International Tax Planning

Transcription

1 canadian tax journal / revue fiscale canadienne (2014) 62:3, International Tax Planning Co-Editors: Michael Maikawa* and Ken Buttenham** Estate Planning: US-Resident Beneficiaries of a Canadian Estate Part 2 Mathieu Ouellette and Jennifer Warner*** Estate planning offers taxpayers a means of distributing their assets, subsequent to death, in a way that minimizes tax liabilities for both the deceased and their beneficiaries. Serious obstacles can arise if the estate has non-resident beneficiaries and a significant portion of its value is derived from shares of a Canadian investment corporation. The authors of this two-part article examine Canadian and us tax implications for a Canadian resident who wishes to bequeath shares of a Canadian investment corporation to beneficiaries that include both Canadian and us residents. In part 1, the authors reviewed how the residence of an estate is determined pursuant to Canadian rules and us tax rules, the application of us anti-deferral rules, and the resulting unexpected tax liabilities for us-resident beneficiaries. In part 2, they discuss the use of unlimited liability corporations and other planning strategies that may be used to mitigate the overall tax burden on the deceased and their beneficiaries. Keywords: Estate planning n unlimited liability corporation n non-resident n beneficiaries n distributions n United States Contents Introduction 836 Use of an Unlimited Liability Corporation in Cross-Border Estate Planning 837 Canadian Tax Treatment of a ULC 837 US Tax Treatment of a ULC 837 Converting a Canadian Corporation into a ULC 838 Canadian Tax Implications 840 US Tax Implications 840 Planning the Distribution to Beneficiaries of a Canadian Estate 844 Consequences of Liquidating InvestULC 845 Canadian Tax Consequences on the Disposition 845 * Of PricewaterhouseCoopers LLP, Toronto. ** Of PricewaterhouseCoopers LLP, Toronto. *** Of Bessner Gallay Kreisman LLP, Montreal. 835

2 836 n canadian tax journal / revue fiscale canadienne (2014) 62:3 US Tax Consequences on the Actual Disposition 845 Timing of the Disposition 846 Effect on RDTOH 846 Effect on the Capital Dividend Account 847 Limitations on the Distribution of Tax-Free Dividends 849 Discretionary Allocation of Income 852 Taxation of US Beneficiaries 854 US Tax Treatment of Property Received from the Estate 854 Application of Part XII.2 Taxes 855 Conclusion 856 Introduction This is the second part of a two-part article that examines the Canadian and us tax implications where a Canadian resident bequeaths shares of a Canadian investment corporation to Canadian and us-resident heirs. In part 1, the tax implications of the us anti-deferral rules were highlighted, including the potential results to us-resident beneficiaries. 1 In part 2, we discuss the use of certain structures in particular, an unlimited liability corporation (ulc) to minimize the adverse tax impact of us anti-deferral rules. We also suggest other planning strategies relating to the distribution and liquidation of the estate that can reduce the tax burden for Canadian-resident and us-resident beneficiaries, as well as the overall tax liability borne by the estate. In the discussion that follows, we illustrate certain points by referring to an example we used throughout part 1 involving a Canadian resident, Mr. Candad. While the basic facts of this example are set out in part 1, for the reader s convenience we reproduce them here: n Mr. Candad is the sole shareholder of a Canadian corporation, Investco. n Investco was incorporated under the provisions of the Canada Business Corporations Act 2 (cbca) and is located in Quebec. n Investco s sole activity is the holding of investments; its assets comprise mainly marketable securities and other investments, and it generates only passive income. n Mr. Candad has three children over the age of 18; two ( u and s ) are us residents, and the third ( c ) is a Canadian resident. Mr. Candad wants the total value accumulated in Investco to be distributed equally among his children upon his death. 1 Mathieu Ouellette and Jennifer Warner, Estate Planning: US-Resident Beneficiaries of a Canadian Estate Part 1, International Tax Planning feature (2014) 62:1 Canadian Tax Journal RSC 1985, c. C-44, as amended.

3 Use of an Unlimited Liability Corporation in Cross-Border Estate Planning international tax planning n 837 A ulc, for Canadian corporate-law purposes, is a separate legal entity with perpetual existence and having the same powers as a natural person. 3 ulcs maintain the same qualities as traditional corporations, except that shareholders of a ulc do not have limited liability in respect of certain debts and obligations of the corporation. A ulc can be incorporated under the provincial corporate laws of Alberta, 4 British Columbia, 5 or Nova Scotia; 6 no similar legislation has yet been adopted in the other seven provinces. ulcs can be useful and effective in cross-border estate planning because they are considered to be corporations for Canadian tax purposes, but they can be disregarded entities under the us check-the-box classification rules. 7 Canadian Tax Treatment of a ULC A ulc and its shareholders are taxed in Canada in the same manner as a Canadian limited liability corporation. The Canada Revenue Agency (cra) has confirmed that a ulc meets the definition of a corporation in subsection 248(1) of the Income Tax Act (ita). 8 A ulc is taxed on its worldwide income at the entity level. Distributions declared as dividends by a ulc under corporate law are treated as dividends for tax purposes. US Tax Treatment of a ULC The us check-the-box regulations are used to classify entities for us tax purposes. These regulations allow a business entity with two or more members to be classified as either a corporation or a partnership. A business entity with only one owner is 3 Barry D. Horne, The Nova Scotia Unlimited Liability Company: Surf and Turf, in Report of Proceedings of the Fifty-Seventh Tax Conference, 2005 Conference Report (Toronto: Canadian Tax Foundation, 2006), 26: Business Corporations Act, RSA 2000, c. B-9, as amended (herein referred to as the BCA (Alberta) ). On May 17, 2005, Bill 16, the Business Corporations Amendment Act, 2005 (SA 2005, c. 8), was proclaimed in force, permitting the incorporation of a company in Alberta as an unlimited liability company (commonly referred to as an AULC ). 5 Business Corporations Act, SBC 2002, c. 57, as amended (herein referred to as the BCA (British Columbia) ). On March 29, 2007, Bill 14, the Finance Statutes Amendment Act, 2007 (SBC 2007, c. 7), containing changes to the BCA passed third reading in the BC legislature. The most significant of these changes is an amendment permitting the incorporation of a company in British Columbia as an unlimited liability company (commonly referred to as a BCULC ). 6 Companies Act, RSNS 1989, c. 81, as amended (herein referred to as the CA (Nova Scotia) ). ULCs formed under the NSCA are commonly referred to as NSULCs. 7 Treas. reg. sections and under the Internal Revenue Code of 1986, as amended (herein referred to as the IRC ). 8 CRA document no , June 27, 1994; and Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended.

4 838 n canadian tax journal / revue fiscale canadienne (2014) 62:3 classified as a corporation or is disregarded. If the entity is disregarded, its activities are treated in the same manner as those of a sole proprietorship, branch, or division of the owner. 9 Canadian corporations incorporated under the cbca or formed under most provincial statutes are generally classified as per se corporations under the checkthe-box rules. 10 However, a corporation all of whose shareholders have unlimited liability pursuant to certain provincial laws, such as a ulc incorporated in Nova Scotia, Alberta, or British Columbia, is disregarded under the check-the-box regulations. 11 As a result of being disregarded under us regulations, an entity is considered to be a hybrid. In contrast, an entity that is disregarded under Canadian tax law is considered to be a reverse hybrid. A hybrid entity can be, for example, a business entity such as a ulc that Canada treats as a corporation but the United States treats as a disregarded entity or partnership. In contrast, a reverse hybrid can be a business entity that Canada treats as a flowthrough structure but the United States treats as a corporation. Limited partnerships that have elected to be classified as a corporation for us tax purposes are considered to be reverse hybrids. As we discussed in part 1, the us Congress has enacted rules designed to prevent us residents from deferring taxes through the use of foreign corporations in particular, controlled foreign corporations (cfcs) and passive foreign investment companies (pfics). These anti-deferral rules seek to tax a us person s pro rata share of the income earned in a foreign corporation on a current basis. However, they will not apply to the shares of a ulc. A ulc is considered to be a transparent entity for us tax purposes and therefore is not a foreign corporation, but rather a sole proprietorship, partnership, branch, or division of the owner. In the example of Mr. Candad s estate, if Investco is converted into a ulc at the opportune moment, u and s, as the us-resident beneficiaries of the estate, will not be considered indirect shareholders of a foreign investment corporation, and thus will not be subject to the cfc or pfic regimes. Notwithstanding this favourable treatment, no Canadian corporation should be converted into a ulc without careful consideration of any possible legal or fiscal consequences, as well as the method and timing of the transition. The manner of effecting such a conversion and the potential pitfalls are discussed below. Converting a Canadian Corporation into a ULC As previously stated, under current Canadian law, only three provinces Nova Scotia, Alberta, and British Columbia permit the incorporation of a ulc. Under the corporate law of these provinces, a corporation formed outside any one of these 9 Treas. reg. section (a). 10 Treas. reg. section (b)(8)(i). 11 Treas. reg. section (b)(8)(ii)(A)(1).

5 international tax planning n 839 jurisdictions can be converted into a ulc by amalgamation or continuation. In British Columbia, the Business Corporations Act states that a ulc can result from an amalgamation provided that all entities are bc companies. 12 Pursuant to the same statute, a bculc can be formed by continuation provided that the pre-existing company is a ulc incorporated in Alberta (an aulc) or Nova Scotia (an nsulc), or a foreign corporation within a prescribed class. 13 Under the Alberta Business Corporations Act, a ulc can result from continuing an existing company, whether limited or unlimited, and whether from a different jurisdiction. 14 Similarly, in Nova Scotia, under the newly amended Companies Act, existing companies from other jurisdictions can be continued as ulcs. 15 The corporate-law provisions enacted in Canadian jurisdictions generally allow a corporation incorporated in one jurisdiction to be continued in another through the filing of articles of continuance. The cbca provides for the continuation of a federally incorporated company in a different jurisdiction. Section 188(1) of the cbca reads: (1) Subject to subsection (10), a corporation may apply to the appropriate official or public body of another jurisdiction requesting that the corporation be continued as if it had been incorporated under the laws of other jurisdiction if the corporation (a) is authorized by the shareholders in accordance with this section to make the application; and (b) establishes to the satisfaction of the Director that its proposed continuance in the other jurisdiction will not adversely affect creditors or shareholders of the corporation. A similar provision was recently adopted under Quebec s new Business Corporations Act 16 to allow a corporation incorporated under that statute to be continued in a jurisdiction other than Quebec. Section 297 of the bca (Quebec) reads: A corporation may, if so authorized by its shareholders and by the enterprise registrar, apply to the appropriate authority of a jurisdiction other than Québec requesting that the corporation be continued as if it had been constituted under the laws of that other jurisdiction. Quebec s previous corporate legislation did not permit such a continuance; therefore, care must be taken in converting a corporation that remains subject to part i 12 BCA (British Columbia) section Ibid., section BCA (Alberta) section 15.5(1). 15 CA (Nova Scotia) section Business Corporations Act, CQLR, c. S-31.1 (herein referred to as the BCA (Quebec) ).

6 840 n canadian tax journal / revue fiscale canadienne (2014) 62:3 of the former Companies Act. 17 Such a corporation must first be continued under the bca (Quebec) before articles of continuance to another jurisdiction are filed. 18 Canadian Tax Implications Continuing a corporation into the jurisdiction of Alberta, British Columbia, or Nova Scotia has no Canadian tax consequences. The cra has confirmed that the continuation of a corporation into a different jurisdiction will not result in a disposition of the corporation s assets, a disposition of the shares held by the corporation s shareholders, or a deemed year-end of the corporation under the ita. 19 Generally, amalgamating with an aulc, a bculc, or an nsulc pursuant to ita section 87 will also be a non-taxable event for Canadian tax purposes, because for many purposes of the ita, the new corporation will be deemed to be the same corporation as, and a continuation of, each predecessor corporation. US Tax Implications The us tax consequences related to the conversion of a Canadian limited liability corporation into a ulc will depend on the timing of the conversion. There are two possible points in time when such a corporation can be converted into a ulc without attracting adverse tax consequences from the application of the us anti-deferral regimes: 1. before the death of the individual shareholder or 2. within the 30-day window before the foreign corporation (the limited liability corporation) will qualify as a cfc. Conversion Before the Death of the Shareholder Converting a Canadian investment corporation into a ulc before the death of the individual will result in exposure to us taxes if the corporation owns assets that are United States real property interests (usrpi). 20 The definition of usrpi and the us tax implications associated with the ownership of such assets are discussed in a separate section below. Another potential risk is that the individual shareholder will be subject to us estate tax upon death. As stated previously, a ulc with a sole shareholder is viewed as a disregarded entity under the us check-the-box classification rules. A disregarded 17 CQLR, c. C BCA (Quebec) section 715: A company constituted, continued or resulting from an amalgamation under Part I of the Companies Act (chapter C-38) must, before 14 February 2016, send articles of continuance to the enterprise registrar in accordance with this Act. Otherwise, it is dissolved as of that date. 19 CRA document no R3, IRC section 897.

7 international tax planning n 841 entity is defined as an entity that is disregarded as an entity separate from its owner. 21 As a result, for us tax purposes, the individual shareholder of the ulc will be considered to own directly the assets held in the ulc. If the corporation is converted into a ulc before the death of the shareholder, the resulting structure will expose the individual shareholder to us estate tax if us-situs assets are held by the ulc. As discussed below, the consequences of such exposure can be significant. The United States imposes a federal estate tax on a transfer of us-situs property owned by a person who was not a resident of the United States at the time of death; specifically, us estate tax applies to the portion of the deceased Canadian resident s gross estate that is situated in the United States at the time of death. 22 As a general rule, the Canadian resident s gross estate subject to estate tax includes all property, real or personal, tangible or intangible, situated in the United States. 23 This definition includes real property situated in the United States, shares of stock of a us corporation irrespective of the location of the share certificates, and debt obligations (including bank deposits) of a us person. 24 The estate tax for an individual who is strictly a Canadian resident is computed at the same rates as the tax imposed on the transfer of the taxable estate of a us decedent. Certain credits are available to reduce the us tax liability for the deceased Canadian resident. A unified credit of us$13,000 is generally allowed against us tax on the estate of a non-resident. 25 Article xxix b(2) of the Canada-us income tax treaty 26 provides that a Canadian resident is entitled to a unified credit against us estate tax payable that is the greater of the foregoing amount and the amount that bears the same ratio to the credit allowed for us residents that the individual s us-situs assets are of his or her worldwide assets. In 2014, the tax exemption amount on estate tax available for us residents was us$5.34 million. 27 Therefore, in 2014, a Canadian resident would be entitled to a unified credit against us estate tax that is the greater of us$13,000 and us$5.34 million (us-situs assets/worldwide assets). Given the potential impact of us estate tax applicable on the death of a Canadian resident who owns us-situs property, it is important to identify any us-situs assets that form part of the inventory of assets held in an investment corporation. 21 Treas. reg. section (b)(2)(i)(C). 22 IRC section IRC section Treas. reg. section IRC section 2102(b)(1). 26 The Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997, and September 21, 2007 (herein referred to as the Canada-US treaty ). 27 The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. no , establishes an exemption amount of $5 million in 2010 and 2011 and indexes this amount for inflation for years after The American Taxpayer Relief Act of 2012, Pub. L. no , makes permanent the exemption provisions in the 2010 Act.

8 842 n canadian tax journal / revue fiscale canadienne (2014) 62:3 In our example, if us estate tax may apply, Investco can be converted into a ulc immediately after the death of Mr. Candad but before the expiration of the 30-day period after which Investco would qualify as a cfc. 28 The conversion of Investco into a ulc after death would also reduce Mr. Candad s risk associated with the unlimited liability features of the ulc. Conversion Within 30 Days of the Death of the Shareholder Subsequent to the transfer of the shares into the estate that occurs immediately after the death of the shareholder, the shares are considered to be indirectly owned by the us beneficiaries in proportion to their respective interests in the estate. 29 Because of this connection to the United States, the implications of the conversion of the corporation into a ulc from a us perspective are noteworthy: the act of continuing a Canadian corporation into a ulc is treated as a distribution of the corporation s assets to the shareholder in a deemed liquidating distribution. 30 The deemed distribution of the assets held by the corporation to its shareholder is a taxable event for both the corporation and the shareholder under us tax rules. Pursuant to irc section 336(a), the corporation will realize a gain or loss on the distribution of property to its shareholder as if such property were sold to the shareholder at its fair market value. The shareholder receiving the property from the liquidation will realize a capital gain or loss on the disposition of the shares of the corporation. 31 This gain or loss is equal to the amount for which the fair market value of the property received exceeds the shareholder s basis in the shares of the corporation. 32 As a consequence of the distribution in complete liquidation of the corporation, the shareholder is treated as having acquired the property of the corporation at a cost equal to fair market value. The shareholder will thus have a fair market value basis in the assets immediately after the distribution. 33 If we consider the effect of the distribution in complete liquidation in our example, where Investco continues as Investulc, Investco will be deemed to have disposed of all of its assets in favour of the estate. Investco will be deemed to have realized a gain, the amount of which will be equal to the excess of fair market value of the assets over their cost. Because Investco is a Canadian-resident corporation, and thus a foreign corporation for us tax purposes, it is subject to us taxes solely on income received from sources within the United States 34 or on income effectively connected 28 For a discussion of the circumstances in which Investco might qualify as a CFC, see part 1 of this article, supra note 1, at ( Controlled Foreign Corporations ). 29 Treas. reg. section (c)(2). 30 Treas. reg. section (g)(iii). 31 IRC section 331(a). 32 Treas. reg. section (b). 33 IRC section 334(a). 34 IRC section 881(a).

9 international tax planning n 843 with the conduct of a us trade or business. 35 If the assets owned by Investco do not include any usrpi, the gains realized from the distribution of Investco s assets will not be subject to us taxation. The estate will be deemed to have exchanged its shares in Investco for the property received. The estate will realize a gain, the amount of which will be equal to the excess of the fair market value of the property received over the estate s adjusted cost base for the shares in Investco. Like Investco, the estate is a Canadian resident, and thus a foreign estate for us tax purposes. As such, the estate is treated as a non-resident alien individual who is not present in the United States at any time. 36 Accordingly, the estate will not be subject to us taxation on the gain realized on the disposition of Investco shares. 37 Although the distribution in complete liquidation will not result in any us tax liability for the estate, the estate will nonetheless benefit from the step-up in the us basis of the assets received as a result of the distribution. This step-up would be advantageous if Mr. Candad preferred not to have Investulc wound up after his death, but rather to have the shares of Investulc bequeathed to his children, so that they could continue the management of the company. Under this scenario, the us-resident beneficiaries (u and s) would realize lower gains on the future sale of Investulc s underlying assets, because the basis would have been stepped up to fair market value at the time of the conversion. However, where Invest ulc is wound up and the liquidation proceeds are distributed to Mr. Candad s children, this step-up will have no relevant effect. US Tax Consequences on the Disposition of a USRPI As discussed above, as part of Investco s conversion into a ulc, Investco will not be subject to us taxation on the distribution in complete liquidation if the assets distributed do not include usrpi. However, any gain recognized on the disposition of any property that is considered to be usrpi will be subject to us taxes. 38 The Canada-us treaty contains certain provisions for the treatment of gains realized in Canada or the United States. These provisions are in line with the domestic treatment in the United States of the taxation of gains realized on the disposition of usrpi by a Canadian resident. Article xiii(1) of the treaty states that the gains realized by a Canadian resident on the disposition of real property situated in the United States are taxable in the United States. More precisely, article xiii(3)(a) of the treaty specifies that real property situated in the United States includes usrpi. If Investco owns usrpi, the conversion into Investulc, which would otherwise result in no us taxes payable, can generate a significant us tax liability. 35 IRC section 882(a). 36 IRC section 641(b). 37 IRC section 871(a) and Treas. reg. section See also Federal Tax Coordinator 2d (Thomson Reuters) (looseleaf ), at paragraph 10118, Foreign Trusts and Estates. 38 IRC section 897(a)(1).

10 844 n canadian tax journal / revue fiscale canadienne (2014) 62:3 A usrpi is broadly defined. It includes an interest in real property situated in the United States or the Virgin Islands; fee ownership, co-ownership, or a leasehold interest in land, as well as improvements on such land; and an option to acquire land or improvements thereon, or a leasehold of land or improvements thereon. 39 A usrpi also includes any interest (other than an interest as a creditor) in any us corporation, unless the taxpayer can prove that the corporation was not a United States real property holding corporation at any time during the preceding five-year period ending on the date of the disposition of the interest. 40 A United States real property holding corporation is defined as any corporation that holds usrpi interests, the fair market value of which equals or exceeds 50 percent of the total value of (1) the corporation s usrpi, plus (2) the corporation s interests in real property outside the United States, plus (3) the corporation s other trade or business assets. 41 An interest in a class of regularly traded stock on an established security market could qualify as a usrpi, but only in respect of a beneficial owner holding more than 5 percent of the class of shares. 42 Specific exclusions from the definition of a usrpi are interests in the following assets: 43 n n A us-controlled real estate investment trust (reit). A us-controlled reit is one in which less than 50 percent of the fair market value of the outstanding stock is directly or indirectly held by foreign persons during the five-year period ending on the applicable determination date, or the period since June 18, 1980, if shorter. A corporation that has disposed of all of its usrpi in transactions in which the full amount of gain, if any, was recognized. Various investment instruments can qualify as usrpi, so it is important to determine whether any of the assets held in Investco qualify, because the disposition of usrpi would create a us tax liability for Investco at the time of conversion into a ulc. Planning the Distribution to Beneficiaries of a Canadian Estate In most situations, following the death of an individual, the executor of the estate will execute the instructions of the deceased individual s will by proceeding with the liquidation of the estate, once all specific bequests have been distributed and outstanding debts have been paid. In our example, because the shares held in the estate 39 IRC sections 897(c)(1)(A)(i) and 897(c)(6)(A), and Treas. reg. sections (c)(1)(i) and (c)(2)(i). 40 IRC section 897(c)(1)(A)(ii). 41 IRC section 897(c)(2). 42 Treas. reg. section (c)(2)(iii). 43 Treas. reg. section (c)(2)(i).

11 international tax planning n 845 are those of an investment company, as opposed to an operating company, the assets of the corporation will generally be liquidated and the proceeds of liquidation will be available for distribution to the estate and ultimately to the heirs. One of the most significant aspects of estate planning is the planning of the distribution to beneficiaries. In this section, we consider a number of issues that must be addressed when a Canadian estate has beneficiaries in both Canada and the United States. Consequences of Liquidating InvestULC The liquidation of the corporation following its continuation into a ulc will entail the disposition of all the assets of the corporation. If we assume that the corporation has invested in assets that are situated in both Canada and the United States, the different tax implications related to the disposition of these assets must be addressed. Canadian Tax Consequences on the Disposition For Canadian tax purposes, a disposition of capital property of a corporation will result in the realization of a capital gain or loss. Because Investulc is an investment corporation, its assets are composed mostly of capital property. 44 The capital gains on the disposition of the corporation s assets will be taxable in Canada. The taxable portion (50 percent) of the capital gains realized on the disposition of the capital property will be taxable to the corporation at a rate of percent, 45 of which percent is refundable to the corporation through the refundable dividend tax on hand (rdtoh). 46 The non-taxable portion of the capital gain will be included in the corporation s capital dividend account (cda). 47 A foreign tax credit for non-business-income tax paid is available to the investment corporation in respect of any taxes paid in the United States on the deemed disposition of usrpi that occurred on conversion into a ulc 48 to the extent that the actual disposition occurs in the same year. If the deemed disposition and the actual disposition do not occur in the same year, the absence of a carryforward provision under ita subsection 126(1) will restrict the availability of the foreign tax credit. US Tax Consequences on the Actual Disposition For us tax purposes, the assets of Investulc will be considered to have been disposed of by the estate. As a result of the conversion of Investco to Investulc, the basis of any usrpi received by the estate will have been stepped up. If we assume that there is no appreciation in the value of the usrpi while it is held by the estate, 44 See ITA subsection 54(1), the definition of capital property. 45 The 2014 tax rate applicable to Canadian-controlled private corporations in Quebec. 46 See ITA section See ITA subsection 89(1), the definition of capital dividend account. 48 ITA subsection 126(1).

12 846 n canadian tax journal / revue fiscale canadienne (2014) 62:3 no gain should be realized by the estate on the actual disposition. Therefore, there would be no resulting us tax liability to the estate. Timing of the Disposition The overall Canadian and us tax implications are very different if the corporation actually disposes of usrpi in a year subsequent to the conversion of Investco to Invest ulc. Article xxiv of the Canada-us treaty provides that when the same source of income is taxed in both states, a foreign tax credit is generally available to provide some relief to the taxpayer, as is the case where the conversion and disposition occur in the same year. Inattention to the timing of the disposition of usrpi can result in double taxation of the proceeds. As discussed previously, Investco is subject to us taxes, in respect of usrpi, on the deemed distribution in complete liquidation resulting from the conversion into Investulc. If usrpi are alienated, by distribution to the estate (on liquidation of the corporation or otherwise) or by actual sale, within the same taxation year in which the deemed distribution occurs, a foreign tax credit will be available to Investulc in respect of the taxes paid in the United States. 49 If the usrpi are disposed of in a subsequent year, the foreign tax credit in respect of taxes paid in the United States cannot be used to reduce the Canadian taxes payable on the disposition of the same assets, and double taxation will result. When conversion into a ulc and alienation of usrpi do not occur in the same year, the use of the foreign tax credit is restricted. It is thus of particular importance that the timing of the disposition of any usrpi coincide with the conversion of Invest co into Investulc in order to avoid any limitations on the availability of a foreign tax credit. Effect on RDTOH The rdtoh account is available to private corporations. ita subsection 129(3) includes in rdtoh percent of the corporation s aggregate investment income for the year in excess of the amount of the foreign tax credit deducted for the year. As discussed in part 1, the majority of the executors of Mr. Candad s estate should be Canadian residents. 50 As a result, Investulc will be regarded as a Canadiancontrolled private corporation. Thus, the refundable portion of part i tax will be added to the rdtoh of Investulc. On redemption of the shares of Investulc, the deemed payment of a dividend will result in a refund of the rdtoh to the corporation. The amount of the dividend refund is the lesser of one-third of the taxable dividend deemed paid on redemption and the balance of the rdtoh Ibid. 50 See Ouellette and Warner, supra note 1, at 199 and the discussion of ITA section 94 at See ITA subsection 84(3) and paragraph 129(1)(a).

13 international tax planning n 847 The dividend refund received by Investulc effectively results in a net cash inflow for the non-resident beneficiaries and Investulc. More precisely, Investulc will receive a refund of up to one-third of the taxable dividend paid on the share redemption, while the estate will withhold and remit 15 percent withholding tax on the amount distributed to the non-resident beneficiaries. 52 Above, we have discussed the tax liabilities that will arise if Investco owns assets that are usrpi. The disposition of any usrpi will also affect the refundable portion of part i tax that can be added to Investulc s rdtoh. A foreign tax credit claimed by Investulc in the taxation year will reduce the amount that can be added to the corporation s rdtoh balance. The addition to the rdtoh will be reduced by the amount of foreign tax credit claimed less percent of Investulc s foreign investment income for the year. 53 If, as discussed above, Investulc claims a foreign tax credit for us taxes payable in respect of gains realized on the distribution of usrpi, its rdtoh will be reduced, constituting an incremental cost for Investulc. Effect on the Capital Dividend Account The fundamental principle of tax integration provides that an amount that would have been tax-free if received directly by a shareholder should not become taxable if received first by a private corporation and then flowed to the shareholder. In the context of a Canadian estate that owns the shares of a private Canadian corporation, 54 whether it is incorporated as a limited liability corporation or a ulc, the cda can be paid to the estate and further distributed to a Canadian beneficiary retaining the tax-free feature. 55 The cda generally includes the non-taxable portion of capital gains realized from the disposition of capital property, reduced by one-half of any capital losses. It also includes capital dividends received from other private Canadian corporations and the proceeds from life insurance policies. 56 Capital Gains The liquidation of the assets held in the investment corporation will likely create capital gains and losses, assuming that there are inherent gains or losses on those assets. If the disposition of the corporation s capital assets results in an overall capital gain, the non-taxable portion of the capital gain will be credited to the cda. 52 Under ITA paragraph 212(1)(c), distributions to non-resident beneficiaries of an estate are subject to a 25 percent withholding tax, which is reduced to 15 percent under article XXII(2) of the Canada-US treaty. 53 See ITA paragraph 129(3)(a) and the definition of foreign investment income in subsection 129(4). 54 See ITA subsection 89(1), the definition of Canadian corporation. 55 ITA subsections 83(2) and 104(20). 56 See ITA subsection 89(1), the definition of capital dividend account.

14 848 n canadian tax journal / revue fiscale canadienne (2014) 62:3 Life Insurance Policies It is not unusual for a private corporation to own insurance on the life of the shareholder. The life insurance will fund payment of tax liabilities upon the shareholder s death through the redemption of shares. When life insurance proceeds are paid to a corporation, the amount credited to the corporation s cda is the total proceeds received in excess of the adjusted cost basis of the policy. 57 The ita contains stop-loss rules in subsection 112(3.2) (discussed in a separate section below) that are designed to prevent the use of life insurance policies to maximize the tax-free distribution of funds through the cda. Where subsection 112(3.2) applies, limits are imposed on the amount of capital losses that may be designated under ita subsection 164(6) to reduce the capital gains realized in the year of death of the individual. However, certain life insurance policies may be protected from the stop-loss rules pursuant to the grandfathering of these policies. 58 In the context of an estate plan, the proceeds from policies that have been grandfathered can be distributed to the estate as a capital dividend without triggering the application of subsection 112(3.2). For a life insurance policy to qualify for grandfathering, it must meet the following criteria: 59 n The life insurance policy existed on April 26, n The shares of the corporation were owned on April 26, 1995 by the deceased taxpayer, the taxpayer s spouse, or a trust of which the taxpayer was a beneficiary. n The insured life was that of the taxpayer or the taxpayer s spouse. n The corporation was the beneficiary of the life insurance policy on April 26, n It is reasonable to conclude that one of the main purposes of the policy was to fund the redemption of the shares of the corporation. Life insurance policies that meet these conditions will be sheltered from the stop-loss rules. Although it may appear that only life insurance policies that were subscribed to before April 27, 1995 would be grandfathered, the cra appears to have adopted a broader application of the grandfathering rules, and will accept the grandfathering of certain life insurance policies that were subscribed to after April 26, Accordingly, the CRA states, [I]t is our view that any further modifications, alterations, cancellation of such a policy would not, in and of themselves, result in the loss of grandfathering. Accordingly, 57 Ibid., paragraph (d) of the definition. 58 See Stop-Loss Provisions Grandfathering, in Income Tax Technical News no. 12, February 11, Ibid.

15 international tax planning n 849 changes such as converting the existing policy to a universal life policy, replacing the existing policy with a new life insurance policy, or increasing the amount of life insurance either by increasing the death benefit payable under the existing policy or adding a new life insurance policy with additional death benefit would not preclude the grandfathering provisions from continuing to apply if the conditions outlined in paragraph 131(1)(b) of s.c. 1998, c. 19 existed on April 26, The position of the cra offers the possibility, in certain circumstances, to extend the application of the grandfathering rules to life insurance policies acquired after April 26, 1995, provided that the acquisition of the policy is directly related to a policy that is grandfathered. Limitations on the Distribution of Tax-Free Dividends In planning the distribution of corporate funds to an estate, maximizing the use of the cda generally yields the most favourable tax results. Although the cda provides the advantage of distributing tax-free dividends, it does not come without limitations. These include the following: n the application of the stop-loss provisions under ita subsection 112(3.2); n pursuant to ita subsection 83(2), the requirement that payment of the cda be made on the full amount of the dividend declared; and n pursuant to ita subparagraph 212(1)(c)(ii), the application of withholding taxes to the distribution of a capital dividend to a non-resident. Notwithstanding such limitations, as discussed in more detail below, with proper planning the cda can be an effective tool for reducing the taxes payable by an estate or its beneficiaries. In the context of an estate such as Mr. Candad s, the executors will be faced with all of the above limitations on the distribution of the corporation s cda. Recall that the intended beneficiaries of the estate are Mr. Candad s two non-resident children, u and s, and his Canadian-resident child, c. Under the particular conditions assumed in our example, planning around each limitation is crucial to achieving the maximum tax benefits for all of the beneficiaries. Subsection 112(3.2) Stop-Loss Rules The death of Mr. Candad will result in an immediate deemed disposition of the shares of Investco for their fair market value immediately before his death. 61 Mr. Candad will realize a capital gain on his final return, with the amount of the gain being equal to the fair market value of the shares immediately before his death 60 CRA document no E5, June 28, ITA paragraph 70(5)(a).

16 850 n canadian tax journal / revue fiscale canadienne (2014) 62:3 in excess of the adjusted cost base of the shares. The deemed disposition will result in the acquisition of the shares of Investco by the estate at an adjusted cost base equal to their fair market value at the time of death. 62 Investco will first be converted into a ulc before its shares can be redeemed. InvestULC will redeem all of its outstanding shares as a means of transferring the liquid assets to the estate and subsequently to the beneficiaries. On redemption of the shares of Investulc, the estate will be deemed to have received a dividend in accordance with ita subsection 84(3). The amount of the deemed dividend will be equal to the fair market value of the shares in excess of their paid-up capital. In addition to the deemed dividend, the redemption of the shares will create a capital loss for the estate. 63 The taxation of both the capital gain in the final return of the deceased and the deemed dividend in the estate effectively gives rise to double taxation since the taxes apply to the same property and value. To mitigate double taxation, within the first year following Mr. Candad s death, the estate may elect to designate the capital loss realized on the redemption of the shares as Mr. Candad s capital loss. 64 The capital loss can then be used to reduce the capital gain reported in Mr. Candad s final return. The amount of the capital loss will essentially be equal to the capital gain realized on the shares at the time of death. This mechanism should ultimately eliminate all or a significant portion of the capital gains realized in the year of death. The deemed dividend resulting from the share redemption presents an opportunity to utilize the cda to pay a tax-free dividend. However, the limitation in ita subsection 112(3.2) will apply to reduce the amount of capital losses available for carryback against Mr. Candad s capital gains if Investulc elects to pay more than 50 percent of the deemed dividend from the cda. Subsection 83(2) The second limitation, in ita subsection 83(2), directly affects the loss carryback transaction as well, by imposing certain constraints on the payment of a dividend from the cda. Specifically, subsection 83(2) provides that where a dividend becomes payable by a corporation and the corporation wishes to elect to pay the dividend from its cda, the corporation must elect the full amount of the dividend as a capital dividend. There is no means of severing the payment of a dividend into taxable and non-taxable portions. One might imagine that a possible solution to the application of both the stop-loss rules in subsection 112(3.2) and the constraint in subsection 83(2) would be to simply carry out the redemption in two stages, thus creating two separate deemed dividends. However, the cra has stated that if consecutive share redemptions are carried out in the context of an estate plan, by administrative policy 62 ITA paragraph 70(5)(b). 63 The capital loss represents the excess of the adjusted cost base of the shares redeemed over the proceeds of disposition. The proceeds of disposition are reduced by the deemed dividend under paragraph 54(j). 64 ITA subsection 164(6).

17 international tax planning n 851 the stop-loss rules in subsection 112(3.2) will apply to each share redemption separately, with the result that the capital loss available for carryback will be reduced. 65 Considering the facts of Mr. Candad s estate, it would not be optimal to pay out only 50 percent of the cda, because the remaining balance would be unused (since Investco would be liquidated and would be dissolved once the assets had been distributed). A possible solution to circumvent the limitations imposed on the possibility of splitting the dividend would be to increase the paid-up capital of the shares, before carrying out the share redemption. 66 In our example, the increase in the paid-up capital would occur before the redemption of the shares of Investulc. This operation would trigger a deemed dividend pursuant to ita subsection 84(1). The corporation could thus elect to pay the full amount of the dividend from the cda. The increase in paid-up capital should reflect the amount available in Investulc s cda. The character of income earned by an estate is generally not retained when that income is paid to a beneficiary, subject to certain rules allowing an estate to designate certain types of income to retain their character. 67 ita subsection 104(20), in particular, permits an estate to designate capital dividends received by the trust as capital dividends received by the beneficiary for the purpose of a number of provisions of the ita. Subparagraph 212(1)(c)(ii) The final limitation in respect of the tax-free benefit of a capital dividend arises when a capital dividend is paid to a non-resident beneficiary. Notwithstanding the general tax-free nature of a dividend paid from the cda, any dividends paid to a non-resident from the cda will nonetheless be subject to withholding taxes. 68 The cra has confirmed, in a technical interpretation, that withholding taxes apply to a capital dividend distributed from an estate to a non-resident. The position stated in the technical interpretation is as follows: Subparagraph 212(1)(c)(ii) of the Act provides that an amount that may reasonably be considered to be a distribution of, or derived from, a dividend that is not a taxable dividend (e.g. a capital dividend) received by the trust or estate on a share of the capital stock of a corporation resident in Canada is subject to Part xiii tax. Part xiii tax must be withheld by the payer and remitted on behalf of the non-resident in accordance with subsection 215(a) of the Act CRA document no I7, June 9, See Dereka Thibault, Life Insurance Taxation: An Update, in 2010 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2010), 9:1-16 (the section titled Stop Loss Pitfalls and the 50% Solution ). 67 ITA subsections 104(19) through (22). 68 ITA subparagraph 212(1)(c)(ii). 69 CRA document no E5, November 18, 2011.

18 852 n canadian tax journal / revue fiscale canadienne (2014) 62:3 Under part xiii, a non-resident is generally subject to a 25 percent withholding tax on a dividend paid from the cda. However, if the non-resident is entitled to the benefits of the Canada-us treaty, the withholding rate may be reduced to 15 percent, pursuant to article xxii(2) of the treaty. As a planning point, to fully benefit from the tax-free receipt of dividends, any dividend paid from the cda should be distributed to a Canadian-resident beneficiary. In reference to Mr. Candad s estate, to achieve the optimal tax treatment, a dividend paid from the cda should effectively be paid to the Canadian-resident beneficiary, c, and the taxable dividends that will be paid upon the redemption of the shares of Investulc should be allocated to the us-resident beneficiaries, u and s. The estate can directly allocate the taxable deemed dividend to the us-resident beneficiaries and not have the amount of the dividend taxed in the estate. The estate can deduct, from its income in the year, the dividends payable to the beneficiaries. 70 These dividends are included in the income of the beneficiary in the year in which they become payable. 71 As a result of the allocation of the taxable dividends to the us-resident beneficiaries, part xiii withholding taxes will apply, and may be reduced under article xxii(2) of the treaty. The withholding taxes applicable to the non-resident beneficiaries, whether imposed at the 25 percent rate under part xiii or the 15 percent rate under the treaty, will generally be substantially lower than the effective tax rate on dividends paid to a Canadian-resident individual or estate. Thus, if the taxable dividends can be allocated to non-resident beneficiaries, as opposed to being taxed in the estate or in the hands of a Canadian-resident beneficiary, the tax savings can be significant. To have the capacity to achieve such tax savings, the executors of the will must be granted the discretionary powers to pay deemed income for tax purposes as traditional income, as well as the flexibility to decide the nature and type of income that will be allocated and distributed to a particular beneficiary. Typically these powers are addressed in the will. The position of the tax authorities in relation to the discretionary powers of executors is discussed briefly below. Discretionary Allocation of Income Following the liquidation of Investulc s assets, the corporation will be left with only the cash proceeds from the disposition of its assets. As discussed above, proceeds from the sale of the assets of the corporation are distributed to the estate. Generally, if the deceased has a will, the executors are required by law to distribute the inventory of the estate in accordance with the instructions set forth in the will. 72 The will can provide a certain amount of discretion to the executors in regard to the 70 ITA paragraph 104(6)(b). 71 ITA paragraph 104(13)(a). 72 See, for example, Civil Code of Québec, LRQ, c. C-1991, article 613.