office work and metaphor for the payment of taxes
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The post-mortem pipeline is a common strategy used to tackle double taxation when an incorporated business owner passes away (read: Holding private company shares at death could cost your client). Although the pipeline strategy can access favourable tax rates, the planning is meticulous, so a beneficiary could wait years before receiving their inheritance. To distribute estate assets quickly, what’s known as the 164(6) loss carryback strategy might be a better option.

Let’s recap the double taxation challenge. The fair market value (FMV) of a corporation can be taxed twice: once at capital gain rates on the deemed disposition of the deceased’s shares at the time of death, and again at dividend rates when the company is wound up or shares redeemed by the executor of the deceased’s estate. Provided it’s possible to sell underlying corporate assets and wind up the corporation within the first taxation year of the deceased’s graduated rate estate (GRE), the 164(6) can be a valuable alternative strategy that also addresses the looming double tax issue, allowing easy estate distribution while keeping professional fees at a minimum.

The mechanics of the strategy involve carrying back the loss triggered in the GRE’s first taxation year to offset the capital gain at death reported in the deceased’s terminal tax return, reducing or eliminating the terminal or capital gains tax. Here’s an example to see how the loss is triggered and double tax is addressed.

Rocco died as sole shareholder of a company that holds a mutual fund portfolio valued at $10 million with an inherent gain of $5 million. The shares have nominal (i.e., $1) adjusted cost base and paid-up capital, both of which can reduce the tax impact. Assume top tax rates and no opening corporate tax balances.

The deceased taxpayer is deemed to dispose of all capital property, including private company shares, immediately before death at FMV. Immediately thereafter, the deceased’s estate (i.e., GRE) is deemed to acquire the shares at FMV, giving the estate high cost base shares (see the tables below).

Table 1: Terminal or capital gains tax on deemed disposition of shares at death

Deemed proceeds at FMV (see Table 2)$9,511,750
ACB($1)
Capital gain$9,511,749
Taxable capital gain (50%)$4,755,875
Personal capital gains tax (53.53% in Ontario)($2,545,820)

Table 2: Corporate tax and date-of-death share value

Proceeds$10,000,000
Adjusted cost base($5,000,000)
Capital gain$5,000,000
Taxable capital gain (50%)$2,500,000
Corporate tax (50.2%)($1,255,000)
Refundable tax (30.67%)$766,750
Total corporate tax($488,250)
Share value$9,511,750

The terminal tax liability of $2.5 million can be reduced or eliminated using the strategy (shown in Table 5), provided the executor files an election by letter and reports the total capital losses carried back triggered in the estate’s first tax year/return.

In Rocco’s case, when the corporation disposes of the non-depreciable capital property with an inherent gain—mutual funds, in this case—a realized capital gain will be triggered subject to a 50% inclusion rate, while the remaining 50% non-taxable portion ($2.5 million) can be distributed to the GRE tax-free via the corporate dividend account (CDA) by special election. Additionally, the corporation will receive a generous tax refund otherwise known as refundable dividend tax on hand (RDTOH) when the taxable windup dividend is paid to the GRE.

The strategy’s effectiveness relies on the presumption that the corporate assets are easily disposable and sold first before the executor proceeds to wind up the corporation. This ensures corporate tax balances discussed above are available when the corporation is wound up.

The GRE is deemed to receive a dividend and dispose of the private company shares when Rocco’s executor winds up the corporation (see Table 3). Generally, the company’s value will be distributed as a taxable non-eligible dividend. However, the availability of the CDA balance saves Rocco’s GRE almost $1.2 million ($2.5 million × 47.39%) in dividend tax.

Luckily, the Income Tax Act (ITA) allows a reduction in proceeds on the disposition by the deemed dividend, adjusting the proceeds of disposition to a nominal amount. The significant capital loss available for carryback arises on the difference between the adjusted proceeds and the GRE’s acquired high cost base, which can then be carried back to offset the capital gain reported on death by way of the 164(6) election.

Table 3: GRE reports deemed dividend and disposition on windup

Estate taxes on windup
Total distribution$9,511,750
Paid-up capital($1)
Deemed dividend$9,511,749
Capital dividend (tax-free)$2,500,000
Non-eligible dividend (47.39%)$7,011,749
Dividend taxes$3,322,868
Share disposition on windup
Proceeds of disposition$9,511,750
Deemed dividend($9,511,749)
Adjusted proceeds$1
GRE’s adjusted cost base$9,511,750
Capital loss available for carryback 164(6)($9,511,749)

A set of stop-loss rules in the ITA may prevent the use of the capital loss in certain situations. For instance, Subsection 112(3.2) can grind down the allowable capital loss available for carryback when an excessive CDA amount is paid.

Let’s compare the taxes payable when no tax plan is executed versus where a 164(6) strategy is utilized (see the table below).

Table 4: Taxes paid with no tax planning

Corporate tax$488,250
Terminal tax$2,545,820
Estate tax$3,322,868
Total taxes$6,356,938
Total proceeds$10,000,000
Effective tax rate63.57%

This scenario assumes the capital loss wasn’t triggered within the required time frame and no further strategies were considered or available, resulting in double tax. Rocco’s GRE is exposed to a 64% tax rate.

Provided the loss is triggered in the GRE’s first taxation year, the 164(6) strategy allows the capital loss to offset the capital gain reported at death, eliminating double taxation (see Table 5). This can be accomplished by filing a T1 amendment, or a request to apply the loss can be filed with the original T1 return.

Table 5: The 164(6) loss carryback offsets capital gain reported at death

Deemed disposition of shares at death$9,511,750
Adjusted cost base($1)
Capital gain$9,511,749
164(6) loss carryback($9,511,749)
Taxable capital gain
Personal taxes (53.53%)

For Rocco’s estate, the combined tax rate is reduced from 64% with no tax planning to 38% (see Table 6).

Table 6: Tax summary using Subsection 164(6) loss carryback

Corporate tax$488,250
Terminal tax
Estate tax$3,322,868
Total taxes$3,811,118
Total proceeds$10,000,000
Effective tax rate38.11%

Important characteristics of GREs

GRE status is required for available use of this strategy. For an estate to be classified as the deceased’s GRE, it must be a testamentary trust as defined in Subsection 108(1) of the ITA, the executor must elect in the trust’s first taxation year that it’s a GRE, and no other estate for the deceased can be designated as such. If the intent is to utilize this strategy, it’s crucial GRE status be maintained, since tainting can accidentally occur if, for example, certain loans are made to the estate.

Not only is the GRE one of the only trusts that can access graduated tax rates for up to 36 months subsequent to death (after which, like most trusts, top personal income tax rates apply). The GRE is also the only trust authorized to have an off-calendar year-end during the same 36-month period, so access to graduated tax rates during this time period is possible with a date of death at year-end.

Pitfalls

Although this strategy reduces tax, it eliminates tax at favourable capital gain rates (accessible via the pipeline strategy), and instead accesses higher dividend rates. As well, the strategy requires a taxable dividend payment beyond what’s required to recover RDTOH, so it’s best suited if timely estate administration is possible.

As previously stated, the availability of this strategy depends on the nature of corporate assets and operations, and the sometimes high expectations of estate beneficiaries expecting a timely inheritance. The premise relies on the executor’s ability to sell underlying corporate assets in a timely fashion, which can be problematic or just not possible if, for instance, the corporation holds commercial real estate; a quick sale is contingent on an available purchaser. If beneficiaries prefer not to partake in lengthy planning transactions under the pipeline, the 164(6) strategy may take precedence.

Rebecca Cicco, CPA, CA, is director of tax and estate planning at Mackenzie Investments.