees exercise this power, it would be appropriate for subsection 118.1(3) to apply.[23] On the other hand, where the charity is an income beneficiary and a distribution is made out of the trust's income, subsection 104(6) would be the relevant provision.[24] These comments on subsections 118.1(3) and 104(6) will also apply to alter ego trusts; however, the amount deductible under subsection 104(6) by alter ego trusts will be restricted in certain circumstances...."[25]
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Certain post mortem planning issues that could arise for trusts were reviewed in the previous section, with spousal trusts being one of the types of trusts that could be affected. It was assumed in the last section that the particular trusts (spousal, alter ego, joint partner) were properly set up, including a properly drafted trust deed. If a spousal trust is properly established, the rollover rules apply Ð for both inter vivos and testamentary spousal trusts. The use of a proper testamentary spousal trust, of course, results in the transfer of assets from a deceased to the spousal trust on a rollover basis. Instead of the fair market value deemed disposition rules of subsection 70(5) applying, the rollover in subsection 70(6) results. The fair market value deemed disposition rules then apply on the death of the spouse beneficiary (with the issues reviewed in the previous section potentially applying).
There are a number of criteria that must be satisfied to achieve a rollover of assets at tax cost to the spousal trust. The criteria include the spouse beneficiary being entitled to receive all of the income of the trust during his or her lifetime (with income defined to be income for trust law purposes less certain dividends),[26] and only the spouse beneficiary can receive or obtain the use of the income and capital of the trust, again during the lifetime of the spouse beneficiary.[27]
One of the planning considerations when setting up a spousal trust must be ensuring that the will or trust deed contains the appropriate terms. An improperly drafted trust deed or will (inadvertent or otherwise) could cause a fair market value deemed disposition on the death of the spouse, rather than the intended rollover. To illustrate the importance of a properly drafted will, consider the following examples:
The message is clear, it is essential that the person drafting a spousal trust deed, or a will that is to contain a spousal trust, must make sure that the trustee powers not allow for any non-fair market value or non-commercial transactions to beneficiaries other than the spouse beneficiary, during the lifetime of the spouse beneficiary. The trust deed or will must be carefully reviewed for such powers or similar clauses.
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As discussed in the previous sections, post mortem planning can mean significant deemed dividends (often from the ownership of fixed value preferred shares) together with the realization of large capital losses, and/or implementing pipeline planning and possibly taking advantage of the bump rules. Any time dividends are realized on preferred shares, Part VI.1 tax must be considered. Also, any time bump planning is contemplated, the bump denial rules must be reviewed. Although Part VI.1 tax is generally considered to apply to a public offering of preferred shares, this tax can apply whenever there are taxable preferred shares, which can arise with private corporation shares. Similarly, the bump denial rules are not usually thought of when dealing with a closely held private corporation, but must still be reviewed. As mentioned in the introduction to this paper, both of these rules can be very complicated. It is beyond the scope of this paper to review all of the technical details of the rules. Instead, an overview of the issues will be provided together with examples illustrating the planning considerations.
i) Part VI.1 Tax This tax can be as much as 50% of the taxable dividends, although there is a $500,000 dividend allowance available, as well as other exclusions. Generally, if there is an arm's-length executor or trustee involved in an estate or trust, Part VI.1 tax must be considered, unless the estate or trust controls the company paying the dividends. Consider the following example:
Example #1
Under this example, the estate controls ABC Co. If the freeze preferred shares are redeemed as part of the post mortem capital loss planning, with the estate retaining voting control of the company, Part VI.1 tax should not apply because of the substantial interest exclusion.[29] However, consider this second example where voting control is with other shareholders and the executor of the estate is not related to any member of the Jones family:
Example #2
In this example, the substantial interest exclusion would not apply as the estate should not be considered related to ABC Co., and does not own 25% or more of the votes and value of ABC Co., or 25% or more of each class of issued shares of ABC Co. Other exclusions are available,[30] including the exclusion for ABC Co. being an investment holding corporation, which could apply depending on the assets and activities of the company. There is also an exclusion for deemed dividends in subsection 191(4) which may apply in a post mortem plan as the capital loss is often triggered on a redemption of shares. The message for this potential trap is to consider Part VI.1 tax before the death of the shareholder or trust beneficiary so that any necessary planning can be put into place before it may be too late.[31]
ii) Bump Denial Rules These rules consist of several definitions[32] and have been the subject of a few articles and papers in recent years (the details of the rules are realistically well understood by very few tax practitioners and therefore it is essential that a tax specialist be consulted when considering these rules).[33] At the risk of oversimplifying a very complicated area, consider these three general rules:
Example #1
Example #2 
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There can be significant benefits arising from the implementation of a post mortem plan for the estate of a deceased shareholder of a private corporation. This article has reviewed some of these benefits as well as some of the pitfalls and technical issues that must be considered and overcome. Putting together an appropriate post mortem plan is an exercise that must be dealt with not only after the death of a shareholder, but, just as importantly, during the shareholder's lifetime. Careful consideration of all of the issues and planning alternatives today will assist in the eventual completion of a successful post mortem plan.
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[1] Bill C-28, which contains the legislation for the new eligible dividend rules, received third reading in the House of Commons and first reading in the Senate on Dec. 11, 2006, but has not yet become law.
[2] There are a number of references that review the issues in detail. For example, see Jim Barnett, Peter Everett, Chris Ireland and Shelagh Rinald, "Post Mortem Planning for Private Company Shares: The New Regime", in Report of Proceedings of the Fifty-Fourth Tax Conference Reports (Toronto: Canadian Tax Foundation; 2003), 321-95; and Marco Faccone and Leanne Gehlen "Post Mortem Estate Planning", 2006 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2006).
[3] Supra footnote 1.
[4] All statutory references in this paper are to the Income Tax Act, RSC 1985 c.1 (5th Supp.) as amended.[5] For a detailed review of the requirements and mechanics of subsection 164(6), see Barnett et al, supra footnote 2.
[6] By utilizing the provisions of subsection 164(6), the potential double taxation to the estate and beneficiaries is removed. If no planning is completed, the deceased would have paid capital gains tax in the terminal return and the estate and/or beneficiaries could end up paying tax in the future on the same value when the shares are redeemed or taxable dividends received on the shares.
[7] Pursuant to the requirements of paragraph 88(i)(d) or subsection 87(11).
[8] Most professional services firms have issued publications on these new rules. Other reference sources include Richard J. Bennett, "June 29, 2006 Draft Legislation on Eligible Dividends", 2006 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2006); and David Louis, "The Good, the Bad, and the Ugly", Small Business Times, Number 23, August 2006, (Toronto: CCH Canadian Limited).
[9] For Manitoba, Ontario, Quebec, Nova Scotia, Prince Edward Island, and Newfoundland and Labrador, the capitals gains rate is lower than the eligible dividend rate so pipeline planning should be completed before capital loss planning using eligible dividends (with no remaining refundable dividend tax on hand balance in the company).
[10] Paragraph 104(4)(a).
[11] Subsection 104(2).
[12] Paragraph 104(23)(a). This provision is to be repealed under the July 18, 2005 draft legislation, and replaced by paragraph 249(1)(c).
[13] As in the previous example for Mr. Jones directly owning the shares of ABC Co., it has been assumed that ABC Co. does not have any balance in its capital dividend account either at the time of Mr. Jones' death, or created after his death.
[14] Paragraph 88(1)(d.3)
[15] See technical interpretation 2000-0039395.
[16] Subsection 40(3.61) is effective for dispositions after March 2004.
[17] The lack of application of subsection 40(3.61) to these trusts, and the resulting perceived inequity, has been pointed out to the Department of Finance by several organizations, including CALU, the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants (by letter dated January 19, 2005), and the Society of Trust and Estate Practitioners (by letter dated March 9, 2005).
[18] Note that the denied loss can be added to other shares owned in the company by virtue of paragraph 40(3.6)(b). However, in our ABC Co. example, all of the shares owned by the trust have been repurchased.
[19] Pursuant to subsection 84(2).
[20] The proceeds for purposes of calculating the capital loss would be reduced by the subsection 84(2) deemed dividend (paragraph (j) of the definition of "proceeds of disposition" in section 54); the adjusted cost base of the shares would be equal to their fair market value on the date of Mr. Jones' death.
[21] For example, see CRA documents 2001-0093363 and 2003-0018823.
[22] Subsection 118.1(4).
[23] Subsection 118.1(3) determines the credit for charitable donations.
[24] Allowing a deduction to the trust for distributions of income.
[25] The deduction would be restricted to the extent of income up to the end of the date of death of the alter ego beneficiary.
[26] Subsection 108(3).
[27] Subparagraphs 70(6)(b)(i) and (ii). Other criteria that must be satisfied include the trust being resident in Canada, and that the property transferred must vest indefeasibly in the spousal trust within 36 months of the date of death of the taxpayer (or such longer period as agreed to by the Minister).
[28] CRA document 2006-0185551C6.
[29] Subsection 191(2).
[30] Subsection 191(1).
[31] For a more detailed discussion of the issues, exclusions and planning possibilities, see Barnett, et al, supra footnote 1.
[32] The definitions are in subparagraph 88(1)(c)(vi) and include "specified person," "specified shareholder," "restricted person" and "restricted property."
[33] The papers include Judith Woods and Jerald Wortsman, "The Bump Denial Rule in Subparagraph 88(1)(c)(vi)", in Report of Proceedings of the Fiftieth Tax Conference, 1998 Conference Report (Toronto: Canadian Tax Foundation, 1999), 14:1-40; and Marc N. Ton-That, "The Bump Denial Rules: In History and in Practice", in Report of Proceedings of the Fifty-Second Tax Conference, 2000 Conference Report (Toronto: Canadian Tax Foundation, 2001), 27:1-66.
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Chris Ireland is a CALU member with PPI Financial Group in Vancouver. He can be reached by e-mail at cireland@ppi.ca.
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