DIVIDEND REGIME FAIZAL VALLI, CA 1

Transcription

1 POST-MORTEM AND SHAREHOLDER AGREEMENT CONSIDERATIONS IN LIGHT OF THE ELIGIBLE Introduction DIVIDEND REGIME FAIZAL VALLI, CA 1 The purpose of this paper is to demonstrate the complexities of allocating the general rate income pool ( GRIP ) 2 among shareholders within the context of a shareholder agreement, particularly on the death of a shareholder. This paper will briefly review the eligible dividend 3 regime, and the effect of the GRIP on common post-mortem planning strategies. This paper will also outline potential methods to allocate the GRIP balance among shareholders of a Canadian-controlled private corporation ( CCPC ). 4 Finally, a comprehensive case is utilized to illustrate a tax efficient post-mortem strategy in a non-arm s length situation. Eligible Dividends Tax integration has long been a policy objective of the Canadian income tax system. Corporate income is subject to corporate taxes. Such corporate after-tax income is then available for distribution to the corporation s shareholders by way of a dividend, which is then subject to personal income taxes, resulting in two levels of taxation. The tax policy seeks to achieve integration such that income earned in a corporation and paid to its shareholder(s) provides roughly the same after-tax result as income earned directly by an individual. However, tax integration has generally only been achieved for active business income 5 earned by CCPC s up to the available small business deduction, 6 but has not been achieved for such income earned by large private corporations, or public corporations. 7 In recent years, investors turned to more tax efficient structures, namely income trusts 8 and publicly traded partnerships, 9 to earn greater after-tax income, as compared to after-tax income earned from public corporations. The main attraction to these structures was that the income was distributed directly to individual unitholders, without the imposition of taxes at the entity level, thus providing better integration. In an effort to improve tax integration, the Department of Finance ( Finance ) issued a press release on November 23, 2005 titled Minister of Finance Acts on Income Trust Issue, in which Finance introduced the concept of eligible dividends, or generally, corporate dividends paid from after-tax income subject to the general corporate tax rate. 10 Accordingly, the recipient of an eligible dividend would be entitled to an enhanced gross-up 11 and dividend tax credit, 12 whereas the existing gross-up and dividend tax credit would remain the same for non-eligible dividends, or corporate dividends paid from after-tax income benefiting from the small business deduction. As a result, the eligible dividend regime generally results in better tax integration for large corporations or public corporations, since the taxation of eligible dividends reflects the fact that dividends are paid from income subject to the higher general corporate tax rate. F. Valli, Page 1

2 Eligible dividends are taxable dividends received by a person resident in Canada and designated as such. 13 Eligible dividends may be paid by a CCPC to the extent that such CCPC has an amount in its GRIP. 14 A CCPC s GRIP is comprised of income that has been subject to the general corporate tax rate. A taxpayer receiving an eligible dividend must gross-up income by 45% of the dividend (for 2009). However, the taxpayer is entitled to a dividend tax credit of 11/18 (for 2009). 15 This gross-up and dividend tax credit compares favorably to 25% gross-up and 2/3 dividend tax credit available for non-eligible dividends. The eligible dividend regime has changed the tax planning framework for Canadian owner-managed corporations. As an example where owner-managers would typically bonus down corporate income to the small business limit, 16 it may now be more tax efficient to pay higher corporate taxes in order to increase a corporation s GRIP balance, and pay eligible dividends. 17 Furthermore, eligible dividends play an important role in post-mortem planning, especially in the context of the various share redemption strategies discussed below. The Incidence of Double Taxation on Death The potential double tax issue in post-mortem planning for shareholders of CCPC s has been the subject of many past papers. 18 Accordingly, this paper will briefly outline the double tax issue, and then describe some mitigating strategies. The examples below focus on situations where a CCPC has two related 19 or arm s length 20 shareholders, and one shareholder dies. In addition, the shareholder agreement of such CCPC requires a redemption or repurchase of the deceased shareholder s shares. It is assumed that the CCPC has sufficient funds available to redeem or repurchase the deceased shareholder s shares, whether through a corporate-owned life insurance policy, cash reserves, or the sale of the CCPC s property. In order to illustrate the incidence of double tax on death, assume that Mr. Apple owns 100 Class A voting common shares of Opco, a CCPC, with an adjusted cost base ( ACB ) and paid-up capital ( PUC ) of $Nil, and a fair market value ( FMV ) of $1,000,000. Mr. Apple is resident in Alberta, and is subject to the highest marginal personal tax rate. On Mr. Apple s death, there is a deemed disposition of his Opco shares at their FMV immediately before death, which results in a capital gain reported on Mr. Apple s terminal tax return of $1,000, The shares are then deemed to be acquired by Mr. Apple s estate at an ACB equal to their FMV. 22 When the shares acquired by Mr. Apple s estate are subsequently repurchased by Opco, there is a deemed dividend on the repurchase 23 equal to the FMV of $1,000,000. At the same time, the repurchase constitutes a disposition 24 of the shares for which the proceeds are $Nil. 25 This results in a capital loss of $1,000,000 to the estate. Therefore, tax is imposed twice: first on the deemed disposition prior to Mr. Apple s death, and then on the repurchase dividend. Furthermore, Mr. Apple s estate is left with a capital loss of $1,000,000 which may potentially be useless. In order to eliminate such double tax, the executor of Mr. Apple s estate 26 may elect under subsection 164(6) of the Act to carry back the capital loss realized in the estate to Mr. Apple s terminal tax return, within the estate s first taxation year. Accordingly, the $1,000,000 capital loss realized will offset the F. Valli, Page 2

3 $1,000,000 capital gain in Mr. Apple s terminal return, resulting in tax imposed only on the deemed dividend to the estate. 27 Pre-1995 Tax Elimination on Death Prior to 1995, a common way to eliminate tax on death was through the use of a corporate-owned life insurance policy to redeem/repurchase the shares of the deceased shareholder (the Pre-1995 Life Insurance Strategy ). Using the example above, assume that Mr. Orange, a non-arm s length individual, owns 100 Class B voting common shares of Opco (representing 50% of the issued and outstanding voting common shares of Opco) with an ACB and PUC of $Nil, and a FMV of $1,000,000. Accordingly, Opco has a FMV of $2,000,000. Mr. Orange is also resident in Alberta, and is subject to the highest marginal personal tax rate. Finally, Opco owns life insurance policies on the lives of both Mr. Apple and Mr. Orange for $1,000,000 each. Prior to 1995, on Mr. Apple s death Opco would receive life insurance proceeds of $1,000,000, and such amount would be credited to Opco s capital dividend account ( CDA ). 28 A capital gain of $1,000,000 would be reported on Mr. Apple s terminal tax return for the deemed disposition of his Opco shares, and Mr. Apple s estate would be deemed to have acquired the Opco shares with an ACB of $1,000,000. Subsequently, Opco would repurchase the shares acquired by Mr. Apple s estate, giving rise to a deemed dividend which Opco would elect to be a capital dividend, 29 resulting in no tax payable by the estate. In addition, the deemed dividend on repurchase would constitute a disposition of the Opco shares and the estate would report a capital loss of $1,000,000. The estate s executor would then elect to carry back such loss pursuant to subsection 164(6) to offset Mr. Apple s capital gain realized on death. As a result, the tax payable by Mr. Apple and the estate would be eliminated. 30 Table 1 illustrates the Pre-1995 Life Insurance Strategy. 31 F. Valli, Page 3

4 Table 1 Pre-1995 Life Ins. Strategy Terminal return: Capital gain $ 1,000,000 Tax thereon (using current Alberta tax rate) $ 195,000 Estate first return: Deemed dividend - intended to be a capital dividend $ 1,000,000 Tax thereon $ - Proceeds for capital gains purposes $ Nil ACB to the estate $ (1,000,000) Capital loss available for 164(6) election $ 1,000,000 Amended terminal return: Net capital gain as originally filed $ 1,000,000 Capital loss applied under 164(6) election $ (1,000,000) Amended capital gain $ - Total taxes: Terminal return, as filed $ 195,000 Recovery on 164(6) election $ (195,000) Tax on capital dividend $ - Total taxes: $ - Effective April 26, 1995, Finance expanded the stop-loss rules in subsection 112(3). 32 Specifically, subsection 112(3.2) was amended to limit the capital loss to a trust, including a testamentary trust, on the disposition of shares, to the extent that such trust had received non-taxable dividends on such shares. As a result, a portion of the capital gain realized in Mr. Apple s terminal return could now be taxable to the extent that Mr. Apple s estate received a non-taxable (i.e. capital) dividend. Finance also added subsection 40(3.6), the affiliate stop-loss rules, in Subsection 40(3.6) generally states that where a taxpayer disposes of shares of a corporation, and such taxpayer is affiliated 33 with the corporation immediately after the disposition, the taxpayer s loss is deemed to be $Nil, and the loss amount is added to ACB of any shares retained by the taxpayer. However, subsection 40(3.61) was recently added as an exception to the affiliate stop-loss rule in postmortem situations. Specifically, subsection 40(3.61) states that subsection 40(3.6) does not apply where the executor of a deceased taxpayer s estate elects under subsection 164(6). It is important to note that subsection 40(3.6) may still apply to losses of trusts such as spousal or alter ego trusts. F. Valli, Page 4

5 Impact of Subsection 112(3.2) Amendment Table 2 shows the impact of the 1995 amendment to the stop-loss rules in subsection 112(3.2) (the 1995 amendment ), where Mr. Apple s estate receives a $1,000,000 capital dividend. As illustrated, the capital gain in Mr. Apple s terminal tax return is no longer fully eliminated. Rather, $500,000 of the capital gain is taxable. Table 2 Impact: 112(3.2) Amendment Terminal return: Capital gain $ 1,000,000 Tax thereon (using current Alberta tax rate) $ 195,000 Estate first return: Deemed dividend - intended to be a capital dividend $ 1,000,000 Tax thereon $ - Proceeds for capital gains purposes $ Nil ACB to the estate $ (1,000,000) Capital loss before stop-loss rules $ 1,000,000 Reduction in loss available for 164(6) election - Lesser of: (i) capital dividend received of $1,000,000 and (ii) loss otherwise determined of $1,000,000 minus taxable dividend received on the shares by the estate, in this case $Nil on the $1,000,000 Minus 50% of the lesser of: (i) the loss otherwise determined of $1,000,000 and (ii) captial gain on deemed disposition on death of $1,000,000 $ (500,000) Capital loss available for 164(6) election $ 500,000 Amended terminal return: Capital gain as originally filed $ 1,000,000 Capital loss applied under 164(6) election $ (500,000) Amended capital gain $ 500,000 Total taxes: Terminal return, as filed $ 195,000 Recovery on 164(6) election 19.5% $ (97,500) Tax on capital dividend $ - Total tax $ 97,500 F. Valli, Page 5

6 Grandfathering Provisions It is important to note that the 1995 amendment to the stop-loss rules does not apply in the following two circumstances. Pre-Existing Agreements A disposition of shares (by an estate, for example) made pursuant to an agreement in writing in place before April 27, 1995 (a grandfathered agreement ) is not subject to the 1995 amendment. The CRA has taken a strict position in stating that a grandfathered agreement will lose its grandfathered status if it is modified or altered in any way. Grandfathered status may be lost even if changes to a shareholder s agreement are made that do not affect the buyout or redemption/repurchase of a deceased shareholder s shares. The CRA has provided several technical interpretations as to whether specific circumstances will cause a shareholder s agreement to lose its grandfathered status. In addition, several previous papers have discussed grandfathered agreements. 34 Pre-Existing Insurance Where a corporation redeems/repurchases a deceased individual s shares using life insurance proceeds, such redemption/repurchase is not subject to the 1995 amendment where the following conditions apply: 1. the corporation, or a partnership of which a corporation was a member, was a beneficiary of a life insurance policy that insured the life of the individual or the individual s spouse, and such policy was in place on April 26, 1995; 2. the shares being redeemed/repurchased were owned on April 26, 1995 by the individual (other than a trust), or by a particular trust under which the individual (other than a trust) was a beneficiary; 3. it was reasonable to conclude on April 26, 1995 that a main purpose of the life insurance policy was to fund, directly or indirectly, in whole or in part, a redemption, acquisition or cancellation of the share by the corporation that issued the share; and 4. the disposition is made by the individual or the individual s spouse or common-law partner, or the estate of the individual or the individual s spouse or common-law partner within the estate s first taxation year. 35 As a result, shares which meet the above grandfathering circumstances ( grandfathered shares ) may be disposed of using the Pre-1995 Life Insurance Strategy discussed previously, resulting in the elimination of taxes on death. The 50% Solution Alternatively, Opco can employ the 50% Solution, whereby on the repurchase of the Opco shares for $1,000,000, only 50% of the deemed dividend to Mr. Apple s estate, or $500,000, is elected to be a capital dividend. The remaining $500,000 is deemed to be a taxable dividend to Mr. Apple s estate. F. Valli, Page 6

7 Where Opco has sufficient GRIP and designates such deemed dividend to be an eligible dividend pursuant to subsection 89(14), the estate will pay less tax. As a rule of thumb, a capital dividend may be paid to the estate of up to 50% of the capital gain on Mr. Apple s terminal return. If the capital dividend is in excess of 50% of such capital gain, the excess amount will grind down 36 the capital loss available for carryback under subsection 164(6). Table 3 shows the total taxes where the 50% Solution is used. Table 3 Eligible Non-Eligible Dividend Dividend Terminal return: Capital gain $ 1,000,000 $ 1,000,000 Tax thereon $ 195,000 $ 195,000 Estate first return: Deemed dividend - 50% intended to be a capital dividend $ 500,000 $ 500,000 Deemed dividend - 50% as a taxable dividend $ 500,000 $ 500,000 $ 1,000,000 $ 1,000,000 Proceeds for capital gains purposes $ Nil $ Nil ACB to the estate $ (1,000,000) $ (1,000,000) Capital loss before stop-loss rules $ 1,000,000 $ 1,000,000 Reduction in loss available for 164(6) election - Lesser of: (i) capital dividend received of $1,000,000 and (ii) loss otherwise determined of $1,000,000 minus taxable dividend received on the shares by the estate, in this case $Nil on the $500,000 Minus 50% of the lesser of: (i) the loss otherwise determined of $1,000,000 and (ii) capital gain on deemed disposition on death of $1,000,000 $ Nil $ Nil Capital loss available for 164(6) election $ 1,000,000 $ 1,000,000 Amended terminal return: Capital gain as originally filed $ 1,000,000 $ 1,000,000 Capital loss under 164(6) election $ (1,000,000) $ (1,000,000) Amended capital gain $ - $ - Total taxes: Terminal return, as filed $ 195,000 $ 195,000 Recovery on 164(6) $ (195,000) $ (195,000) Tax on deemed dividend 14.55% / 27.71% $ 72,750 $ 138,550 Total tax $ 72,750 $ 138,550 F. Valli, Page 7

8 As illustrated above, the 50% Solution, combined with eligible dividends, may reduce overall tax, as compared to the result in Table 2 where 100% of the deemed dividend is elected to be a capital dividend. In addition, the 50% Solution preserves 50% of the CDA. A practical issue arises where Opco intends to declare a total dividend of $1,000,000, of which $500,000 is intended to be a capital dividend. This is because subsection 83(2) requires the full amount of the dividend to be elected as a capital dividend. In this situation, Opco can first increase the PUC of the shares to be redeemed/repurchased by $500,000, which will result in a deemed dividend equal to the PUC increase. 37 Such deemed dividend may then be elected to be a capital dividend. Opco can then repurchase the estate s shares for $1,000,000, resulting in a deemed dividend to the estate of $500,000. Redemption without Life Insurance Policy Table 4 shows the total taxes where Opco does not have a corporate-owned life insurance policy to fund the redemption/repurchase of Mr. Apple s shares. As a result, Mr. Apple s estate has a deemed taxable dividend of $1,000,000 assuming Opco does not have a positive CDA balance. In this situation, it is assumed that Opco has sufficient funds on hand available to redeem Mr. Apple s shares. However, if Opco needs to liquidate assets to fund the redemption/repurchase, the corporate tax on such liquidation should also be considered. Table 4 Eligible Non-Eligible Dividend Dividend Terminal return: Capital gain $ 1,000,000 $ 1,000,000 Tax thereon $ 195,000 $ 195,000 Estate first return: Deemed dividend $ 1,000,000 $ 1,000,000 Tax on deemed dividend 14.55% / 27.71% $ 145,500 $ 277,100 Proceeds for capital gains purposes $ Nil $ Nil ACB to the estate $ (1,000,000) $ (1,000,000) Capital loss available for 164(6) election $ 1,000,000 $ 1,000,000 Amended terminal return: Capital gain as originally filed $ 1,000,000 $ 1,000,000 capital loss under 164(6) $ (1,000,000) $ (1,000,000) Amended capital gain $ - $ - Total taxes: Terminal retun, as filed $ 195,000 $ 195,000 Recovery on 164(6) election $ (195,000) $ (195,000) Tax on deemed dividend 14.55% / 27.71% $ 145,500 $ 277,100 Total taxes: $ 145,500 $ 277,100 F. Valli, Page 8

9 As Table 4 illustrates, the difference in total taxes is significant where Mr. Apple s estate receives an eligible dividend rather than a non-eligible dividend. As such, it is evident that the executor of Mr. Apple s estate will want to maximize the amount of eligible dividends received so as to reduce the overall tax burden, or consider other alternatives if GRIP is not available. The Pipeline Strategy Another strategy to minimize double tax is commonly known as the Pipeline Strategy. As discussed previously, Mr. Apple is subject to the deemed disposition of his Opco shares immediately before death, and Mr. Apple s estate is deemed to acquire the Opco shares with an ACB equal to their FMV. Assume that Opco receives life insurance proceeds of $1,000,000 upon Mr. Apple s death. The Pipeline strategy then begins with Mr. Apple s estate incorporating a holding company, Holdco, and disposing of the Opco shares to Holdco for their FMV of $1,000,000, in exchange for a promissory note of $1,000,000. Such disposition results in a capital gain of $Nil to the estate. Opco then repurchases the shares owned by Holdco, 38 and elects to pay Holdco a capital dividend on such repurchase using Opco s life insurance proceeds of $1,000,000. Accordingly, Holdco then uses the $1,000,000 proceeds to repay its promissory note to Mr. Apple s estate. As a result of the Pipeline Strategy, tax is only imposed on the capital gain reported on Mr. Apple s terminal tax return. Table 5 illustrates the total taxes using the Pipeline Strategy. F. Valli, Page 9

10 Table 5 Eligible Non-Eligible Dividend Dividend Terminal return: Capital gain $ 1,000,000 $ 1,000,000 Tax thereon $ 195,000 $ 195,000 Estate first return: Proceeds on sale of Opco shares to Holdco $ 1,000,000 $ 1,000,000 ACB of Opco shares $ (1,000,000) $ (1,000,000) Capital gain - Estate $ - $ - Holdco return - repurchase of Opco shares: Deemed dividend - intended to be a capital dividend $ 1,000,000 $ 1,000,000 Tax thereon $ - $ - Holdco return - capital loss on repurchase of Opco shares: Proceeds for capital gains purposes $ Nil $ Nil ACB to Holdco $ (1,000,000) $ (1,000,000) Capital loss available before stop-loss rules $ 1,000,000 $ 1,000,000 Reduction in loss pursuant to paragraph 112(3)(b) $ (1,000,000) $ (1,000,000) Capital loss available for 164(6) election $ - $ - Total taxes: Terminal return, as filed $ 195,000 $ 195,000 Capital gain - Estate $ - $ - Taxable dividend - Holdco $ - $ - Total tax $ 195,000 $ 195,000 Section 84.1 is an anti-avoidance provision that should be reviewed when considering the Pipeline Strategy. The purpose of subsection 84.1 is twofold: to prevent the extraction of PUC, and to prevent capital gains stripping on the transfer of shares to a corporation. Specifically, subsection 84.1(1) applies where a taxpayer (other than a corporation) disposes of shares of a Canadian corporation (the subject corporation ) to another non-arm s length 39 corporation (the purchaser corporation ), and immediately after the disposition, the subject corporation would be connected 40 with the purchaser corporation. In the Pipeline Strategy example above, subsection 84.1(1) will apply since Mr. Apple s estate is disposing of the Opco shares (the subject corporation) to Holdco (the purchaser corporation), a non-arm s length corporation, and immediately after the disposition Opco will be connected with Holdco. As such, paragraph 84.1(1)(b) deems Mr. Apple s estate to have received a dividend to the extent that the proceeds of disposition are in excess of the estate s ACB of the Opco shares. The estate s ACB is reduced for V-day value, 41 and to the extent the capital gains deduction ( CGD ) 42 has been previously claimed on the Holdco shares. 43 In the above example, it is assumed that the ACB of the Opco shares is not reduced with regards to V-day value and the CGD. Accordingly, Mr. Apple s estate will not be F. Valli, Page 10

11 subject to a deemed dividend under paragraph 84.1(1)(b) since the proceeds on the sale of Opco shares of $1,000,000 is equal to the estate s ACB of the Opco shares. Note that care should be exercised when contemplating the use of the Pipeline Strategy, especially where the deceased shareholder has previously claimed the CGD. Summary Table 6 provides a summary of the total taxes in Tables 1 to 5. Table 6 Total Tax Total Tax Eligible Non-Eligible Total Tax Dividends Dividends Pre-1995 Life Ins. Strategy $ - $ - $ - Subsection 112(3.2) Impact 97, % Solution - 72, ,550 Redemption without Life Ins , ,100 Pipeline Strategy - 195, ,000 Based on the above strategies, it is evident that the total taxes can vary depending on whether Mr. Apple s estate receives eligible or non-eligible dividends, with the exception of the Pipeline Strategy. Eligible Dividend Rates Looking Ahead The eligible and non-eligible dividend tax rates for the Prairie Provinces from 2009 to 2012 are shown in Table 7, assuming individuals are in the highest marginal tax brackets in the respective Provinces. Table 7 Eligible Dividends Alberta Manitoba Saskatchewan % 23.83% 20.35% % 25.09% 21.64% % 26.74% 23.36% % 28.12% 24.18% Non-Eligible Dividends Alberta Manitoba Saskatchewan % 38.21% 30.83% % 38.21% 30.83% % 39.14% 30.83% % 39.14% 30.83% Capital Gains to % 23.20% 22.00% F. Valli, Page 11

12 The eligible dividend rate in Alberta will increase to 20.85% from 2012 onward, which will be higher than the capital gains rate of 19.5%. Accordingly, the Pipeline Strategy may be more tax-efficient from 2012 onwards. However, eligible dividend considerations may continue to be important where the Pipeline Strategy is not available, or in provinces where eligible dividend rates are lower than capital gains rates. Shareholder Agreement Considerations As the importance of receiving eligible dividends in the preceding post-mortem planning scenarios has been established, this section focuses on the potential methods of allocating the GRIP balance among related and arm s length shareholders within a shareholder agreement. In the absence of planning or forethought with respect to such allocation, the chance for litigation exists. This section discusses additional issues that should be considered regarding GRIP allocation. Finally, two examples are provided for possible use when drafting a shareholder agreement to contemplate the allocation of GRIP. GRIP Allocation Methods: No Prior Freeze Where the shareholders of a CCPC have not previously carried out an estate freeze, there are a number of different methods that may be utilized to allocate GRIP, which are best described using an example. Accordingly, assume that Mr. Apple and Mr. Orange each own 100 Class A and B voting common shares of Opco, respectively. The ACB and PUC of Mr. Apple s and Mr. Orange s shares is $Nil, and the FMV attributable to each shareholder is $1,000,000. There are no other issued and outstanding shares of Opco. Mr. Apple and Mr. Orange wish to amend Opco s shareholder agreement to contemplate the allocation of Opco s GRIP balance on the death of one of the shareholders. Allocation: Percentage of Voting Shares The shareholder agreement may contemplate allocating Opco s GRIP balance according to the percentage of voting (or equity) shares owned by each shareholder. The advantage of this method is its simplicity. The disadvantage is that it does not account for how long Mr. Apple and Mr. Orange have each been shareholders of Opco. For example, suppose that Mr. Apple has been the sole shareholder of Opco since its incorporation in 2000, whereas Mr. Orange became a shareholder in If Mr. Apple dies in 2009, the allocation of the GRIP balance by percentage of voting shares may not seem equitable if the opening GRIP balance generated by Opco from 2001 to 2005 is greater than the 2006 to 2008 GRIP additions, when Mr. Orange was a shareholder. 44 Another disadvantage is that this method does not contemplate allocation of GRIP to non-voting shares. Adjustment for Years of Shareholdings The shareholder agreement may contemplate allocating Opco s GRIP balance according to the percentage of voting shares held, adjusted for the number of years each individual has been a shareholder. In the F. Valli, Page 12

13 above example, Mr. Apple s shares should be entitled to 100% of the opening GRIP balance generated from 2001 to 2005, and 50% of the GRIP additions from 2006 to Adjustment for Prior Eligible Dividends Received The shareholder agreement may also contemplate eligible dividends already designated to each shareholder prior to the allocation determination time, being the time of death of one of the shareholders. For example, suppose that Opco has no prior GRIP balance and generated its first GRIP addition of $100,000 in In addition, suppose that only Mr. Apple received an eligible dividend of $50,000 in 2008 on his Class A common shares, and subsequently died in In this case, it would seem inequitable to allocate 50% of the remaining GRIP balance of $50,000 to Mr. Apple s shares since he already benefitted from the $50,000 eligible dividend in Rather, the remaining GRIP balance of $50,000 might be allocated entirely to Mr. Orange. GRIP Allocation Methods: Prior Freeze or Freeze Contemplated Suppose Mr. Apple is currently the only shareholder of Opco, and he is contemplating carrying out an estate freeze and introducing his son Barry as a new common shareholder. In this situation, Mr. Apple has complete control over amending the shareholder agreement, and he may choose to have all of the GRIP balance attributed to his common or preferred shares on death. Opco may then issue a separate class of common shares to Barry subsequent to the estate freeze. Allocation: FMV of Shares Held Alternatively, a more equitable method may be to allocate the GRIP balance according to the FMV of all shares owned by each shareholder. This method may also apply in arm s length situations and where Mr. Apple has already carried out an estate freeze. Again, the shareholder agreement may also account for the number of years each individual has been a shareholder, and prior eligible dividends received by each shareholder. Additional GRIP Allocation Considerations The following considerations may also apply when determining GRIP allocation. Ability to Negotiate GRIP Balance The shareholder s agreement may provide additional flexibility if shareholders can negotiate the allocation of the GRIP balance. For example, suppose Opco has a GRIP balance of $100,000, of which $50,000 is otherwise allocable to each of Mr. Apple and Mr. Orange. In this situation, the shareholder agreement may allow the executor of Mr. Apple s estate to negotiate with Mr. Orange to receive an additional GRIP allocation. If, for example, Mr. Apple s estate accepts lower redemption/repurchase proceeds in exchange, then subsection 69(1) should be reviewed. F. Valli, Page 13

14 Application to RDTOH and CDA The shareholder agreement may also contemplate the allocation of a corporation s refundable dividend tax on hand ( RDTOH ) 45 and CDA balances. This may also provide additional flexibility where the deceased shareholder s estate can negotiate with the surviving shareholder to obtain the most tax-efficient outcome. It is arguable whether the RDTOH balance is a tax pool that should be allocable to shareholders, or whether such tax pool should belong to the corporation, since it represents a pre-payment of tax by the corporation. However, if shareholders decide to provide for the allocation of the RDTOH balance, they should address how the RDTOH entitlement will be distributed to Mr. Apple s estate. 46 Non-Resident Shareholders Pursuant to subsection 89(1), only a Canadian resident can receive an eligible dividend. As such, a nonresident shareholder cannot take advantage of the lower eligible dividend tax rate. However, suppose for example that a non-resident of Canada and a Canadian resident each own 50% of the same class of shares of a CCPC, and the CCPC intends to pay an eligible dividend of $100,000 to its shareholders. In this situation, the non-resident shareholder will receive an ordinary taxable dividend, rather than an eligible dividend. In addition, the CRA has stated that such $50,000 dividend designated as an eligible dividend to the non-resident shareholder will not reduce the GRIP balance. 47 Amendments to Grandfathered Shareholder Agreements As previously discussed, grandfathered shares may still be disposed using the Pre-1995 Life Insurance Strategy to eliminate tax the death of a shareholder. However, the benefits of amending a grandfathered shareholder agreement to allocate GRIP should be weighed against the cost of losing grandfathering status. Wasting Estate Freeze Implications Where a shareholder owns fixed-value preferred shares, such shareholder may consider having the preferred shares redeemed using the available GRIP balance, in order to take advantage of relatively low eligible dividend rates between 2009 and Accordingly, such shareholder s GRIP entitlement might also be adjusted to account for eligible dividends received during such shareholders lifetime. Application upon Departure of a Shareholder The shareholder agreement may contemplate the allocation of GRIP (and/or CDA and RDTOH) upon a shareholder s departure from the corporation, rather than just upon death. This may apply where the corporation repurchases/redeems the shares of the departing shareholder, rather than circumstances where the departing shareholder sells his or her shares to another party. Where the corporation has three shareholders, for example, and the departing shareholder cannot utilize his or her GRIP allocation, the shareholder agreement may contemplate how GRIP is allocated between the remaining two shareholders upon the third shareholder s departure. F. Valli, Page 14

15 Examples for Drafting Shareholder Agreement As should be evident so far, an important consideration when drafting a shareholder agreement is to provide maximum flexibility to the shareholders. In addition, the shareholder agreement may allow for the most tax-efficient outcome to the deceased shareholder and the estate, or the most equitable outcome to the deceased and surviving shareholders. At the April 21, 2009 presentation to the Calgary branch of STEP Canada, Chris Ireland and Kevin Wark provided the following example for possible inclusion in a shareholder agreement. The executor shall obtain professional advice as to the most tax-efficient manner of disposing the shares income tax benefits available to the deceased shareholder and the estate, including capital losses, the capital gains exemption, the refundable dividend tax on hand, the capital dividend account and the general rate income pool shall be maximized and the surviving shareholders shall co-operate in structuring a buyout that meets the tax planning objectives of the deceased and the estate. The following is another example for possible inclusion in a shareholder agreement, which contemplates an equitable allocation of GRIP and CDA. Again, suppose Mr. Apple and Mr. Orange each own 50 Class A and B common shares of Opco, respectively, and are each entitled to 50% of the FMV of Opco. Opco was incorporated in 2001 and has a taxation year that ends on December 31 st. In addition, Mr. Apple was the sole shareholder of Opco from 2001 to On death or exit of a shareholder, the corporation s GRIP, used as the basis for eligible dividends, and the corporation s CDA balances (the tax balances ), unless otherwise provided herein, shall be allocated to the deceased or departing shareholder in the following order: 1. Subject to the adjustment under paragraph 3 below, where the corporation has only common shares issued and outstanding, the tax balances shall be allocated in proportion to the percentage of common shares owned by each shareholder at the determination time [i.e. the determination time being the time of death or departure]; or 2. Subject to the adjustment under paragraph 3, where the corporation has issued and outstanding common shares and fixed value preferred shares, the tax balances shall be allocated in proportion to the fair market value of all of the issued and outstanding shares owned by each shareholder at the determination time. 3. The above allocations shall be adjusted to take into account the years of shareholdings of, and eligible dividends and capital dividends received by, each shareholder, as follows: a. for the years from 2001 to 2005, 100% of the tax balances generated in those years shall be allocated to Mr. Apple; b. for the years after 2005, the tax balances generated in those years shall be allocated in accordance with paragraph 1 or 2 above, as applicable; F. Valli, Page 15

16 c. the total entitlement to eligible dividends and capital dividends for each shareholder, from the commencement of his/her shareholding up to the determination time (the total entitlement ), shall be determined; d. the total of eligible dividends and capital dividends received by each shareholder, from the commencement of his/her shareholding up to the determination time (the total received ), shall be determined; and e. the total entitlement shall be reduced by the total received. The shareholders hereby acknowledge that it is their intent to allocate the tax balances in an equitable manner. The purpose of this shareholder agreement example is to ensure that each shareholder receives the proportionate amount of GRIP and CDA created in the corporation based on the proportionate FMV of shares (or common shares) owned by each shareholder. Such proportionate amount is adjusted for each prior year of ownership, as well as prior GRIP and CDA allocated to the shareholders. Where a corporation receives proceeds from a life insurance policy on the death of a shareholder, the allocation of the resulting CDA may be made to the deceased shareholder s shares, if so desired, pursuant to an additional provision within the above example, or as a separate share redemption provision within the shareholder agreement. As a continuation of the above example, Table 8 outlines the share ownership in Opco since incorporation, Opco s GRIP additions, and eligible dividends received by the shareholders. Table 8 Percentage Ownership GRIP Eligible Div. Received Year Mr. Apple Mr. Orange Addition Mr. Apple Mr. Orange % 0% $ 500,000 $ - $ % 50% $ 500,000 $ 250,000 $ % 50% $ 500,000 $ 375,000 $ 375, % 50% $ 500,000 $ 250,000 $ 250, % 50% $ 1,000,000 $ - $ - $ 3,000,000 $ 875,000 $ 625,000 Suppose that Mr. Apple died on May 1, Accordingly, the allocation of GRIP to Mr. Apple s shares will be as follows. F. Valli, Page 16

17 Table 9 GRIP Entitlement Year Mr. Apple Mr. Orange $ 500,000 $ $ 250,000 $ 250, $ 250,000 $ 250, $ 250,000 $ 250, $ 500,000 $ 500,000 $ 1,750,000 $ 1,250,000 Previous Eligible Div. Received $ (875,000) $ (625,000) GRIP Entitlement $ 875,000 $ 625,000 As illustrated in Table 9, the GRIP entitlement is determined for each of Opco s taxation years based on the FMV of shares owned in each such year. The GRIP entitlement is then adjusted for previous eligible dividends received. Comprehensive Case The following comprehensive case is used to illustrate a tax-efficient post-mortem strategy in a non-arm s length situation. Mr. Apple is a resident of Alberta for income tax purposes, and is not a resident or citizen of any other country. Mr. Apple is married to Mrs. Apple, and has two children from a prior marriage. Mr. Apple is the sole shareholder of Holdco, a CCPC, and owns 100 Class A common shares with a FMV of $50,000,000, and an ACB and PUC of $Nil. The FMV of the common shares of Holdco is derived from Holdco s ownership of 100 common shares of Opco. Holdco is the sole shareholder of Opco, a CCPC which carries on business in Canada. The FMV of the common shares of Opco is $50,000,000 and the ACB and PUC of the Opco shares held by Holdco are $Nil. The Holdco shares are not subject to the grandfathering provisions pursuant to subsection 112(3.2). Finally, Holdco has a CDA balance of $8,000,000, and Opco has a GRIP balance of $20,000,000. Mr. Apple died on May 1, Holdco s shareholder agreement requires the repurchase of Mr. Apple s shares on death. In addition, Mr. Apple s will has allocated 50 Class A common shares of Holdco to his wife, and the remaining 50 Class A common shares to his two children. The executor of Mr. Apple s estate would like to minimize the overall tax burden to Mr. Apple. F. Valli, Page 17

18 Tax-Efficient Solution In the present case, the most tax efficient solution is to utilize subsection 70(6) to transfer 50 Class A common shares to Mr. Apple s spouse, 48 and to pay a capital dividend and an eligible dividend to Mr. Apple s estate on Holdco s repurchase of the remaining 50 shares. The eligible dividend should be designated in the 2009 calendar year to take advantage of lower eligible dividend tax rates. Implication of Common Shares Acquired by Estate On Mr. Apple s death, there will be a deemed disposition of the common shares of Holdco at their FMV of $50,000, common shares will be transferred to Mrs. Apple on a tax-deferred basis pursuant to subsection 70(6), and will be deemed to have been acquired by the estate for their ACB of $Nil. The remaining 50 common shares will be deemed to have been acquired by the estate with an ACB of $25,000,000 and PUC of $Nil. As a result, the capital gain on Mr. Apple s terminal return will be $25,000,000 (rather than $50,000,000). Subsection 47(1) should be reviewed with respect to the estate s acquisition of the 100 Class A common shares. Where subsection 47(1) applies, a taxpayer must average the cost of identical properties acquired after Whether a given property is identical to another is a question of fact which must be determined on a case by case basis. However, shares of a corporation of the same class will likely be identical property for the purposes of subsection 47(1). 49 Pursuant to the preamble of subsection 47(1), such provision applies where a taxpayer who owns one property, or two or more identical properties, subsequently acquires one or more other properties, each of which is identical to each such previously acquired property. In the present situation, the estate will acquire all 100 common shares of Opco at the same time, notwithstanding that the 50 common shares eventually transferred to Mrs. Apple will have a different ACB than the 50 common shares that will be transferred to the children. As such, subsection 47(1) should not apply since there is no previously owned identical property in the estate. The CRA has commented favourably on the above issue in Document No E5. 50 In that case, the taxpayer owned 100 common shares of a family farm corporation. The taxpayer died and under his will, the shares were divided between his two children. The shares were distributed from the estate to the children two years after the death of the taxpayer. One child was resident in Canada while the other was a non-resident. The shares transferred to the child resident in Canada benefited from the rollover provision at subsection 70(9.2), thus incurring no income tax on the taxpayer s death and resulting in shares with low ACB. However, the shares transferred to the non-resident child were subject to the deemed disposition under subsection 70(5) resulting in capital gains to the deceased taxpayer and a high ACB on such shares. The taxpayer queried the CRA as to whether subsection 47(1) would apply to average the ACB of the two children s shares when they were held in the estate. The CRA responded by F. Valli, Page 18

19 stating that subsection 47(1) would not apply, as the estate acquired the shares at the same moment (i.e. the taxpayer s death). In a similar situation, 51 the CRA confirms that subsection 47(1) does not apply in a case when an estate holds identical shares which have differing ACB s due to the application of subsection 70(5) to a portion of the shares and the application of subsection 70(6) to the remainder of the shares. Accordingly, subsection 47(1) should not apply to the 100 Class A common shares acquired by Mr. Apple s estate. Tax-Efficient Solution Steps The following steps should be undertaken to administer Mr. Apple s estate and minimize overall taxes on Mr. Apple s death. Step 1: GRIP Dividend to Holdco In order to shift the appropriate GRIP balance to Holdco, Opco will pay a $17,000,000 dividend on the 100 common shares owned by Holdco. The dividend will be designated as an eligible dividend in accordance with subsection 89(14), and will be deductible by Holdco pursuant to subsection 112(1). Step 2: Exchange 50 Class A Common Shares For Holdco to be able to declare a capital dividend and eligible dividend only on the 50 Class A common shares being transferred to the children, such shares will have to be exchanged for a separate class of common shares, such as Class B common shares. Such exchange would occur on a tax-deferred basis pursuant to subsection 51(1). Step 3: Increase PUC of Class B Common Shares Next, Holdco will increase the PUC of the 50 Class B common shares by $8,000,000, resulting in a deemed dividend to the estate of $8,000, Holdco will elect to pay such dividend from its CDA, resulting in a tax-free capital dividend to the estate. The 50 Class B common shares will then have a PUC of $8,000,000. Step 4: Repurchase of Class B Common Shares Within the first taxation year of Mr. Apple s estate, Holdco will repurchase the 50 Class B common shares from the estate for cancellation at their FMV of $25,000,000. Since the PUC of such shares is $8,000,000 further to Step 3, there will be a deemed dividend in the amount of $17,000,000, 53 which Holdco will designate as an eligible dividend, in accordance with subsection 89(14). In satisfaction of the repurchase, Holdco will issue a promissory note to the estate for $25,000,000. The repurchase of the 50 Class B common shares will trigger a deemed disposition of such shares by the estate. 54 At the time of disposition, the ACB of the 50 Class B common shares will be $33,000,000, 55 and F. Valli, Page 19

20 the proceeds of disposition of such shares will be $8,000, disposition of such shares will be $25,000, Therefore, the capital loss on the deemed Step 5: Carryback of Estate s Capital Loss The executor of Mr. Apple s estate will then elect under subsection 164(6), within the estate s first taxation year, to have the $25,000,000 capital loss realized in the estate to be reported in Mr. Apple s terminal income tax return. Such capital loss is not reduced by subsection 112(3.2) in accordance with the calculation in Table 10. TABLE 10 - CALCULATION OF SUBSECTION 112(3.2) GRIND: The amount (if any) by which the lesser of: (a) Capital dividends received by the estate on the shares; (b) The loss otherwise determined incurred by the estate from the disposition of the shares minus taxable dividends received by the trust on the share STATUTORY REFERENCES AND NOTES 112(3.2)(a) $ 8,000, (3.2)(a)(i) $25,000, (3.2)(a)(ii)(A) ($17,000,000) $8,000,000 Exceeds one half of the lesser of: (c) The loss otherwise determined incurred by the estate from the disposition of the shares during the estate s first taxation year (d) the individual s capital gain on death from the disposition of the shares $12,500,000 (50% of $25,000,000) 12,500,000 (50% of $25,000,000) 112(3.2)(iii)(A) 112(3.2)(iii)(B) Plus: Plus: (e) taxable dividends received on the shares and designated under 104(19) or (20) by the trust in respect of a beneficiary that was a corporation, partnership or trust (f) a life insurance capital dividend received on the shares and designated under 104(19) or (20) by the trust in respect of a beneficiary that was a corporation, partnership or trust N/A N/A 112(3.2)(b)(i) 112(3.2)(b)(ii) F. Valli, Page 20

21 112(3.2) Grind: N/A In this case the lesser of amounts (a) and (b) does not exceed one half of the lesser of amounts (c) and (d), therefore the grind amount is nil. Summary Table 11 shows the total tax on Mr. Apple s death using subsection 70(6) and subsection 164(6), compared to the tax-efficient solution. It is apparent that with optimal tax planning by the executor of Mr. Apple s estate, there is a significant tax savings. Even if there is no GRIP available in the tax-efficient solution, the total tax is $4,710, Table 11 Loss Carryback - Suggested Non-Eligible Case Solution Dividend Eligible Dividend Terminal return: Capital gain $ 25,000,000 $ 25,000,000 Tax thereon $ 4,875,000 $ 4,875,000 Estate first return: Deemed dividend $ 25,000,000 $ 25,000,000 Intended to be a capital dividend $ - $ 8,000,000 Eligible dividend $ - $ 17,000,000 Tax thereon 14.55% / 27.71% $ 6,927,500 $ 2,473,500 Proceeds for capital gains purposes $ Nil $ 8,000,000 ACB to the estate $ 25,000,000 $ 33,000,000 Capital loss available for 164(6) election $ 25,000,000 $ 25,000,000 Amended terminal return: Net capital gain as originally filed $ 25,000,000 $ 25,000,000 Capital loss applied under 164(6) election $ (25,000,000) $ (25,000,000) Amended capital gain $ - $ - Total taxes: Terminal return, as filed $ 4,875,000 $ 4,875,000 Recovery on 164(6) election $ (4,875,000) $ (4,875,000) Tax on deemed dividend $ 6,927,500 $ 2,473,500 Total taxes: $ 6,927,500 $ 2,473,500 F. Valli, Page 21

22 Conclusion In addition to improving tax integration, the eligible dividend regime has drawn focus to the importance of shareholder GRIP allocation in post-mortem planning, since the benefits of receiving eligible dividends are evident. As discussed in this paper, there are a number of issues to consider with respect to the allocation of GRIP between shareholders. Finally, in contemplating the allocation of GRIP and other tax balances, shareholder agreements should be flexible. 1 The author wishes to acknowledge the following individuals for their significant contributions to the writing and research of this paper: Kim G C Moody, CA, TEP, Roberto Domagas, CA and Nicolas F. Baass, LL.B, LL.M (Tax) of Moodys LLP Tax Advisors, as well as Adam Hoffman, LL.B and Jadranka Sahacic of Shea Nerland Calnan LLP Barristers & Solicitors. All errors, however, remain those of the author. 2 GRIP is defined in subsection 89(1) of the Income Tax Act, RSC 1985, c. 1 (5 th Supp.), as amended (herein referred to as the Act ), and is calculated pursuant to the provisions in section Eligible dividend is defined in subsection 89(1). 4 Canadian-controlled private corporation is defined in subsection 125(7). 5 Active business income includes income earned from an active business carried on by a corporation, defined in subsection 125(7). 6 The small business deduction is defined in subsection 125(7) of the Act, and the small business deduction rate is defined in subsection 125(1.1). 7 Public corporation is defined in subsection 89(1). 8 Also known as SIFT trust, which is defined in subsections 122.1(1) and (2). 9 Also referred to as SIFT partnership, which is defined in subsections 197(1) and (8). 10 Corporate tax is computed in accordance with Part I, Division E, Subdivision b of the Act (sections 123 to 125.5). 11 A taxable dividend received is grossed-up pursuant to paragraph 82(1)(b). 12 A dividend tax credit may be claimed by individuals pursuant to section A corporation must designate a dividend as an eligible dividend pursuant to subsection 89(14). In addition, a nonresident may not receive eligible dividends. Regarding the designation of an eligible dividend to a non-resident, see footnote In contrast, a Canadian corporation other than a CCPC may not pay eligible dividends to the extent that such corporation has a balance in its low rate income pool ( LRIP ). LRIP is defined in subsection 89(1), and will not be the focus of this paper. 15 The eligible divided gross-up and dividend tax credit will decrease after 2009 pursuant to paragraph 82(1)(b) and section 121, respectively. 16 The small business limit is defined in subsection 125(2). 17 Alternatively, owner-managers may choose to obtain a deferral within the corporation if there is no immediate need to receive dividends. 18 See Joel Cuperfain Got Me Those Low Capital Gain, High Dividend Tax, Stop-Loss Rules, Estate-Planning Blues in Personal Tax Planning, (2001), vol. 49, no. 3 Canadian Tax Journal, , Marco Faccone, CA and Leanne Gehlen, CA, Post-Mortem Estate Planning: Selected Canadian and US Tax Issues Relating to the Implementation of Post-Mortem Strategies, 2006 British Columbia Tax Conference, (Vancouver: Canadian Tax Foundation, 2006), 12:1-34, and David Christian, Post-Mortem Tax Planning, Report of Proceedings of Fifty- Ninth Tax Conference, 2007 Tax Conference (Toronto: Canadian Tax Foundation, 2008), 37: Related persons are defined in subsection 251(2). 20 Arm s length is defined in subsection 251(1). 21 Pursuant to paragraph 70(5)(a). 22 Pursuant to paragraph 70(5)(b). F. Valli, Page 22