Are You Liable for the Private Corporation Double Tax? - Part 1
When you die as a Canadian resident, you’re deemed to have disposed of all of your assets at FMV. If you hold public company shares, you recognize any capital gain on your final return and your estate can just sell them after and be done with it, given there is no change in value after death. Vs. if you own a private company that owns investments inside of it, like a holding company, it is a little bit trickier than just selling the shares.
This problem is better explained through an example. If a Canadian resident owns a private corporation with investments inside it worth $10m and the ACB is just $1 (these numbers are just to prove my point), upon death he is deemed to dispose of this corporation at $10m. Which means on his final tax return he will have a capital gain of $9,999,999 with taxes owing of $3,613,448.
The estate now takes over the private corporation with it’s ACB being equal to the current FMV of $10m. The estate taking over does not result in an acquisition of control and all the rules that go along with acquisitions of control due to subsection 256(7) of the Income Tax Act. The ACB on the shares is bumped up to FMV of $10m for the estate, but the assets within the corporation are still held at their original cost.
The corporation will then liquidate the investments inside in order to wind down. The problem here is that there will now be tax within the corporation. And because it is investment income and not active business income, it is taxed at the high rates inside the corporation. There will be a capital dividend and refundable taxes that can reduce the taxes. But the corporation will pay roughly $1,288,885 in taxes owing on the T2 corporate tax return.
So that is two layers of tax. A double tax. Can we add three layers? The Canadian government says yes. In order to wind-down the corporation and get all the liquidated cash out, the estate will have to pay it out. This will trigger a deemed dividend because the amount paid out exceeds the paid-up capital in the corporation. The total proceeds left in the corporation below of $5,378,115 is calculated as “F” above. You can see the third layer of tax will result in the estate/beneficiaries paying $2,565,360 of taxes in this example.
The winding down of the corporation will also result in the estate realizing a capital loss of $9,999,999 because if you remember from above, they took over the shares at FMV of $10m.
Based on all three of those layers of taxes, the total taxes owing would be $7,467,694. Which means the effective tax rate is 74.68%. Which is absurd. A $10m value of assets is wiped out to $2,532,306 of after-tax proceeds.
Is there any planning for this?
There are ways around paying these exorbitant taxes. I will go into the options you would have in Part ll of this post.
However, if you were to pass and your spouse is still alive, you could just roll these shares over to them. Your spouse would just step into your cost basis and no taxes would be owing. This just delays the taxes from when your spouse were to pass. Also, if you don’t have a spouse or your spouse passed before you, this rollover is out of the question.
If the private corporation is an actual business, there would be a large final tax return bill due. But, if there is a ready market for the shares because it holds an actual business, the estate can just sell the shares and not have to liquidate the assets inside the corporation.
Stay tuned for Part ll.
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