Are You Liable for the Private Corporation Double Tax - Part ll
Last week I wrote about the tax consequences that would occur if you were to die and held a business with just investments in it (a holding company). There were 3 layers of taxes you would be liable for: tax on death, tax when the corporation sells the investments and then taxes when the corporation distributes the cash to the estate/beneficiaries. The result is that you would pay an effective tax rate of 75%. This post is to show you certain planning techniques that will help reduce that tax rate down from 75%.
Option #1 – Section 164(6) Carry Back
The use of this option eliminates the first layer of tax in the final return, the capital gain on death, and is used if the beneficiaries want to wind the company down. The process looks like this: have the estate’s shares redeemed by the corporation (aka wind down the company and take all the cash out). This will create a deemed dividend to the estate and trigger a capital loss. The deemed dividend arises because the estate will have a high ACB and low PUC from the value of when they took over the corporation. From our example in Part l, the deemed dividend was $5,378,114 that created a capital loss of $9,999,999. This capital loss can now be carried back to the final tax return that had a capital gain of $9,999,999 and extinguish it.
The essential part of this is that the estate must do this in the first year following death or else you can’t carry the loss back. Once the loss is taken, the executor will then attach a letter indicating the amount to be carried back on the amended T1 return. By eliminating the tax owing on the final return (the capital gain), it brings the effective tax rate down to just 38.54%.
There are some other things to consider when using this approach like certain stop loss rules that would reduce the amount of capital loss that can be carried back. It’s a complicated formula but the gist of it is that the estate is limited to receive a capital dividend from the corporation on wind-down up to 50% of the capital gain reported on the final return or loss created. Anything above will start reducing the capital loss that can be carried back. One problem with this is if the corporation is a beneficiary of life insurance on the deceased, it could create a large capital dividend account that would reduce the ability of this method to work. If there is a $5m capital gain on the final tax return and a capital dividend account balance of $6m on death, if the total capital dividend paid to the estate is greater than $5m, your capital loss carried back will be ground down.
Option #2 - Post Mortem Pipeline
This option exists if the company is not going to be wound down (at least not right away) or if option #1, realizing the loss within the year, has run out of time. The explanation of this option is the following:
The estate incorporates a new company and subscribes for shares for a small amount.
The estate will sell the original company’s shares for $10m (because the ACB of the original company is the FMV from when it took over in our example) to the newly incorporated company, usually using a Section 85 transfer. In return, it will take back a $10m promissory note. This promissory note is what is referred to as “the pipeline”.
You will now have the estate owning a $10m promissory note from the newly incorporated company, which in turn owns the shares of the original company. The final capital gains tax will still be owing as well as when the corporation sells its assets (1st and 2nd layer of taxes). Because Newco and the original company are now connected for tax purposes, the original company can pay tax-free intercompany dividends up to Newco and Newco can repay the promissory note the estate owns tax-free. The promissory note acts as a “pipeline” for extracting capital out of the business tax-free over a period of a few years.
The two companies can also amalgamate (combine) provided they wait at least 1 year from setting up the structure to amalgamating as CRA has stated. Amalgamating would essentially have the same effect except the promissory note is now included in the combined company.
Option #3 - 88(1)(d) Bump
The “bump” is used to avoid the 2nd layer of tax within the corporation and can even be used to eliminate the third layer. The way it works is bumping up certain non-depreciable assets by increasing the ACB that they are held at up to the FMV on death. Then when these assets are sold within the corporation, there is no gain because the FMV=ACB.
Using our example, the estate incorporates a new company like in the pipeline method. The original company shares that the estate owns is sold to this new company for the $10m in value in exchange for a $10m promissory note. The Newco now owns the OriginalCo shares with an ACB of $10m but the assets within the OriginalCo are held at $100 (this means the outside basis is greater than the inside basis). The Newco and OriginalCo then amalgamate/wound-up and in the process the ACB of $100 within the corporation is “bumped” up to the FMV of the $10m property held. Eliminating the tax when the corporation liquidates the assets inside.
Because the promissory note is still outstanding in this instance, you can then also potentially eliminate the 3rd layer of tax by paying down the note tax-free to the estate.
Closing Thoughts
These are complex tax planning techniques and I would highly stress that you talk to your tax advisor when implementing a strategy of this nature. One’s estate plan will be different than another as each corporation could have different tax attributes and timelines. It is also possible to implement a combination of the techniques but it would depend on the calculations that need to be done. There are a bunch of cases that you can read up on that CRA has commented on if you want to explore certain ways of going about this planning.
DISCLAIMER: The articles posted on TaxCrunch should not be considered specific advice to anyone readying. Please reach out to a professional advisor to seek guidance on any issues mentioned in this post before acting upon anything written here. All posts are time sensitive to what is law at the time written and are subject to changes in legislation.