John G. Ormiston, CPA, CA, TEP Deloitte LLP
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1 John G. Ormiston, CPA, CA, TEP Deloitte LLP 2
2 Acknowledgement The author would like to thank various members of the Lower Mainland Tax Community who readily volunteered several Horror Stories for consideration in this paper. Regrettably, there are many stories out there and as a consequence, this paper has been limited to consider these sample vignettes in the hopes of keeping you and your clients safe, sound and out of trouble. Perhaps there will be a sequel to this paper for your future viewing horror. The author specifically wishes to thank Vincent Lo, Dave Cesmystruk and Jeremy Bergen as well as other members of the Deloitte Tax Group for their valuable assistance in the preparation of this paper. 3 A very simple succession plan Before Dad 100% ACB/PUC Nominal OPCO FMV $800K QSBC You are the long-time external accountant for Dad. He asks for your assistance in selling to Son who works in the business. He would like to take advantage of the tax-free gain available to him. He is prepared to carry a vendor take-back note at reasonable interest terms. He and Son agree to a value of $800,00 for the shares. He wants to keep the transaction simple. Son wants to continue working with you after the sale. 4
3 What next? After SON Note for interest of x% 100% ACB $800k DAD OPCO 5 Issues Dad gets capital gains exemption (potential for AMT). Opportunity for a 5 year reserve on the gain. Section 40. Interest expense should be deductible if terms of the loan are reasonable and rate is fixed non participatory. No deemed year end or other issues. ss. 256.(7) Purchase price of $800,000: Is it fair market value? Possible application of section 69 to effect a one sided adjustment The real issue is repaying the note. Son needs after tax cash to settle note, making the debt exorbitantly expensive to retire. $800, = $1,481,000 of remuneration to have after tax proceeds to settle the debt 6
4 Solution: Simple yes? SON HOLDCO 100 % $800k note DAD OPCO 100 % ACB $800k Son sells shares to a holdco. Holdco assumes the debt to Dad as consideration. 7 Truly Simple solution SON 100 % AMALCO $800k note DAD Problem solved? Company is now buying Dad out with $0.865 versus $0.54. In order to ensure there is a matching of interest expense against operating income, the companies are immediately amalgamated, creating a year end in both companies. 8
5 Bigger problem Section 84.1 results in a deemed dividend to Son of $800K as there is no hard basis as a consequence of Dad claiming the Capital Gains Exemption. Another alternative What if Son incorporated Holdco and Holdco purchases the shares directly from Dad and issues Dad the note? Same results but this time Dad gets the $800K dividend. 9 Potential alternatives Dad repurchases or forecloses on the debt thereby acquiring the shares back from Son. Shares have basis. Section 79 ACB issues. Dad exchanges Common Shares for Preferred Shares under Section 86 and effects a freeze at $800K. Son subscribes for new common shares for future growth. Preferred shares redeemed over time at his marginal tax rate. Other strategies? 10
6 Another Spin Brother 1 Brother 2 50 common shares ACB/PUC Nominal Opco FMV $1.6MM 50 common shares ACB/PUC Nominal Shareholders Agreement with a compulsory buy-sell arrangement. Agreement permits the purchaser to direct the vendor to sell to his assignee. Assignee is a corporation controlled by the purchasing brother Vendor brother claims the $800K exemption. Deemed Dividend applies to vendor brother. 11 How a divorce can get worse Husband Opco 100% Common ACB PUC Nominal FMV $3.2 million A couple is planning a divorce. Husband owns the company. The only funding for the divorce is the business borrowing capacity. It is not possible to borrow enough money to pay the wife with after-tax personal funds 12
7 Tax planning is put in place Common ACB FMV PUC Nominal Preferred ACB PUC Nominal FMV $1.6 million Husband Holdco Opco Wife Preferred ACB PUC Nominal FMV $1.6 million Husband creates a new holding company A freeze is done by paying a stock dividend of high low preferred shares of $3.2M There are put and call options in place for a sale/purchase of the preferred shares by Holdco. There is no requirement in place that the put call be exercised. One half of the preferred shares are transferred to the wife. Sec. 73(1). 13 Husband rolls his shares into Holdco. Couple divorces. Some time later put call option is exercised and Holdco acquires preferred shares from the ex wife. Common ACB Nominal FMV $1.6 million PUC Nominal Husband Holdco Common ACB Nominal FMV Nominal PUC Nominal Preferred ACB Nominal FMV $1.6 million PUC Nominal Wife Opco Preferred ACB Nominal FMV $1.6 million PUC Nominal 14
8 Common ACB Nominal FMV $1.6 million PUC Nominal Husband Holdco Common ACB Nominal FMV Nominal PUC Nominal Preferred ACB Nominal FMV $1.6 million PUC Nominal Preferred ACB Nominal FMV $1.6 million PUC Nominal Wife Opco Note Payable $1.6 million Husband s holding company goes to redeem half of the preferred shares to pay out the wife. Part VI.1 applies to the dividend over $500,000 in a taxation year. Tax to be paid by Opco is 40% of $1.1million or $440,000 as shares are short term preferred shares. This tax is creditable against Part I Tax. 15 A better solution Section 191(3)(b) may deem husband not to have a substantial interest in these shares. This section is an antiavoidance provision. As the preferred shares were stock dividend shares, under section 191(4) the dividend on redemption is not an excluded dividend. Limit annual redemption to $500,000 per taxation year to stay under the Part VI.1 dividend limitation. See comments by Evelyn P. Moskowitz in 1997 conference report, The Preferred Share Rules: Yes, They Apply To You. (97 CR p.9:43 and 44) 16
9 Taking money off the table A X Y Z 100% 33.3 % each $0 GRIP $0 RTDOH A Holdco Employee Holdco 8,000 shares ACB/PUC Nominal (80%) $6 M GRIP 0 RTDOH Opco FMV $10.0 mil $6 M safe income 2,000 shares ACB/PUC Nominal (20%) Before share buy-back 17 A owns 8,000 common shares of Opco through his wholly-owned subsidiary A Holdco 2,000 Shares of Opco are owned by Employee Holdco co-owned by 3 key employees X, Y and Z A is unrelated to X, Y or Z. There is only one class of Opco issued shares ACB to 2 shareholders and PUC of the common shares of Opco are nominal Opco has $6 M GRIP, $6 M safe income attributable to all the common shares of OPCO and $0 RDTOH A Holdco has $0 GRIP and $0 RDTOH The fair market value of all the 10,000 shares of OPCO is estimated to be $10 M A wants to take out $2 M from Opco through A Holdco A requests 2,000 common shares of Opco owned by A Holdco be re-purchased by Opco (First offered to Employee Holdco) 18
10 Taking money off the table (pt. 2) A X Y Z 100% A Holdco Employee Holdco 33.3 % each 6,000 shares 75% Opco 2,000 shares 25% After share buy-back 19 A Holdco is deemed to have received a dividend of $2 M The equity interest of Opco owned by Employee Holdco is increased from 20% to 25% Subsection 55(2) would apply to the dividend recipient when all the prescribed conditions are met and none of the exceptions in paragraphs 55(3)(a) or (b) available. All conditions as prescribed pursuant to subsection 55(2) would apply to the $2 M deemed dividend to be received by A Holdco to extent greater than attributable safe income to the particular shares redeemed Paragraph 55(3)(b) exception for divisive butterfly transactions not available to A Holdco Paragraph 55(3)(a), subparagraph (v) provides a significant increase in the total direct interests in the dividend payer of one or more persons or partnerships who were unrelated persons immediately before the particular time 20
11 Hot off the Press: An accident waiting to happen Existing Structure Mr. X Mr. Y 50% 50% ACB and PUC nominal XY OPCO FMV $13.0 m QSBC ACB and PUC nominal This proposed plan received early July 2015 Asked to review by Mr. X s lawyer for a second opinion 21 Proposed steps to be taken 1. Incorporate Newholdco with voting non-participating shares owned by Mr. and Mrs. X. 2. Have a friend settle a Family Trust with Mr. X as the sole Trustee and the beneficiaries include Mr. X, Mrs. X, children of Mr. and Mrs. X and grandchildren of Mr. and Mrs. X. 3. Family Trust subscribes for class B non-voting participating shares of Newholdco. 4. Section 86 share exchange on 43.8% of the issued and outstanding common shares of XY Opco into a class B common share. 5. Section 85 transfer of these new class B common shares to Holdco, for preferred shares at the nominal a.c.b. with a redemption amount of $5.7 million. 6. Pay a Safe Income dividend of $3.0 from XY Opco on the new class B common shares to New Opco. 22
12 Mr. X Family trust Proposed corporate ownership chart Mr. X Mrs. X Children Grandchildren Mr. and Mrs. X 100% Voting Control X Family Trust 100% Common Shares Holdco $3.0 R/E Trustee Control 100% Preferred Shares Mr. X 6.2% Common Shares FMV $800K 43.8% Common Shares XY Opco 23 Objective of the plan 1. Isolate QSBC exemption of $800K sch of original common shares. 2. Reduce the capital gain on the sale of the shares by doing a safe income dividend to Newholdco and defer the taxes by keeping retained earnings in the company. 3. Earn investment income in Newholdco and income split using the Family Trust. 24
13 Analysis of the plan Section 86 does not work as not all of the shares exchanged (solution -- Section 85). Capital gain rate on a direct flow through is 25% (higher than 23%). Refundable tax erodes the cash available for re-investment. Safe Income has converted a capital gain at 23% to a Dividend rate of 28% (eligible) or 38% (ineligible). Newholdco is an investment company and no longer meets the test as a small business corporation. 25 Analysis of the plan (cont d) Family Trust has spouse and minor children beneficiaries. Newholdco is not a Small Business Corporation Section 74.4 applies corporate attribution to Mr. X. Must pay out dividends on preferred shared to avoid
14 Preferred plan Capital Gain on all shares. Capital Gains Exemption first $800K and 22.9% thereafter. Gift cash to children. Set up accounts for grandchildren with capital gains to avoid attribution. Always look at the business end of the plan. What will you have when you are done. 27 Practice management tips Twilight zone Implementation of electronic and paperless world has at times lead to missing memos as they may be sent out after or before the year end engagement and protocol not in place to make sure properly filed s saved to hard drives and not copied and migrated to the client file can disappear Departing employee s computer and the issues of privacy versus client correspondence 28
15 Practice management tips Time deadlines An age old problem Bulletin Boards are passé Paperless world is still working through Protocol Diarize and send out meeting requests with Stakeholders Assign a responsible person to track the dates with a copy of the requirement, NOA, etc. 29 Practice management tips Rectification Know how it works It is a mechanism to correct errors which may have occurred. Where the intention of the parties was one thing and the results are another Must demonstrate the intent of the parties Good practice to have the recitals to agreements and resolutions state the intention of the transaction. The parties contemplate that the transaction will not result in any income taxes 30
16 Practice management tips Memo to file Develop a template or checklist of punitive sections of the Act and assess your plan against the sections and conclude it does not apply. Such review should cover as a minimum the Sections and Subsections 15(1), 15(2), 40(3.6), 55(2), 69, 74.1, 74.2, 74.3, 74.4, 75(2), 80, 84.1, 85(2.1), 110.6, part V1.1 tax etc. Pay particular attention to Non-Arms Length transfers and transactions, particularly cross border, sections 115, 116 and Reg 105. When using preferred shares with a built in purchase price adjustment consider part V1.1 tax 31 Practice management tips Memo to file continued On aggressive plans ensure client has sign off. Eyes wide open and document it. Ensure that your letters and memos contain caveat language Always ensure that you have documented whether the clients are non-residents or U.S Citizens or Green Card holders; have a memo or get negative assurance in the letters to that effect. 32
17 Practice management tips Other items Be aware of being too busy and too rushed. That is when errors happen Remember the turn the page rule and the possibility of the next page saying Notwithstanding Trying to avoid the G.A.A.R? Do not include or advise that the purpose of the transaction is for creditor proofing. The results is that the creditor proofing defense may disappear. (Botham Holdings Ltd.) Think you have a problem? Don t procrastinate. Unlike wine, bad news does not get better with age. Get a second opinion. Let someone else deal with it. Good Luck! 33
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