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In this issue of CALU Report, CALU members Kevin Wark and Glenn Stephens describe the mechanics and income tax consequences of a strategy that involves a redemption of shares after they have been transferred to a surviving spouse.
Table Of Contents
Prior to the introduction of stop-loss rules in April 1995, it was possible to achieve tax deferral on the redemption of shares owned by the deceased shareholder of a private corporation where such redemption was funded with corporate owned insurance. Grandfathering rules allow transitional relief for certain arrangements that were in place on April 26, 1995. Otherwise, complete tax deferral on a post mortem insured redemption of shares is generally not available.[2]
However, even where grandfathering is unavailable, tax deferral on an insured redemption of shares can still be achieved in situations where a deceased shareholder transfers those shares to a surviving spouse prior to their redemption. This article will describe the mechanics and income tax consequences of the "spousal rollover and redeem" strategy that involves a redemption of shares after they have been transferred to a surviving spouse.[3]
Copyright the Conference for Advanced Life Underwriting, December 2008
This strategy is implemented using a combination of the shareholders' wills and a shareholders' agreement signed by all the shareholders and their respective spouses. This can best be illustrated using the following example:
Billy and June each own 50% of the shares of a private corporation (Opco). They are both Canadian residents and are unrelated to one another. Billy has a wife, Hillary, and June has a husband, Wally, neither of whom is active in the business. The adjusted cost base (ACB) and paid up capital (PUC) of the shares owned by Billy and June is $0 in each case. The fair market value of their shares is $2,000,000 in total ($1,000,000 each). Both Billy and June have fully utilized the $750,000 capital gains exemption on the sale of shares of another corporation.[4] Opco is owner and beneficiary of a $1,000,000 policy on the life of each of Billy and June for the purposes of funding the buyout described below.
The following are the essential elements of the spousal rollover and redeem strategy as they would apply in this case:
Billy and June would each have a will that provides for their respective spouses to inherit the deceased's shares in Opco. Alternatively, as described more fully below, the shares could pass to a trust for the surviving spouse.
Billy and June would enter into a shareholders' agreement dealing with, among other things, the purchase and sale of their shares on death. It will be assumed that Billy predeceases June, in which case the following would occur under Billy's will and the shareholders' agreement:
Hillary inherits Billy's shares in Opco under the terms of his will. In the shareholders' agreement, June has acknowledged Billy's intention to transfer his shares to Hillary by will, and would have consented to the transfer.
The agreement provides that, within a given number of days after Billy's death (a range of 90 to 180 days would be appropriate), Hillary has the option (the "Put Option") to require Opco to redeem her shares.
The agreement also provides that, if Hillary does not exercise the Put Option within the stipulated time, June and/or Opco have the option (the "Call Option") to require Hillary to sell her shares.
The following are the income tax consequences of these transactions, assuming Hillary exercised the Put Option:
On Billy's death, his shares pass to Hillary at the existing ACB of nil.[5]
Opco will receive $1,000,000 of insurance proceeds on a tax-free basis. The amount of the proceeds, less the ACB of the insurance policy, is credited to Opco's capital dividend account (CDA). For purposes of this discussion, it is assumed that the ACB of the policy at the time of Billy's death is nil, resulting in a CDA credit of the full $1,000,000.[6]
On the redemption of her shares, Hillary receives a deemed dividend in the amount by which the redemption proceeds exceed the PUC of the shares ($1,000,000 Ð 0 = $1,000,000).[7] Under the terms of the shareholders' agreement, Opco elects to treat this as a capital dividend, allowing Hillary to receive the funds tax-free.
For capital gains purposes, Hillary's proceeds of disposition ($1,000,000) are reduced by the amount of the deemed dividend (also $1,000,000).[8] Therefore, her proceeds of disposition are nil, the same as her ACB, resulting in no capital gain or loss to Hillary.
Following the redemption of Hillary's shares, June is left as Opco's only shareholder. Her shares at that point represent all of Opco's $2,000,000 value, although the ACB of her shares remain at nil. As a result, when June ultimately disposes of the Opco shares, she will also be liable to pay tax on the capital gain that was attributable to Billy's shares at the time of his death.
The net result of this strategy is the complete deferral of tax with respect to Billy's shares on his death. This duplicates the result in cases where shares are redeemed (using corporate owned insurance) directly from the estate in circumstances where grandfathering is available. In essence, the stop-loss rules are irrelevant in the spousal rollover and redeem strategy because no loss is created in any of the transactions.
The shareholders' agreement described above could include Hillary and Wally as parties, even if they were not shareholders at the time.
Alternatively the agreement could provide that, as a condition of acquiring shares under the will of a deceased spouse, Hillary and Wally would have to consent to be bound by the agreement at the time the shares were acquired from the spouse's estate. This would avoid having to include them as parties at the time the agreement was prepared. If for whatever reason a surviving spouse failed to give this consent, Opco and/or the surviving shareholder would be provided with the right to purchase the deceased's shares from the estate.
The failure of the surviving spouse to provide this consent would also mean that the Opco shares would not vest indefeasibly in the surviving spouse. This would negate the income tax rollover otherwise available on the spouse's death, and creates a significant incentive to the survivor to provide his or her consent. The subject of indefeasible vesting is considered in more detail immediately below.
The above strategy is entirely dependent upon the tax-deferred rollover of shares to the surviving spouse. In the language of the Act, such a rollover is available where the deceased's shares have become "vested indefeasibly" in the spouse within 36 months after death. This raises the question of whether shares that are subject to put and call options can be considered to have vested indefeasibly in the spouse.[9]
The Canada Revenue Agency (CRA) has addressed this issue in Interpretation Bulletin IT-449R (IT-449R).[10] In paragraph 1 of the bulletin, the CRA states that a property vests indefeasibly when a "person obtains a right to absolute ownership of that property in such a manner that cannot be defeated by any future event . . ."
Paragraph 8(d) of IT-449R deals specifically with shares that are the subject of a buy-sell arrangement. It states that there is no indefeasible vesting where the shares are the subject of a compulsory purchase and sale on the shareholder's death. However, it goes on to provide that if the agreement simply gives a third party an option to purchase the shares, the shares will vest indefeasibly at time they are transferred to the deceased's beneficiary (the surviving spouse in our example).
It must be pointed out that IT-449R has been archived by the CRA. Archived bulletins are not necessarily out of date, but neither are they updated by the CRA if administrative positions change. Taxpayers relying on an archived bulletin are advised to contact the CRA to confirm whether the relevant portion of the bulletin continues to be applicable. Regarding paragraph 8(d) of IT-449R, the CRA has confirmed in a recent telephone call that this still represents current administrative practice.
The spousal rollover and redeem strategy can also be used where shares pass to a spouse trust, rather than to the surviving spouse directly. A spouse trust may be attractive from both a tax and estate planning perspective, as it permits income splitting between the trust and spouse and protection against creditors, as well as preserving capital for the benefit of others (typically the couple's children or children from a previous marriage).
In order to qualify for a rollover to a spouse trust, the spouse must be entitled to all the trust's income during his or her lifetime. The trust may also provide for capital encroachment in favour of the spouse, at the discretion of the trustee(s). No one other than the spouse may have access to trust capital during the spouse's lifetime.[11]
In the case of the spouse trust, the Put Option would be exercised by the trustee(s) of the trust. The income tax results would be identical to those described above. The proceeds from the redemption of the shares would become part of trust capital, to be invested and managed in accordance with the will of the deceased.
As discussed above, if the spouse or the trustee(s) of the spouse trust fail to exercise the Put Option, a Call Option would be available under which the surviving shareholders and/or the corporation are entitled to purchase the shares owned by the deceased. If the Call Option were exercised by the corporation, the result would be a redemption of the shares with the same income tax results as described above.
If the Call Option were exercised by the surviving shareholders, the spouse/spouse trust will realize a capital gain in the amount by which the sale proceeds exceeded the ACB of the shares. If available, the $750,000 capital gains exemption could be claimed on the sale. One-half of capital gains in excess of the exemption would be tax-free and the other half would be taxable. This is favourable tax treatment but does not allow for the complete deferral of tax that is otherwise available under the spousal rollover and redeem strategy. On the other hand, unlike the redemption strategy, it allows for an increase in the ACB of the shares owned by the surviving shareholders.
The rollover and redeem strategy relies upon a factor that cannot be predicted, i.e., whether a shareholder will leave a surviving spouse. For this reason, a shareholders' agreement should provide an alternative buyout method for dealing with shares owned by a deceased shareholder in the event that there is no surviving spouse. This would likely entail a purchase of the deceased's shares by the surviving shareholders and/or the corporation directly from the estate. Such a buyout can often be implemented tax-effectively, though rarely on a completely tax-deferred basis.
Life insurance as a funding vehicle is also a key component of these alternative buyout strategies. One popular strategy, commonly known as the 50% solution, avoids the stop-loss rules and permits both the deceased and surviving shareholders to benefit from the CDA credit created by the insurance proceeds. Another strategy, called the 100% solution, permits even greater tax savings to the deceased but results in an element of double taxation as the surviving shareholders receive no increase in the ACB of their shares. These and other strategies have been explored in detail in previous CALU Reports.[12]
A previous CALU Report has also considered how recent changes to the taxation of dividends have affected shareholder agreement planning.[13] Briefly, these rules provide for a lower level of taxation where dividends are paid out of corporate business income (known as the general rate income pool [GRIP]) that was not eligible for the small business tax rate. These rules can potentially affect any shareholders' agreement that provides for a redemption of shares that results in some or all of the proceeds being treated as a taxable dividend.
The spousal roll and redeem strategy will not be affected by these changes if there is sufficient insurance funding and CDA credits to fully redeem the spouse's shares. In such a case, any dividend paid to the spouse would be a non-taxable capital dividend. However, the buyout on death may not be fully funded with life insurance. As well, the shareholders' agreement will likely contain an alternative buyout procedure in the event that the deceased shareholder does not leave a surviving spouse. In either case this might involve the possible use of the "50% solution" or another strategy which assumes that a deemed taxable dividend will be paid on the redemption of shares.
Where the possibility exists of taxable dividends being paid on the redemption of the deceased's shares, the agreement should contemplate to what extent the estate will benefit from the GRIP balance existing at the time of death. Otherwise, there is a possibility of dispute amongst the parties as to how the benefits of the GRIP will be shared. One suggestion is that the shareholders would share access to the GRIP proportionately based upon the fair market value of their shares at the time of death.
Copyright the Conference for Advanced Life Underwriting, December 2008
The roll and redeem can also be utilized where the individual shareholders own their shares through holding companies. Referring back to our example of Billy and June, assume that Billy is the sole owner of Billy Co., and that Billy Co. owns 50% of Opco. Assume that June has a similar structure in place. In this case, as in the previous example, Opco might be the owner and beneficiary of an insurance policy on each life. Alternatively, each holding company could own a policy on the life of its shareholder, with Opco as beneficiary. In either case, insurance proceeds received by Opco would be used to redeem shares owned by the deceased's holding company.
In this case, again assuming Billy predeceases June, the following transactions would take place:
In summary, the above strategy allows for the transfer of the Billy Co. shares to Hillary, and for the redemption of Billy Co.'s Opco shares, all to take place on a tax-free basis. After the redemption is complete, Billy Co. will have $1,000,000 of cash and an equivalent CDA credit. (It may also have other assets which it owned at the time of Billy's death.) Hillary would then be able to receive a tax-free $1,000,000 capital dividend in cash. The capital gain would effectively be transferred into the hands of June Co. (and June) as the remaining shareholder. This essentially duplicates the result that was achieved in the earlier example.
Copyright the Conference for Advanced Life Underwriting, December 2008
With continuous changes in the tax rules that apply to shareholders' agreements, it is perhaps impossible to identify the most tax-effective purchase arrangement on death as it could be implemented many years into the future. This issue is complicated by the fact that the parties under a shareholders' agreement have competing interests regarding which buy-sell method is most advantageous. From a tax perspective, insured share redemption strategies tend to favour the estate of the deceased. Where shares are redeemed, however, there is no increase in the ACB of the survivors' shares. For this reason, surviving shareholders may prefer that they, rather than the corporation, be the purchaser of the deceased's shares.
In light of these issues, it may be advisable for shareholders' agreements to provide the parties with flexibility as to the method of structuring a buy out on death. The agreement could include a statement or series of rules setting out the philosophical basis for determining the buy-sell method that will be used to buy out a deceased shareholder. The stated philosophy or rules would likely provide favourable tax treatment to the deceased by providing his or her personal representative the opportunity to determine the buy-sell methodology. This would, however, be subject to the negotiation of the parties when the agreement was being prepared, and to the tax rules in place at the time of death.
In any event, the agreement would provide that if the roll and redeem strategy could not be used, the purchase and sale of the deceased's shares would be mandatory, thus ensuring the desired transition in the ownership of the business. Whichever method was used, life insurance would be critical in providing the needed funding.
The tax rules impacting insured buy-sell agreements on death have become increasingly complex since the introduction of the stop-loss rules. Insurance advisors can play an important role in educating their clients and their advisors on the pros and cons of the various structures, as well as motivating them to complete their agreements and funding on a timely basis. In particular, the spousal put call arrangement combined with corporate owned insurance may allow shareholders to implement a very tax-effective method of transferring shares on death.
Copyright the Conference for Advanced Life Underwriting, December 2008
Kevin and Glenn are both CALU members with PPI Financial Group. Kevin may be reached by e-mail at kwark@ppi.ca and Glenn at gstephens@ppi.ca
[1] This article is based on an article written by Glenn Stephens and previously published in Insurance Planning, a Federated Press publication.
[2] The stop-loss rules referred to in this article are found in subsections 112(3.2)-(7) of the Income Tax Act, RSC 1985, c. 1 (5th Supplement), as amended, hereinafter referred to as the "Act".
[3] In this Report, the term "spouse" means a legally married person of the opposite sex and a "common-law partner" as that term is defined in subsection 248(1) of the Act.
[4] The capital gains exemption is found in section 110.6 of the Act.
[5] This rollover is provided under subsection 70(6) of the Act.
[6] See the definition of "capital dividend account" in subsection 89(1) of the Act. See the definition of the "adjusted cost basis" of a life insurance policy in subsection 148(9) of the Act.
[7] See subsection 84(3) of the Act.
[8] See paragraph (j) of the definition of "proceeds of disposition" in section 54 of the Act.
[9] The requirement that shares vest indefeasibly in order to qualify for a spousal rollover is found in subsection 70(6) of the Act.
[10] Interpretation Bulletin IT-449R, "Meaning of Vested Indefeasibly", Sept. 25, 1987.
[11] See paragraph 70(6)(b) of the Act.
[12] See "Corporate Redemption Buy-Sell Agreements and the 50% Solution", by Gail Grobe (December 2000 CALU Report) and "Corporate-owned Insurance: Revisiting Share Redemption Arrangements", by Kevin Wark (July 2004 CALU Report).
[13] See "Changes to Dividend Taxation Coming to GRIPs with the Impacts on Life Insurance Planning", by Florence Marino (October 2007 CALU Report).
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