If you have clients who own Canadian private company shares, make sure they pre-plan for post-mortem tax issues. Without a tax-efficient strategy, most of their hard-earned corporate dollars could be paid to the taxman instead of to intended estate beneficiaries.
At death, taxes can be triggered at three levels: personal or terminal, corporate and estate.
Terminal tax is triggered when the deemed disposition of shares is reported at fair market value (FMV) on the business owner’s final tax return (the first level of tax). The shares’ FMV is determined by calculating after-tax values on unrealized gains/losses of underlying corporate assets.
Corporate tax is triggered when the underlying corporate assets are actually disposed (the second level).
Finally, the executor may wind up the company to distribute funds to beneficiaries, which deems the corporation to pay dividends that are taxable to the estate (the third level).
Without tax planning, your clients may encounter a double—and sometimes triple—tax burden. Here’s a hypothetical example.
Tony and his corporation, Mack Investments
Tony, a 56-year-old widower from Toronto and sole shareholder of Mack Investments Inc. (Mack), recently passed. He incorporated the business 20 years ago and paid $100 for 100 Class A common shares from treasury. Therefore, Tony’s adjusted cost base (ACB) and paid-up capital (PUC) are both $100. The ACB refers to what the shareholder paid for the shares, and PUC is derived from transactions with the company.
Mack manages an active investment portfolio, holding investments valuing $10 million with no accrued gains (to keep the example simple), and the beneficiaries want their cash portions of the estate.
Also for simplicity, assume the company’s capital dividend account (CDA), refundable dividend tax on hand (RDTOH) and general rate income pool (GRIP) are nil.
Paragraph 70(5)(a) of the Income Tax Act (ITA) deems the taxpayer to have disposed of all capital property at FMV immediately before death.
Thus, for terminal tax, Tony’s deemed disposition of shares amounts to the difference between the FMV of $10 million and ACB of $100, 50% of which is a taxable capital gain.
As shown in Table 1, Tony’s personal tax owing at death in this situation is almost $2.7 million.
Table 1: Tony’s terminal tax
|Deemed proceeds from shares||$10,000,000|
|Taxable capital gain (50%)||$4,999,950|
|Personal tax (using Ontario’s top marginal tax rate of 53.53%)||$2,676,473|
Usually, corporate tax would be payable if the company held an investment portfolio with accrued gains. Half of the capital gain is subject to corporate taxes, and the non-taxable portion of capital gains can be paid tax-free to the estate by way of the CDA.
Corporate tax can be reduced through the corporation’s RDTOH account when a required dividend is paid. This requirement can be met when the corporation is wound up or through a share redemption, which deems dividends paid to the estate.
In Mack’s case, there are no accrued corporate gains, and therefore corporate tax is nil.
The deceased’s estate is deemed under paragraph 70(5)(b) of the ITA to have acquired the shares at FMV subsequent to the deceased’s deemed disposition.
To accomplish distribution of estate proceeds, the executor will wind up the company. This triggers subsection 84(2) of the ITA, deeming the estate to receive a dividend equal to the company’s value in excess of PUC (see Table 2) and to have disposed of the shares.
The act allows a reduction of the proceeds of disposition equal to the deemed dividend, creating a capital loss that can be carried back to the terminal return (see Table 3). The capital loss can be applied to offset the capital gain tax from the deemed share disposition if the windup is administered in the estate’s first taxation year by electing under subsection 164(6) of the act. For those who don’t plan, the capital loss may be wasted and will only be available for future taxation years.
Table 2: Tony’s estate tax on corporation’s windup
|Capital dividend (tax-free)||None|
|Dividend tax (using Ontario’s top marginal tax rate for non-eligible dividends—46.84%)||$4,683,953|
Table 3: Creation of capital loss available for carryback to the terminal return under 164(6)
|ACB||($10,000,000); deemed acquisition of the shares immediately after death|
|Capital loss (available for carryback)||($9,999,900)|
With no tax planning, total tax could result in a whopping 74% (see Table 4). Mack’s value has been taxed twice: once at capital gain rates arising from the deemed disposition of the shares reported on the terminal return, and again at the higher non-eligible dividend rate upon company windup taxable to the estate.
Table 4: Tony’s tax summary
|Effective tax rate||74%|
However, with proper planning, the additional layer of tax payable at the higher dividend tax rate can be eliminated.
Post-mortem pipeline strategy
The pipeline strategy allows the estate to extract corporate funds without incurring the additional higher rate tax.
Essentially, the shares are deemed acquired by Tony’s estate for $10 million, otherwise known as “hard ACB,” which can be converted to non-share consideration (cash or debt), called “boot,” via a post-mortem pipeline. Boot can eventually be withdrawn from the company tax-free, eliminating the extra layer of high-rate tax.
The estate incorporates a new company (we’ll call it Newco). On behalf of the estate, the executor (provided the will allows flexibility for tax-efficient decision-making) transfers Mack shares to Newco, usually by electing under subsection 85(1) of the ITA (defers gain if shares increased in value from date of death). In exchange for the shares, the estate can take back a promissory note equal to the elected amount, which is usually the cost basis of the shares. As a result, no tax is payable on this transfer.
Now, Newco owes the estate $9,999,900, reducing the combined or aggregate value of the companies to $100. Eventually, the note can be repaid to the estate without triggering a deemed dividend. However, to accomplish this, CRA requires the operating company to continue for at least one year, and possibly longer, before the companies can be amalgamated, forming “Amalco.” Thus, the note can be gradually repaid to the estate.
Subsequent to the note repayment, Amalco is eventually wound up, and this time no taxable dividend (see Table 5) or taxable gain/loss arises (see Table 6) provided the technical provisions of the act are considered.
Table 5: Amalco windup with post-mortem pipeline planning
|Capital dividend (tax-free)||None|
Table 6: Deemed disposition of Amalco shares
|Deemed share disposition on windup|
|Capital loss available||None|
To summarize, dividend tax is eliminated in the estate due to the conversion of the high cost basis on the shares to non-share consideration, reducing the effective tax rate from 74% to 27% (see Table 7, below).
Table 7: Tax summary with post-mortem pipeline planning
|Summary of taxes paid|
|Effective tax rate||27%|
Undergoing a post-mortem pipeline is usually a complicated, timely and costly process. However, the tax savings may more than offset those costs by eliminating a layer of tax and accessing favourable tax rates. CRA has issued numerous favourable advance income tax rulings and interpretations requiring meticulous planning, time requirements and other criteria that must be followed, without which the intended tax-efficient outcome could fall through the cracks.
Other considerations can reduce taxes further. For instance, it’s possible to elect under subsection 164(6) to redeem enough shares to benefit from RDTOH, CDA or GRIP (eligible dividends) and offset part of the terminal capital gain before the pipeline transaction is undertaken—known as a partial pipeline. Also, depending on your client’s situation, a spousal rollover, or selling or redeeming shares during lifetime can be considered. Advisors should encourage their clients to speak with their accountants to help with tax-efficient options that meet their unique needs.