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This issue of CALU Report contains part II of a two-part article dealing with the post-mortem tax planning for an individual who owns private company shares at death. In the article Carol Brubacher of Manulife´s Tax and Estate Planning Group discusses and provides detailed analysis regarding the overall goal of post-mortem planning to minimize the tax burden arising at death and on distribution of a deceased person´s assets to his or her chosen beneficiaries.
In Part I, which was published in the August 2009 CALU Report, Carol looked at an individual who owns common shares of an investment corporation at death. In Part II, Carol looks at an individual who owns fixed value preference shares of an operating company.
This article was originally published in Manulife's Tax and Estate Planning Groups Tax Topics. CALU thanks Carol and Manulife for sharing this excellent discussion with our members.
Regards, Paul McKay, CAE
Table Of Contents
This article will consider the planning opportunities for an individual who owns fixed-value preference shares of an operating company at death. Fixed-value preference shares are often created in connection with an estate freeze.
As with common shares in an investment company, if the business owner holds on to the preference shares until death, he or she will have a deemed disposition of the fixed-value preference
shares at death for proceeds equal to the fair market value (FMV) of the shares. Since the shares have a set redemption value, the FMV equals the redemption value, and the tax liability on death is easily determinable (based on the excess of the redemption value over the adjusted cost base (ACB)). Often the estate plan will require that the corporation redeem the preference shares in order to provide cash for paying tax liabilities and making distributions from the estate. As with common shares, post-mortem planning can be done in order to minimize the overall tax burden.
Post-mortem tax planning for an individual owning fixed-value preference shares at death will be illustrated using the following facts:
The following sections will look at what happens if no planning is done, and compare that to two tax planning strategies that are available to reduce the tax liability at death. Note that both these strategies are similar to those outlined in connection with participating common shares, but in this fact pattern we are not concerned with unrealized gains in the underlying assets of the corporation (i.e., the operating assets) because they will not be liquidated to fund the redemption. Instead, the redemption will be funded out of current or future cash flows. (Note: Detailed calculations of the following scenarios are found in the Appendix on page 9.)
a) Do Nothing - Double Tax Issue
At the time of Mr. B´s death, there will be a deemed disposition of his shares at FMV pursuant to subsection 70(5) of the Income Tax Act (the "Act"). This will result in a capital gain of $2.5 million, and one-half of the capital gain will be taxable and reported on Mr. B´s terminal income tax return. Mr. B´s estate will now own the preference shares which will have ACB of $2.5 million equal to the redemption value, however, PUC will still be nominal. If Mr. B´s estate plan requires that the preferred shares be redeemed to provide cash to the estate, and no further planning is done, the redemption will trigger a taxable dividend of $2.5 million. As illustrated below, this would result in a tax liability of $575,000 on the capital gain plus $775,000 on the taxable dividend.
The total tax payable is $1.35 million or 54% of the value of the shares ($2.5 million). Considering capital gains tax rates are around 23%, double tax is the result. Some of the tax planning techniques that could be put in place to mitigate this tax result are outlined in the next two sections.
b) Adjusted Cost Base Pipeline
The Adjusted Cost Base (ACB) pipeline is a post-mortem planning strategy designed to limit the tax on death, to that arising from personal tax on capital gains arising on death. The ACB pipeline is a method of turning the ACB created on the deemed disposition at death into a loan from the corporation that can be repaid without incurring further tax. This allows the tax paid basis (i.e., the ACB that has already been taxed) to be extracted from the corporation without paying any additional tax. We will use the same example as above to llustrate the sequence of transactions to implement this strategy.
As above, Mr. B is deemed to dispose of his shares at FMV on his death. The resulting capital gain of $2.5 million is reported on Mr. B´s final personal income tax return resulting in income tax of $575,000. Consequently, the shares are transferred to the estate with a FMV and ACB equal to $2.5 million.
To create the "ACB pipeline," a new company (Newco) is incorporated and the estate sells the shares of Opco to Newco in exchange for two things: a promissory note receivable equal
to the value of the Opco shares ($2.5 million); and common shares of Newco with nominal value. There should be no gain or loss on the sale of shares by the estate to Newco because the FMV of the Opco shares should equal the ACB (due to the deemed disposition at death). (See Diagram below for illustration of structure.)
Opco then redeems the shares owned by Newco, which would result in a deemed dividend equal to redemption proceeds ($2.5 million) less the share´s PUC ($0). Since the dividend is between two connected corporations, the dividend would be a tax-free inter-corporate dividend. Newco can use the redemption proceeds to repay the promissory note owing to the estate without incurring any further tax. The net result of the pipeline planning strategy is that $2.5 million can be extracted from Opco on a tax-free basis.
Essentially the ACB of the preference shares has been converted into a note payable and the only tax incurred is the capital gains tax of $575,000 which arose on Mr. B´s death. The second layer of tax on the redemption has been eliminated and Mr. B´s daughter becomes the sole shareholder of Opco (since the fixed-value preference shares have been redeemed, only the common shares remain).
Life Insurance Opportunities
Corporate-owned life insurance can be used in conjunction with the ACB pipeline planning to improve the outcome. Let´s continue with our example and assume Opco purchases $2.5 million of life insurance on Mr. B to provide the necessary funds at death to redeem the preference shares owned by Newco, allowing Newco to repay the promissory note owing to Mr. B´s estate. For our example, we have assumed the ACB of the life insurance policy is nil.
At the time of Mr. B´s death the pipe-line strategy would be implemented as described above. Mr. B´s preference shares are deemed to be disposed of at FMV realizing a capital gain of $2.5 million and a corresponding tax liability of $575,000. A new holding company (Newco) is incorporated;
the estate transfers the fixed-value preference shares to Newco in exchange for common shares of Newco with nominal value and a $2.5 million promissory note. Opco receives the life insurance proceeds of $2.5 million as well as an addition to its CDA for the amount the death benefit exceeds the policy´s ACB. In this example the CDA credit is $2.5 million since the ACB of the policy is nominal. Opco uses the life insurance proceeds to redeem the preference shares owned by Newco. The $2.5 million deemed dividend on redemption is a tax-free intercorporate dividend, and Newco uses the redemption proceeds to repay the $2.5 million promissory note owing to the estate. The estate in turn uses the proceeds to fund the tax liability on death and can distribute the remainder to the beneficiaries.
The net tax effect is the same with or without insurance, except with insurance the redemption has been funded by the life insurance, whereas without insurance the redemption would have to be funded by the operating company's capital or future earnings.
Another advantage of the plan with life insurance is that Opco still has the $2.5 million CDA balance from the receipt of the life insurance proceeds as it was not needed for the pipeline strategy. The CDA can be used by Mr. B´s daughter to extract tax-free capital dividends from Opco in the future. The cost of this plan is the cost of the life insurance premiums paid by Opco.
In our calculations we have not put a "value" on the remaining CDA balance. The calculation of the CDA "value" depends on a number of factors, such as when will the shareholder(s) be able to take advantage of the CDA, or can the shareholder(s) take advantage of the CDA, what are the dividend tax rates now versus when the CDA is expected be used? The CDA "value" can range anywhere from a low of zero to a high of the CDA balance times the current dividend rate.
The table below summarizes the results of the "No Planning" option compared to the "ACB Pipeline" plan with and without insurance.
c) Redemption and Loss Carryback
The second planning opportunity is for Opco to redeem the preference shares held by Mr. B´s estate after his death and the use of subsection 164(6) loss carryback provision. This planning typically results in dividend tax treat-ment as compared to the capital gains treatment that arises from ACB pipe-line planning.
As above, when Mr. B dies, he is deemed to dispose of his preference shares in Opco at the FMV immediately before his death. The capital gain of $2.5 million is reported on Mr. B´s terminal tax return. Within the estate´s first taxation year Opco purchases/redeems the preference shares from the estate. Redemption of the shares results in a deemed dividend of $2.5 million. The deemed dividend is a taxable dividend and income tax of $775,000 would be payable by the estate.
However, the redemption also causes a disposition of the shares by the estate, resulting in a capital gain or loss. The adjusted proceeds for determining the gain or loss is the redemption proceeds less the deemed dividend. Since the redemption amount equals the deemed dividend in this example, the adjusted proceeds are nil. The capital loss is then calculated as the adjusted proceeds less the ACB of the shares. Note that the ACB of the shares is $2.5 million because of the deemed disposition at death. As a result there is a capital loss of $2.5 million. If the shares are redeemed in the first year of the estate, the capital loss of $2.5 million can be carried back to offset the capital gain of $2.5 million triggered on the deemed disposition at death pursuant to subsection 164(6) of the Act.
Thus the total tax burden on Mr. B´s death in this scenario includes only the personal income tax payable by the estate on the taxable deemed dividend arising on the redemption of the fixed-value preference shares ($775,000). No tax is payable on the capital gain at death because it is fully offset by the capital loss arising on the redemption.
If you were to compare the ACB pipeline planning strategy, and the redemption and loss carryback strategy for a business owner holding fixed-value preference shares at death, the ACB pipeline results in tax at the personal capital gains rate, and the redemption and loss carryback planning results in tax at the personal dividend rates. In our example the capital gains rate we used is lower than the dividend rate, therefore, the ACB pipeline strategy resulted in total income taxes of $575,000, while the redemption and loss carryback strategy resulted in tax liability of $775,000. Currently in most provinces capital gains treatment is preferred over dividend treatment,
however, with the new eligible dividend rates, this is not true for all provinces. Based on the rates we are using in our example, one might conclude that it would always be advantageous to take capital gains treatment; however, the existence of corporate-owned insurance may alter the decision.
Life Insurance Opportunities
Life insurance can be used in conjunction with the redemption and loss carryback planning strategy. Let´s continue with our example and assume Opco purchases $2.5 million of life insurance on Mr. B to provide funds at death to redeem the preference shares owned by the estate. Assume that at the time of death, the life insurance policy has zero ACB so that the CDA credit to the corporation equals the death benefit.
As above, there is a deemed disposition of Mr. B´s preference shares at his death. Opco will receive the life insurance proceeds of $2.5 million as well as an addition to its CDA of $2.5 million. Opco then redeems the fixed-value preference shares owned by the estate using the life insurance proceeds to fund the redemption. The redemption will result in a $2.5 million deemed dividend ($2.5 million redemption proceeds less PUC of nil), of which Opco could declare the entire dividend as a tax-free capital dividend.
As above, the redemption also results in a disposition of the shares, resulting in a capital loss of $2.5 million. Pursuant to subsection 164(6), the capital loss can be carried back to Mr. B´s terminal return to offset the capital gain reported on the deemed disposition, assuming the shares are redeemed during the first year of the estate. However, application of the subsection 112(3.2) stop-loss rules will likely deny a portion of the loss realized by the estate as a result of the redemption of the shares.
Without these rules, there would be no tax payable on the redemption of shares in this type of planning. The stop-loss rules limit the amount of losses which can be carried back using
subsection 164(6) of the Act when a capital dividend has been paid (or is deemed to be paid) on the shares. If the shares are grandfathered, the stop-loss rules will not be applicable. There are two ways that shares can be grandfathered. Very briefly, the basic requirements of the two rules are as follows:
Note that this is a very brief description of the basic rules. The detailed rules should be consulted to determine the grandfathered status of any particular shares.
If the shares are not grandfathered, and the PUC and ACB of the shares are equal then the loss carryback will be limited if the taxable dividend on redemption is less than half of the capital gain on death.
Assuming the grandfathering rules do not apply in our example, Mr. B would be subject to the stop-loss rules if Opco elected that 100% of the deemed dividend on redemption was a capital dividend. The stop-loss rules will permit only half of the capital loss to be carried back to the capital gain reported on the terminal return.
The net result is there is no tax payable by the estate on the deemed dividend received, but there is capital gains tax payable of $287,500 on half of the capital gain realized on the deemed disposition at death. The drawback of this planning scenario is that CDA credit received from the life insurance proceeds has been fully utilized on the share redemption, however, tax was still payable on 50% of the redeemed amount (at capital gains tax rates). The 50% solution discussed below is one way to avoid this issue.
Life Insurance Opportunities - 50% Solution
If the stop-loss rules apply, a life insurance planning strategy that can be used is the "50% solution." With the 50% solution only a portion of the CDA that is available is used. In our example, Mr. B is still deemed to dispose of his preference shares at FMV on his death and Opco uses the life insurance proceeds to redeem the preference shares owned by the estate. The redemption still gives rise to a deemed dividend of $2.5 million, but with the 50% solution, Opco elects only 50% of the deemed dividend be a tax-free capital dividend. The other 50% is a taxable dividend. The redemption triggers a disposition of the shares by the estate giving rise to the same capital loss of $2.5 million. However, in this case since the capital dividend paid on the shares is restricted to 50% of the loss none of the loss carryback is "stopped" by the stop-loss rules in subsection 112(3.2) of the Act. As a result, the full loss on the disposition can be carried back to the terminal return to offset the gain on death pursuant to subsection 164(6) of the Act.
The net result is that there is no tax payable on the terminal return as a result of the deemed disposition. The only tax payable is $387,500 on the taxable dividend by the estate. Since dividend tax rate is higher than capital gains rate, in this example the tax payable under the 50% solution is higher than the tax paid above when a full capital dividend was declared. However, Opco still has a $1.25 million CDA balance remaining with the 50% solution which can be used to pay a tax free capital dividend to Mr. B´s daughter in the future.
Life Insurance Opportunities - Spousal Rollover and Share Redemption
It is possible to replicate the tax treatment of grandfathered shares through what is commonly referred to as the "roll-and-redeem" strategy. This strategy uses the tax-free spousal roll-over rules at death (under subsection 70(6) of the Act). If Mr. B predeceases his spouse (Mrs. B), at the time of his death he can transfer his preference shares to Mrs. B or a spousal trust at cost, thereby deferring the tax liability on death.
Continuing the above example, at the time of Mr. B´s death Opco would receive $2.5 million insurance proceeds tax free and a credit to its CDA. Opco can then use the life insurance proceeds to redeem the preference shares owned by Mrs. B, resulting in a deemed dividend of $2.5 million. Opco can declare the entire deemed dividend as a tax-free capital dividend. The stop-loss rules outlined above do not apply in this scenario because there was no gain at death, and no loss carried back that could be denied. Therefore, the spousal rollover and share redemption result in no tax payable on Mr. B´s death.
The table below summarizes the results of the redemption strategies discussed above. For detailed calculations refer to the Appendix at the end of this document.
In general, insurance can enhance estate values arising on the redemption of fixed-value preferred shares because of the reduction in income tax borne by the estate as a result of the capital dividend account credit. This analysis does not take into account the cost of the insurance premiums that is ultimately borne by the common shareholders, nor does it reflect the benefit of having insurance proceeds available to fund the redemption.
Copyright the Conference for Advanced Life Underwriting, October 2009
In many cases capital gains are taxed at a lower rate than dividends, thus ACB pipeline planning is often preferred. However, this conclusion could change if there are changes to the dividend or capital gains tax rates, and may not hold true if there is income that can be paid out as an eligible dividend, or if there are refundable tax or capital dividend account balances arising from other sources.
In some cases, life insurance can affect the choice of post-mortem planning strategy. For example in the above analysis, life insurance made the redemption strategies preferable. Life insurance provides an effective vehicle for funding a tax liability, redemption strategies and can also be used for estate equalization and preservation.
The choice of planning that will be implemented in any particular case depends on all of the facts and circumstances at the time of death. The purpose of this article is to outline the planning strategies that are available; however, an analysis of all the rules and issues is beyond its scope. Due to the complexity of post-mortem estate planning, it is important to involve a professional tax advisor.
Copyright the Conference for Advanced Life Underwriting, October 2009
Note that section 84.1 of the Act may reduce the amount of the note receivable that can be taken back where there is V-Day value or the capital gains exemption was used.
Carol Brubacher is a consultant with Manulife's Tax and Estate Planning Group in Kitchener, ON. You can e-mail her at firstname.lastname@example.org
The original article was published in Tax Topics, a publication of Manulife's Tax and Estate Planning Group. This article may not be reproduced without the written permission of either Manulife or CALU.
Copyright the Conference for Advanced Life Underwriting, October 2009