Estate Freezes An Overview of Estate Freeze Transactions in Canada

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1 An Overview of Estate Freeze Transactions in Canada, Dentons Canada LLP Toronto Overview Part I: Estate Freeze Basics Factors to be considered by practitioners when reviewing a client s situation and putting together an estate freeze implementation plan. Part II: Melts, Thaws & Re-Freezes How and when an estate freeze structure can be unwound Why practitioners may want to recommend unfreezing or thawing Basics of unfreezing and refreeze transactions Part III: Partnerships & Examples of when a partnership freeze is appropriate Krauss decision 2

2 Part I: Estate Freeze Basics What is an Estate Freeze? An estate freeze is the generic term used to refer to a series of transactions designed to limit the growth of business or investment assets held by a particular shareholder and provide that future growth accrues to a different shareholder, typically one that did not hold shares prior to the freeze. Main purpose of an estate freeze is to minimize the income tax arising on death as a result of the deemed disposition of capital property on death under s. 70(5) of the Income Tax Act (the Act ). 3 Part I: Estate Freeze Basics Share Terms and Valuation Issues Growth Shares: Ordinary common shares, often do not have votes and can receive discretionary dividends. Control Shares: Ordinarily have all voting power, are redeemable and retractable for a nominal amount. Freeze Shares: Frozen by having a redemption and retraction value equal to the FMV of the corporation at the time of freeze. Because determining the correct FMV is critical to the estate freeze implementation, a Price adjustment clause ( PAC ) is a standard element of an estate freeze. Also, an unlimited amount of dividends would undermine the value set on Freeze Shares, therefore a cap on the value of the dividend is also suggested. 4

3 Part I: Estate Freeze Basics Example 1: Basic Estate Freeze with Family Trust Freezor exchanges common shares for Freeze Shares and skinny shares having nominal value but giving continued control (the Control Shares ) A Relative of the Freezor subscribes for Growth Shares and settles the Family Trust. Freezor and his children are beneficiaries of the trust. 5 Part 1: Estate Freeze Basics Example 2: The Investco Structure Freezor is concerned with preserving and maximizing ability to claim lifetime capital gains exemption ( LCGE ) on future disposition of shares. Shares of the corporation must therefore meet definition of qualified small business corporation share under s (1) of the Act. 6

4 Part 1: Estate Freeze Basics Example 2(a): Investco Variation Possible downside of setting up Investco as a corporation owned by the Freezor is the value of Investco is not subject to the Freeze, as it continues to accrue to the Freezor. With some clients, it is not desirable to have Investco shares held by the Freezor. Therefore, it may be possible to split control and value of Investco between the Freezor and Family Trust, respectively. 7 Part 1: Estate Freeze Basics Example 3: Corporate Attribution & Stock Dividends Under s. 74.4(2) of the Act, corporate attribution may apply to the Freezor as a designated person and will be deemed to receive an amount as interest computed at the prescribed rate in respect of the amount transferred or lent to the corporation. It is preferable to design an estate freeze plan such that s. 74.4(2) simply cannot apply by excluding the possibility of having a designated person benefit from the freeze. 8

5 Part 1: Estate Freeze Basics Example 4 : US Persons Where a trust beneficiary is not a resident of Canada, it is not possible to effect a tax-deferred rollout of the trust directly to that beneficiary, due to the limitation imposed under s. 107(5) of the Act. To avoid this limitation is to transfer the shares held by the trust to a Canadian-resident Corporation, all of the shares of which are owned by the non-resident beneficiary. The trust must specifically allow for this. 9 Part 1: Estate Freeze Basics Example 5: The Family Law Estate Freeze Ontario law provides that on a breakdown of a marriage, each spouse is required to calculate his or her net family property ( NFP ) (being the increase in value of his or her assets from the date of marriage), and the spouse with a larger NFP is obligated to make an equalization payment. Estate freezes can be used to draw a line in the assets, to clearly demark which assets were owned prior to marriage and which were acquired during. Growth Shares can be structured as a gift, with a deed of gift is provided demonstrating the donor s specific intention to exclude the gift from any future NFP calculation, these shares can also fall outside the NFP. 10

6 Part II Melts, Thaws & Re-Freezes 11 Part II: Melts, Thaws & Re-Freezes Melts Typically refers to a strategy to draw out the value of the frozen corporation, without undoing the freeze structure. The value drawn out of the company reduces the value of the Growth Shares but the overall structure is not impacted. Accomplished by paying additional amounts to the Freezor in addition to what was ordinarily expected or planned when the freeze was first implemented. For example, salary or bonus payments. 12

7 Part II: Melts, Thaws & Re-Freezes Thaws Distinct from a melt and a refreeze in that it involves an unwinding of the structure put in place when the estate freeze was implemented. In Canadian tax parlance, the structure is said to be thawed or unfrozen. The simplest strategy for thawing an estate freeze is to have the Growth Shares reacquired by the Freezor. Depending on how much the value of the business has grown since the freeze, however, an acquisition of the Growth Shares may not give rise to material tax consequences. 13 Part II: Melts, Thaws & Re-Freezes Re-Freezes Transaction where the existing, already frozen corporation is either simply subject to a second freeze, or the original freeze is thawed and replaced with a new estate freeze structure. Often implemented where the value of the corporation has declined in since the implementation the freeze The CRA has accepted that a re-freeze transaction does not confer a benefit on a shareholder provided that the decrease in the value of the corporation did not result from the stripping of corporate assets by the shareholder (or at his direction). 14

8 Part II: Melts, Thaws & Re-Freezes Re-Freezes An alternative technique is the use of a new corporation to effect the re-freeze through what has been referred to as a Reverse Freeze. A useful planning technique when a family situation has changed and the current structure no longer represents a fair allocation of the future growth of the family business. 15 Part II: Melts, Thaws & Re-Freezes Re-Freezes The family trust itself could exchange its Growth Shares with the corporation, taking back Freeze Shares and thereby capping the value of the company that can ultimately accrue to the older siblings. A new family trust can then be settled to acquire Growth Shares, in which all the children can participate. This will have the effect of ensuring that all children participate equally. 16

9 Part III Partnership Freezes 17 Part III: Partnership Freezes Partnership Freeze Basics A transaction whereby the value of certain assets is frozen through the use of a partnership, and not a corporation. Such transactions are typically used where the use of a corporation is not feasible: Regulated professionals (e.g. licensed securities professionals) Where corporation would be a large corporation, and such status not desirable Unrecoverable transfer taxes would arise on transfer to a corporation 18

10 Part III: Partnership Freezes Example: Krauss The taxpayer and her son each conveyed interests in real property to a partnership, making an election to defer income tax under s. 97(2). Each transferor received 1,252,000 Class A partnership units and a credit to their partnership capital account of $1,252,000. A PAC was included. The son and a related corporation also transferred interests in other properties to the partnership in exchange for Class B partnership units. A family trust benefiting the taxpayer s daughter-in-law and grandchild subsequently acquired100 Class C units of the partnership for $100. The Partnership made $343,431 the following year. Taxpayer and her son received $108,355 on their Class A units. The balance of $126,721 was allocated to the Class C units held by the family trust. The CRA reassessed the taxpayer and son to include 50% of the income allocated to the Class C units to her income. The CRA relied on subsections 103(1) and 103(1.1) of the Act. 19 Part III: Partnership Freezes Example: Krauss The Tax Court did not agree with the appellant s argument that the allocation in the partnership agreement represented a reasonable allocation. The court took issue with the quantum of income allocated to the family trust given the nominal contribution made to by the trust to the partnership. The court noted that, in its view, Partnership does not replicate the economics of a typical estate freeze. There is a more fundamental flaw in the tax planning purporting to divert $126,721 of income in a year to a partner whose only contribution was $100. The court stated that I begin from the premise that structured properly, a partnership can replace a typical estate freeze through a corporation. Despite this strong and unequivocal endorsement, the CRA continues to view partnership freezes warily. 20