ANTE-MORTEM AND POST-MORTEM ESTATE PLANNING

Transcription

1 ANTE-MORTEM AND POST-MORTEM ESTATE PLANNING Marc Graham BDO Canada LLP Barrie Lucinda Main Beard Winter LLP Toronto 2015 Ontario Tax Conference

2 M. Graham and L. Main 1 Introduction 1 It is not uncommon to come across an investment company when reviewing a client s estate plan. Investment companies are often, though certainly not always, the consequence of one of the following: the accumulation of retained earnings over the life of a business, the proceeds of the sale of a business, the attempt to avoid the payment of US estate tax on US security holdings or as a means for owning other assets such as Canadian securities to eliminate the application of estate administration tax (more commonly in Ontario referred to as probate fees) on the fair market value of the securities at the time of an individual s death. While there are many benefits to utilizing such corporations from the perspective of Canadian income tax, US estate tax and/or Ontario probate fee planning, there is the potential for double income taxation when an individual dies owning capital stock in such corporations. The first layer of tax occurs at the time of the shareholder s death. Upon the death of the shareholder, he or she is deemed pursuant to subsection 70(5) of the Income Tax Act, RSC 1985, c 1 (5th Supp) ( Act ) to dispose of capital property (i.e. the shares of the investment company) at the fair market value ( FMV ) subject to certain exceptions. 2 Income tax is payable on the resulting capital gain. This capital gain is reported in his or her terminal income tax return. The estate receives the shares from the deceased at an adjusted cost base ( ACB ) equal to FMV immediately prior to the deceased s death (being the deemed proceeds on death). Because these sorts of corporations are not often ongoing operating companies, they are typically wound up following the shareholder s death and the assets are distributed to the estate s beneficiaries or the corporate assets are liquidated and the cash distributed to the estate s beneficiaries. In the absence of any planning, the second layer of tax occurs upon such liquidation/distribution in two possible ways. First, the receipt of such distributions from the corporation will usually trigger taxable dividends. 3 Secondly, if the corporation sells or distributes assets with unrealized capital gains, the corporation itself will incur capital gains taxation on the sale or distribution of the assets. This paper will review the methods commonly employed to eliminate or reduce this double tax after the death of the taxpayer. The paper will also review recent changes to the taxation of trusts and estates which will invariably have an effect on the use of some of these methods. The paper will conclude by providing a few ante-mortem planning ideas when advising clients who hold an interest in an investment company with unrealized accrued gains in the underlying assets. 1 The authors would like to thank Tim Taylor, Joel Russell and Jamie MacMillan at BDO Canada LLP and Gloria Shu, articling student, at Beard Winter LLP for their research and guidance. 2 Subsections 70(6) and 70(9) of the Income Tax Act, RSC 1985, c 1 (5th Supp). 3 A dividend is created pursuant to subsection 84(3) of the Act when the proceeds paid on such purchase are greater than the paid up capital of the shares.

3 M. Graham and L. Main 2 The Loss Carry Back The use of the loss carry back rule found in subsection 164(6) of the Act is one way to mitigate the exposure to double taxation. The rule permits the estate trustee, in the first taxation year of the estate, to elect 4 to deem the capital loss realized by the estate on the disposition of the shares (as a result of the deemed dividend received by the estate on the liquidation and wind up of the corporation) to be a capital loss of the deceased on the deceased s terminal tax return. 5 The result of loss carry back is that the capital gain is eliminated on the terminal tax return and the estate is liable for income tax on the deemed dividend that resulted on the windup and, thus, the estate is only subject to one layer of tax. One must be mindful of the stop-loss rules found in subsection 112(3.2) of the Act which can deny the loss carry back under subsection 164(6). Where the full value of the shares can be redeemed using the capital dividend account ( CDA ) all of the tax can be avoided on death. Accordingly, the provisions of subsection 112(3.2) limit the capital loss available for carry back where the CDA has been used to redeem the shares and create the loss. In general, the capital loss available for carry back under subsection 164(6) is reduced to the extent that more than half of the loss is a result of the dividend being paid from the CDA. It is important to note that each dividend is treated as a separate dividend for the application of subsection 112(3.2) and, accordingly, the dividend must be created on all shares so that one half of the dividend is taxable and other half is a capital dividend. In order to achieve this, it is necessary to first to do a paid up capital ( PUC ) increase on all of the shares for the first half of the intended dividend. This will be a taxable dividend to the estate pursuant to subsection 84(1). Secondly, the required shares are redeemed, which triggers the other half of the deemed dividend and the corporation would elect to pay that deemed dividend as a capital dividend. Furthermore, the stop loss rules within subsections 40(3.4) and 40(3.6) need to be considered. However, subsection 40(3.61) exempts the portion of the estate capital loss that is being carried back under subsection 164(6) from the application of subsections 40(3.4) and 40(3.6) for dispositions occurring after March 22, Accordingly, subsections 40(3.4) and 40(3.6) should not be a concern when the subsection 164(6) loss carry back approach is being implemented. Recent Tax Changes: The Graduated Rate Estate While the loss carry back is a relatively straightforward concept and mechanism to implement, as a result of recent changes to the taxation of trusts and estates, its use may not be available or could result in other, often unintended, adverse tax consequences. 4 This requires a valid and timely filed election in prescribed form pursuant to Regulation Subject to the stop loss rules found in subsection 112(3.2).

4 M. Graham and L. Main 3 The Canadian federal government introduced draft legislative changes to the taxation of testamentary trusts and estates on August 29, The new legislation includes the definition of a Graduated Rate Estate : 7 1. In its first taxation year the estate must designate itself as a Graduates Rate Estate in its income tax return. 2. There can only be one such designation for a deceased taxpayer. 3. The estate has not celebrated its 36 th month anniversary. 4. The estate must be a testamentary trust. 5. The deceased s Social Insurance Number must be included on the estate s tax return. Many tax related benefits currently granted to testamentary trusts and estates will continue only for so long as an estate qualifies as a Graduated Rate Estate. 8 If and when the estate no longer qualifies as a Graduated Rate Estate, the taxation rules applicable to inter vivos trusts 9 will apply to the estate. Only a Graduated Rate Estate can utilize the loss carry back rule found in subsection 164(6) of the Act. As such, the loss of the Graduated Rate Estate status could mean that double taxation for an estate holding shares in a private corporation with an accrued capital gain cannot be as easily avoided. Exacerbating the problem is the fact that in Ontario we often use multiple Wills as a probate fee saving strategy. On death, the deceased s Will may have to be admitted to court for a grant of probate (properly referred to as a Certificate of Appointment of Estate Trustee With a Will). The court confirms the validity of the Will and the authority of the person(s) named as the estate trustee(s) (also known as the executor). If the deceased died without a valid Will, an application for a grant of probate may still be necessary (properly referred to as a Certificate of Appointment of Estate Trustee Without a Will). Third parties rely on the grant of probate to transfer assets on the instructions of the appointed estate trustee(s). 6 For further background see L. Main, Proposed Changes to the Taxation of Testamentary Trusts, The Six-Minute Estates Lawyer 2014, Law Society of Upper Canada, April 29, 2014; L. Main, Recent Changes to the Taxation of Life Interest Trusts, The Six-Minute Estates Lawyer 2015, Law Society of Upper Canada, May 6, 2015; B. Cohen, Death of a Taxpayer: Will & Estate Planning in Light of the 2014 Budget Changes, Canadian Tax Foundation 2014 Ontario Tax Conference, October 2014; and C. Brown and W. Fowlis, Trust Update 2015, 2015 Canadian Tax Foundation 2015 Prairie Provinces Tax Conference. Portions of this paper first appeared and were presented by Lucy Main at the following two conferences: Proposed Changes to the Taxation of Testamentary Trusts, The Six-Minute Estates Lawyer 2014, Law Society of Upper Canada, April 29, 2014 and Recent Changes to the Taxation of Life Interest Trusts, The Six-Minute Estates Lawyer 2015, Law Society of Upper Canada, May 6, Supra note 2 at ss 248(1). 8 Benefits include graduated rate of taxation for income earned and kept in the estate, no requirement to pay tax in instalments and an off-calendar year end. 9 An inter vivos trust s income tax rates are the top graduated tax rates applicable to individuals. Its tax year end is December 31.

5 M. Graham and L. Main 4 Upon submission of an application for a grant of probate, provincial governments generally charge a fee. Ontario has one of the highest probate fees payable (properly referred to as estate administration tax). 10 A particularly valuable means of reducing probate fees payable is with the employment of multiple Wills. 11 Any assets that would likely require probate to be transferred or otherwise dealt with on death 12 would be dealt with in one Will, often referred to as the Primary Will or Public Will. Probate fees will be payable on the fair market value of the assets governed by this Will. The Secondary Will or Private Will is intended to deal with those assets which, either legally or practically, do not currently require probate to be transferred. 13 If there is uncertainty with respect to whether or not a certain asset requires probate to be transferred instead of having the Secondary Will govern the disposition of the asset, it may be worthwhile to create a Tertiary Will to deal with the asset. As a consequence, if the asset does require probate to be transferred it will not taint the Secondary Will. 14 Multiple Wills are sometimes also used when there are assets in different provinces or countries. The Wills may individually deal with only the assets located in their respective jurisdiction. Another source of a potential second estate is when there is a secret Will that is either not revealed or discovered until the testator s death. There are a multitude of reasons why one may execute such a secret Will, including providing for a secret child born out of wedlock or a mistress. The same issues regarding the taxation of such estates arises as those for multiple Wills established for the less exciting reasons of probate fee planning or dealing with assets in different jurisdictions. While always a concern, these changes have forced practitioners to decide if there two estates for income tax purposes and only one can qualify as a Graduated Rate Estate when the multiple Wills strategy is employed. Many lawyers and tax practitioners have always treated multiple Wills as creating only one estate for income tax purposes and have filed a single tax return, particularly if the estate trustees and beneficiaries were the same. 15 However, not all tax practitioners have shared this view and some have been filing on the basis of two distinct estates being created on death. The potential of having two estates raises a particular concern for estates with private company shares (which is arguably the most common reason for setting up multiple Wills). If the Secondary Estate (the one holding the private company shares) is not the Graduated Rate Estate, some post 10 Currently, in Ontario probate fees are payable at approximately 1.5% of the fair market value of the assets on death: $5 is charged per $1,000 for the first $50,000 in assets and $15 is charged per $1,000 after the first $50,000 in assets. Recently, a private member s bill introduced by conservative Monte McNaughton suggested a maximum probate fee of $3,250. The bill was defeated on September 24, 1015 on its second reading (41 members voted against the bill and 9 voted for the bill). 11 Granovsky Estate v. Ontario, 1998 CanLII (ON SC). 12 For example, public company shares and, generally, real property, bank accounts and unregistered investments. 13 For example, shares of privately held Canadian companies, personal effects and, in limited cases, real property. 14 The Secondary Will can be tainted if any assets that are governed by the terms of the Secondary Will require probate to be transferred. In this case, the Secondary Will will have to be submitted for probate and, as a result, all assets governed by the Secondary Will will then be exposed to probate fees. 15 D. Watt, Ottawa Overhauls Trust Rules, January 23, Though note that in B. Donovan, New Tax Changes to Canadian Trust Rules Mean it s Time to Revisit your Estate Planning, March 6, 2015 it is stated that many practitioners treated them as separate estates. Subsection 104(2) of the Act will in certain circumstances treat two trusts as one for the purposes of the calculation of income. See CRA doc E5.

6 M. Graham and L. Main 5 mortem planning techniques to reduce the effect of double taxation will not be available and the pipeline strategy may be the only option worth considering. 16 While the new legislation suggests that there can be multiple estates, arising from multiple Wills, the Department of Finance s Explanatory Notes released on August 29, 2014 confirm that there will only be one estate for tax purposes. Moreover, the Canada Revenue Agency ( CRA ) at the 17 th annual Society of Trust and Estate Practitioners ( STEP ) national conference stated that even when there are multiple Wills, there is only one estate formed for tax purposes. 17 Recent Tax Changes: Life Interest Trusts The federal government also recently introduced new measures affecting how testamentary spousal trusts and alter ego trusts and joint spousal trusts ( life interest trusts ) will be taxed on the death of the life tenant. Effective January 1, 2016 there will be a deemed disposition of the assets held by a life interest trust at the end of the day on the date of death of the last surviving life tenant (being the settlor in the case of an alter ego trust, the spouse in the case of a testamentary spousal trust, and the last spouse to die in the case of a joint spousal trust). 18 A new tax year will start the following day. The explanatory notes accompanying the draft legislation provide as follows: Paragraph 104(13.4)(a) deems the trust s income for the particular year to have become payable to the particular beneficiary in the particular year, with the result that all of the trust s income for the particular year is required by subsection 104(13) to be included in computing the particular beneficiary s income for the beneficiary s taxation year (i.e., the beneficiary s final taxation year) in which the particular year ends. The trust s income for the particular year is also deemed not to have become payable to any other beneficiary, or to be included under subsection 105(2) in computing the particular beneficiary s income, with the result that those other beneficiaries will not be required to include any part of the trust s income in computing their incomes, and no amounts may be designated by the trust for the particular year under subsections 104(13.1), (13.2) and (19) to (22) in respect of any beneficiary other than the particular beneficiary. 19 The consequence of this deemed disposition is a recognition of any income including capital gains in the terminal tax return of the life tenant. The life tenant will have to include any such income in his or her terminal tax return and pay any applicable tax thereon. This includes income tax created in the stub year (i.e. the taxation year that was shortened due to the death of the life tenant) and the income tax triggered as a result of the deemed disposition of the trust s assets as a consequence of the death of the life tenant. The benefit of having the deceased life tenant recognize the income tax in his or her terminal tax return is that it will be taxed at his or her then marginal tax rates. 20 However, it can result in 16 A. Minicucci, Trusts and Post-Mortem Planning A 2014 Update, Canadian Tax Foundation 2014 Ontario Tax Conference at pg P. Cross and A. Ross, The Good, the Bad and the Ugly QDTs, GREs ad Life Interest Trusts 18 th Annual Estates and Trusts Summit Day Two, Law Society of Upper Canada, October 8, 2015, pg Supra note 2 at ss 104(13.4). 19 See pg Graduated marginal tax rates would have applied to the income generated as a consequence of the deemed disposition on the death of the spouse in the case of a spousal testamentary trust. However, all capital gains created as a result of the death of the life tenant or last life tenant to die in the case of alter ego and joint spousal trusts were always payable at the highest marginal tax rate.

7 M. Graham and L. Main 6 unintended and serious tax consequences best illustrated with a simple and commonly seen example: Carrie was married to Ryan. Together they had four children. Carrie and Ryan later divorced. Thereafter she lived a comfortable but modest lifestyle. Carrie then met Brad, a very wealthy entrepreneur, and soon thereafter they married. Brad has two children from a previous relationship. They each included spousal trusts in their Wills on the understanding that the surviving spouse would have use of the income and capital of the trust but, ultimately, when the second spouse died, their monies (i.e. the trust fund) would be distributed equally amongst their own children and not shared with their spouse s children. Brad died first. The spousal trust for Carrie s benefit was set up pursuant to the terms of his Will. When Carrie died 10 years later, there was a significant amount of monies held in the spousal trust. Brad s Will provided that the balance of the trust funds be divided equally between his two children and paid to them outright. They are both alive at the time of Carrie s death. Carrie s terminal tax return will have to include all of the income triggered in the spousal trust as a result of her death. Brad s two children will receive the trust assets without bearing any of this tax liability. Carrie s estate will bear the tax created by this deemed year end to the extent that it has sufficient assets to do so. Carrie s four children, therefore, will take the tax hit and their inheritance will be depleted and, possibly, eliminated as a direct consequence. This example demonstrates the potential inequalities created by the use of a basic testamentary spousal trust in the context of a blended family. When the ultimate beneficiaries of the life interest trust are the same as the beneficiaries of the estate of the life tenant the practical effect of this legislative change is minimal. However, life interest trusts are frequently used when the beneficiaries are in fact different, 21 as in the case of a blended family. The tax liability created as a consequence of the death of the life tenant is shared by the life tenant s estate and the life interest trust. 22 However, if there are sufficient assets in the estate of the life tenant, CRA is not required to seek payment of the tax from the life interest trust: Must the CRA abide by the Minster of Finance s views and assess the trust first? The simple answer is no. The Minister of Finance s statements that the government intends to have the CRA pursue the trust before the beneficiary s estate is not binding on the CRA. 23 With specific regard to life interest trusts holding shares in private corporations with accrued capital gains there is a further concern. Upon the redemption of shares by the estate in a subsection 164(6) approach a capital loss will be generated in the life interest trust if the ACB exceeds the PUC of the shares of the corporation. Unfortunately, the estate beneficiaries cannot utilize this capital loss to offset the capital gain included in the life tenant s terminal tax return because a life interest trust is not a Graduated Rate Estate. However, there may be some hope: 21 Beneficiaries could be the same when the Wills are prepared but change after the death of the first spouse. 22 Supra note 2 at ss 160(1.4). 23 Supra note 6 (Brown) at pg 12.

8 M. Graham and L. Main 7 if a late designation under subsection 104(13.2) is permitted, the life interest trust can designate that income deemed payable to the life interest beneficiary (specifically the capital gain on the deemed disposition of the private company shares) be included in the income of the trust and not the life interest beneficiary. When the loss carry back is then applied, there should be no remaining income in the trust such that subsection 104(13.3) should not apply to deny the application of subsection 104(13.2). In the STEP Roundtable, the CRA confirmed that they will continue to accept late designations under subsection 104(13.2) to allow the carry back of a loss so long as it is not for the purposes of retroactive tax planning and it is not statute barred; and specifically provided that a late designation should be possible to achieve the above described planning. 24 It may be prudent to obtain CRA s approval to such planning before implementing same. The Pipeline Strategy For the 2015 tax year the top marginal tax rate on capital gains is substantially lower 25 than the top marginal tax rate on ineligible dividends in all of the provinces and territories. And, while not as significant, the capital gains tax rate is lower than the eligible dividend tax rate in all of the provinces and territories with the exception of the Yukon. Therefore, subject to other considerations, having the accrued gain to the time of death taxed once as a capital gain will produce the lowest overall tax cost to the estate. Furthermore, with the current potential limitations in using the subsection 164(6) loss carry back approach for certain estates after 2016, where possible the pipeline will likely be the preferred approach to extract corporate assets in an attempt to avoid the double tax burden that can occur on death. The post-mortem pipeline strategy involves having an estate sell the shares (which have an ACB equal to their FMV as a result of the deemed disposition on death as explained above) of an existing corporation to a newly formed estate owned private corporation ( Holdo ) for consideration which includes a note payable by Holdco to the estate (or shares of Holdco with PUC) in the amount of the taxed cost basis of the existing shares to the estate. As a result, assets of the corporation can be distributed to the estate (i.e. the shareholder) on the repayment of the note (or return of PUC), avoiding any additional tax to the shareholder. The repayment of the note or PUC is the pipeline to remove the corporate assets, as demonstrated by this basic example: 24 Supra note 17 at pg See

9 M. Graham and L. Main 8 1. As a result of the deemed disposition on death, the estate owns preferred shares in Corp. X with an ACB and FMV of $1 million. 2. The estate sells the shares of Corp. X to Holdco for a $1 million note payable. 3. Subsequent to the sale, Corp. X and Holdco amalgamate. 4. Amalgco repays the $1 million note to the estate with corporate assets. The pipeline was a fairly routine and generally accepted post-mortem tax planning strategy used by practitioners to avoid the potential double tax problem on death until CRA made comments on the strategy at the STEP 2011 Conference. 26 The CRA indicated that subsection 84(2) could apply (and thereby re-characterizing the funds received on the repayment of the promissory note as a taxable dividend) to the pipeline strategy if both of the following conditions were present: 1. the funds or property of Corp. X were distributed in short time frame following death of deceased; and 2. Corp. X had no business assets, holding mostly cash. Since 2011 much has been written by practitioners 27 to analyze and opine on CRA s and the courts 28 interpretations of the application of subsection 84(2), section 84.1 and the General Anti- Avoidance Rule ( GAAR ) with respect to post-mortem tax planning and the potential re- 26 CRA doc C6. 27 Smith, Nick Pipeline and Bump Planning, 2014 British Columbia Tax Conference, (Toronto: Canadian Tax Foundation, 2014), 7A: 1-7; David Baxter, Brandon Wiener and Alexander Demner, Surplus Stripping -What's Acceptable, What's Not, and What Should Be?, 2014 British Columbia Tax Conference, (Toronto: Canadian Tax Foundation, 2014), 12: 1-44; Minicucci, Armando Trusts and Post Mortem Tax Planning - A 2014 Update, 2014 Ontario Tax Conference, (Toronto: Canadian Tax Foundation, 2014), 5B: 1-33). 28 Her Majesty the Queen (Appellant) v. Dr. Robert G. MacDonald (Respondent), 2013 DTC 5091, 2013 FCA 110; Lucie Descarries, René Leroux, Suzanne Gauthier, Nicole Beauregard, Jean Leroux, and Denise L. Bissonnette (Appellants) v. Her Majesty the Queen (Respondent), 2014 DTC 1143, 2014 TCC 75 (informal procedure).

10 M. Graham and L. Main 9 characterization of the funds as a taxable dividend. Accordingly, other than to summarize below, this paper will not deal with this issue in great detail and we refer the reader to those publications. Suffice it to say, CRA s and the courts current position remains a significant consideration for each practitioner when implementing the pipeline strategy. In summary, CRA has issued a number of advance income tax rulings 29 since the 2011 STEP conference on pipeline transactions confirming that subsection 84(2), section 84.1 and the GAAR will not apply in circumstances where the following conditions are met: 1. The original corporation's business will continue for at least one year following the implementation of the pipeline structure. 2. The original corporation will not be amalgamated or wound-up into the pipeline corporation for at least one year. 3. The original corporation's assets will not be distributed to the shareholders for at least one year, followed by a progressive distribution of the corporation's assets over an additional period of time. Most recently, there have been two favourable rulings given by CRA 30 where CRA ruled that the post-mortem planning pipeline would be successful and that subsection 84(2), section 84.1(1) and the GAAR would not apply. In both rulings, the shares owned by the estate (the deceased taxpayer) were shares of companies carrying on an investment type business. The facts and objectives outlined in these rulings were consistent with the conditions set out above which was to gradually return property of the company to the estate s beneficiaries equal to the cost basis of the shares as a result of the deemed disposition under subsection 70(5). While it appears that CRA is allowing the extraction of surplus as a capital gain through acceptable pipeline planning, and while there are good arguments why CRA s policy is too restrictive, it is best to follow CRA s current position where possible. Furthermore, it is prudent, particularly for large amounts of money, to obtain an advanced tax ruling from CRA to ensure the transaction will not be offensive to CRA. Because the alternate to the pipeline would be the use of a timely filed subsection 164(6) loss carry back in the first year of the estate, this matter would require early attention. Loss Carry Back vs. Pipeline Given that capital gains are taxed at a lower rate than dividends, 31 and with the objective of tax minimization, the preferred method to extract corporate assets in a post-mortem plan would appear to be the utilization of the pipeline as described above. However, certain attributes can have an impact on the post-mortem plan which can further reduce the overall tax implications and need to 29 See CRA docs R3, R3, R3, R3, R3, R3, R3 and R3. 30 CRA docs R3 and R3 (both in French). 31 See

11 M. Graham and L. Main 10 be carefully explored before the decision is made to proceed with the pipeline approach. In most cases the combination of both the loss carry back and a pipeline the hybrid approach yields the most tax efficient result. Below we have summarized the various attributes to consider and the applicable approach that should be implemented. Factors in support of the subsection 164(6) approach 1. If the company has a balance in its refundable dividend tax on hand ( RDTOH ) account at the time of death, sufficient shares should be redeemed equal to three times that of the RDTOH balance. 2. If the company has a capital dividend account ( CDA ) balance, the appropriate value of shares should be redeemed, subject the stop loss rules. Note: if the stop loss rules do not apply (i.e. due to a grandfathered insurance policy 32 ), then the maximum value of shares should be redeemed. 3. If the company has unrealized capital gains and recaptured depreciation on investment properties, consideration should be given to realizing them in order to trigger the RDTOH and CDA balances for the purpose of effecting the subsection 164(6) loss carry back. 4. If the company has general rate income pool ( GRIP ) and the tax rate on eligible dividends is less than the capital gains tax rate (as noted above, for 2015, this is only the case in the Yukon) then redeem additional shares. Note: When undertaking a subsection 164(6) approach in #1 and #3 above, redemption should to the extent that the corporation has a GRIP balance, the redemption should be designated as an eligible dividend first and an ineligible dividend second If the shares of the deceased have significant V-day value 34 or the capital gains exemption has been previously claimed on the shares (i.e. soft ACB for the purposes of section 84.1), consideration should be given to redeeming such value. The pipeline approach does not work where the shares in question have a cost base that is related to the capital gains exemption or 1972 V-day protection claims made by the deceased or a related party. In such a situation, the use of the pipeline method will either produce an immediate deemed dividend (where debt is taken back) or a PUC reduction (where shares are taken back) 32 In general, the stop loss rules under subsection 112(3.2) of the Act can be avoided where the disposition of shares occurs after April 26, 1995 and where life insurance was in place prior to that date and was established for the purpose of funding the redemption. Where grandfathering is available, the full amount of the CDA can be used to redeem shares and full capital loss can be applied under subsection 164(6) without restriction. 33 Per subsection 89(14) a portion of the total dividend can to be designated as eligible dividends if paid after March 28, Capital gains legislation has been in effect since January 1, 1972, and capital gains and losses which accrued before the end of 1971 are in general meant to be excluded from the tax system. To ensure any accrued gains or losses on property owned at December 31, 1971 are not taxed, it is necessary to value capital property on a Valuation Day immediately before the end of Transitional provisions found in sections 24 and 26 of the Income Tax Application Rules exist to determine this V-day value and compute the cost for capital gains purposes.

12 M. Graham and L. Main 11 under section Accordingly, where the objective is to ultimately remove the assets from the corporation, the subsection 164(6) loss carry back approach should be used to redeem the appropriate value of shares If the specific fact scenario does not fit within CRA s current policy of acceptable pipeline planning, such that there are subsection 84(2) concerns, then the loss carry back method should be utilized. Factors in support of the pipeline approach 1. The deceased s shares do not have significant V-day value or capital gains exemption in ACB (i.e. section 84.1 does not apply). 2. The company has non-depreciable capital properties with significant unrealized gains (consider using the bump and pipeline approach) The remaining share value, after the subsection 164(6) approach, should be sold to a holding company for a promissory note (in accordance with CRA s acceptable pipeline policy and subject to the rules in section 84.1) to preserve the capital gains tax rate. The overall tax implications are best appreciated through a comparison of the tax liabilities that result through an example which considers the various attributes noted above: Jake (a resident of Ontario) owns 100 preferred shares of Investco at time of his death. Jake s children own the common shares. The preferred shares exercise voting control of the corporation: - FMV: $1,000,000 - ACB: nil - PUC: nil The shares do not qualify for the capital gains exemption. The corporation has a CDA balance of $100,000. The corporation has an RDTOH balance of $50,000. The corporation has a GRIP balance of $200,000. Assume following personal tax rates: - Capital gains: 24.77% - Eligible dividends: 33.82% - Ineligible dividends: 40.13% 35 Administratively, CRA allows a taxpayer to designate the particular shares on which the capital gains exemption was claimed (CRA doc ). 36 An analysis of the bump rules is beyond the scope of this paper; however, the general purpose of bump is to push the high ACB resulting from deemed disposition of shares on death through to underlying non-depreciable capital assets (e.g. land) in the corporation and thus bumping the ACB of those assets so that they can be distributed to the beneficiaries with little to no additional tax. This is accomplished through a wind-up or amalgamation and done in conjunction with the pipeline restructuring.

13 M. Graham and L. Main 12

14 M. Graham and L. Main 13 Alternative 3 Hybrid Approach Redeem sufficient shares to use CDA ($100,000) Redeem sufficient shares to use RDTOH Pipeline balance of shares TERMINAL RETURN Capital gain on deemed disposition $ 1,000,000 Capital loss (164(6)) on redemption of $250,000 of shares) (250,000) Net capital gain 750,000 Tax rate 24.77% Tax owing on terminal T1 ESTATE RETURN Deemed dividend on redemption of shares 300,000 Designated as a capital dividend (100,000) Designated as eligible dividend (equal to 3x RDTOH) ( 150,000) Amount of ineligible dividends $ - Tax on eligible dividends $150,000 X 33.82% Dividend refund (received by X Co.) Total tax owing Note: Steps would be required to avoid the 50% reduction in the capital loss under 112(3.2) were rates used. Summary of Alternatives: Ante-Mortem Planning While it is not possible to plan for every eventuality, when it is expected that an estate will face double tax on the death of a shareholder, there are ways in which we can better plan to provide for a more efficient and cost effective estate administration:

15 M. Graham and L. Main 14 Understand the income tax implications triggered on death. It may be a worthwhile exercise to walk through the possible income tax issues at the Will drafting stage. Current values could be used to demonstrate to the client the possible tax outcomes. In this regard, the ante-mortem planning can be completed knowing the likely tax outcomes on death. Ensure it is clear that there will be only one Graduated Rate Estate when multiple Wills are employed. As discussed above, while many practitioners may agree that even when there are multiple Wills there is only one estate for income tax purposes, it may be worthwhile making the testator s intention that only one estate will be created very evident in the Wills. 37 A concern exists when there are different estate trustees for the Wills. This could be the result of different skill sets being needed to deal with assets in separate Wills or, in the case of multijurisdictional Wills, it could be a legal requirement to have local resident act as the estate trustee for a Will dealing with assets in a foreign jurisdiction. Again, it may be useful if different estate trustees have to be used to indicate clearly in all of the Wills that it is the testator s wish that the estate trustees work together to deal with any income tax issues on death and confirm that a single Canadian tax return is to be filed for the entire estate. Provide time. Estate trustees can be in a difficult situation when there is pressure from beneficiaries to wind up the estate and no clear direction in the Will to allow the estate trustees to take advantage of the estate s status as a Graduated Rate Estate. The estate trustees may also need time to carry out the appropriate post-mortem tax plan. A clause could be included in the Wills specifically providing the estate trustees with up to 36 months to distribute the estate assets. It would not, however, be wise to prohibit any distributions during this time. Flexibility is the key. 38 When the testator wants to include a spousal trust in the Will. If the testator wants to include such a trust in his or her Will for non-tax reasons the payment of tax on the death of the second spouse has to be thought out. This item is very tricky and as Clare Sullivan recently proclaimed at a Law Society of Upper Canada presentation: The problems this [the new changes to the taxation of life interest trusts] creates are numerous and drafting to solve them may well be impossible. 39 When suggesting solutions, she then goes on to state that: No fix appears to be bullet proof. That is why the Canada Revenue Agency MUST fix the problem. 40 (her emphasis) The following are some of the solutions currently being bandied about (in no particular order): Gift to the estate: One proposed solution is to include a requirement in the life interest trust for the trustees to reimburse the estate of the deceased life tenant for all income taxes paid as a consequence of the deemed year end and resulting income inclusion of tax liability in the life tenant s terminal tax return. While this would certainly be the easiest solution for all future life interest trusts to be drafted, it is not a solution without its own problem. A 37 See Sullivan, Clare, The New Tax Rules Multiple Wills and the Impact on Drafting, Law Society of Upper Canada, 18 th Annual Estates and Trusts Summit Day Two, October 8, 2015 for suggested draft wording. 38 See ibid for sample wording. 39 Ibid, pg Ibid.

16 M. Graham and L. Main 15 gift to the deceased life tenant s estate would result in his or her estate losing its designation as a Graduated Rate Estate as it would taint the testamentary nature of the estate. 41 This would prevent the estate from being able to use the loss carry back strategy if there was the potential application of double tax. Gift to the beneficiaries: A similar solution involves a gift equivalent of the tax made payable (or, better yet, the tax actually paid) as a consequence of the death of the life tenant to the beneficiaries of his or her estate. 42 In this regard, the concerns raised above regarding the tainting of the Graduated Rate Estate because of a gift to the estate to pay the income tax are avoided. The Will or trust could be drafted in such a way so as to provide a method of calculating the gift. A maximum amount could be set if there were concerns about there being sufficient assets to pay the tax and to benefit the beneficiaries of the life interest trust. The drafting of such a clause will be difficult as the life tenant could later amend their Will. In addition, their Will may provide for a series of cash legacies (i.e. not only residuary beneficiaries) and, as such, the clause would need to specify which class of beneficiaries would benefit from such gift and in what proportions. The tax elimination clause some estate planners include in Wills to reduce or eliminate the income tax payable as a consequence of the deemed disposition on death by making a gift to a registered charity, with necessary modifications, could be used as a starting place for the drafting of such a clause. 43 Creation of a debt obligation: The testator who is including a spousal trust in his or her Will could at the same time execute a debt instrument (like a promissory note) payable to the estate of his spouse. In the event the testator is the first to die, the spousal trust is created and on the death of the second spouse, the debt obligation would kick in to pay the tax owing to the second spouse s estate for the tax triggered. Again, this would require careful drafting to ensure it correctly calculated the payment based on the tax payable. This strategy is like the first strategy but does not have the risk of tainting the second spouse s Graduated Rate Estate. Marriage contracts: The spouses could enter into a marriage contract at the time they execute their Wills which would set out the terms of the payment of the tax payable on the death of the second spouse. Mutual Wills: Mutual Wills do not permit, without the spouse s consent, a change to a Will. In this regard, the spouses know that the tax situation will be dealt with and later circumstances (i.e. another marriage) will not lead to a change in the second to die spouse s 41 See supra note 6 (Brown) at pg 19 for more on this issue and a different view on tainting. 42 M. Getzler, A. Spinner & K. Slezak, Tax Update, Ontario Bar Association, March 24, See, for example: Society.

17 M. Graham and L. Main 16 Will. However, mutual Wills are fraught with issues and not very common. While the benefit is that they cannot be easily changed and cannot be changed without both spouses consenting, this can be the greatest fault of mutual Wills. Consider the situation where one spouse no longer has capacity but the Wills need to be updated to provide for a newly born grandchild or the tax laws change again and the previous planning is no longer desirable or efficient. Power of appointment: A power of appointment could be included in the spousal trust to provide the surviving spouse with the power to appoint in his or her Will some of the life interest trust s capital to fund the tax liability on his or her eventual death. While the problem of tainting the Graduated Rate Estate is avoided with this solution: this fix does not deal with the issue of whether or not the estate of the life beneficiary actually uses the funds to pay the tax so as to relieve the spousal trust from any joint and several liability. 44 Joint last to die insurance: Instead of trying to draft around the problem, a joint last to die insurance policy may be a viable solution. The insurance could cover the anticipated tax payable on the death of the life tenant. Planning when the spousal trust already exists. With no grandfather rules introduced, what is there to be done about existing structures? The following was noted in STEP s webcast on this topic on November 14, 2014: The terms of virtually every life interest trust do not provide for the distribution of property to the life interest beneficiary s estate (i.e., the life interest beneficiary s interest in the trust ceases on death), nor do they provide for the payment of the life interest beneficiary s taxes upon death, such that the trust may not be permitted to fund the taxes owing (unless 160(1.4) is enforced by the CRA). 45 Consequently, trustees may want to seek an amendment or variation to the terms of the life interest trust to deal with the payment of the tax on the death of the life tenant. In addition, the trustees may want to determine if they can and it is appropriate to encroach on the trust s capital and wind up the trust. However, this is not always possible depending on the terms of the trust deed or Will and the capacity of the person with such power to make such changes. Moreover, if a court application is required, the costs may not be insignificant. These concerns were articulated in STEP s letter to the Minister of Finance: our concerns are magnified by the fact that many individuals will have trusts currently in existence which will be adversely impacted by these changes in These existing arrangements may not be able to be amended (by virtue of the fact that the settlor is deceased or incapable), and even if an amendment is legally possible, a court order may be required. In short, we are concerned that the 44 Supra note 37 at pg Beware: A New Era in Estate Planning, Qualified Disability Trusts, Graduated Rate Estates, Life Interest Trust Taxation, STEP Canada, Webcast November 14, 2014 at slide 28.

18 M. Graham and L. Main 17 hasty introduction of these previously unannounced changes will have serious unintended repercussions. 46 Practically speaking, perhaps the only effective way to mitigate against the potential negative tax consequences for the life tenant s estate is to attempt to negotiate with the beneficiaries of the life interest trust to determine who and how the tax liability will be satisfied on the death of the life tenant. Failing which, another option may be to simply ensure that the life tenant s estate has insufficient assets to pay any the anticipated tax liability. This would essentially force the life interest trust to bear the tax and the trustees would have no practical recourse against the deceased life tenant s estate. This is easier said than done as the options to do so may not be available to the life tenant or may be undesirable. Give them the power. The Will drafter should consider including the following powers in the Wills which deal with private corporation shares: Power to enter into reorganizations. Power to incorporate new companies. Power to act as a corporate director. Power to make tax elections and designations. Power to borrow money. Power to value estate assets. Power to retain professional advisors. Power to carry on business. It is always helpful to provide the explicit powers in the Wills the estate trustees may need. In this regard, the power is clearly provided and reference to legislation and common law is not needed and direction from the court is also not required. Powers of Attorney for Property are often tacked on to an estate plan and not much thought is given to them. However, the attorneys also need powers to do their job. It may be worthwhile including in a Power of Attorney for Property the explicit power to allow the attorney to rearrange the grantor s financial affairs for income tax and probate fee planning purposes. For example, if the attorney is permitted to transfer assets into an alter ego trust, we could effectively deal with the situation of a pending mismatch of tax when the grantor is also the beneficiary of a life interest trust. 46 STEP Canada, September 25, 2014 submission: Legislation Proposals Relating to the Income Tax Act Released August 29, 2014, pg 2.

19 M. Graham and L. Main 18 Conclusions Whenever an estate plan involves an individual holding shares in a private corporation, which in turn has RDTOH, a CDA balance or owns assets with an accrued unrealized gain, the various postmortem tax planning techniques need to be considered. The loss carry back planning uses a loss which is triggered before the first anniversary of the deceased s date of death to offset the capital gain created by the deemed disposition of the shares on the individual s death. Conversely, the pipeline planning (and bump planning which was not discussed above) attempt to withdraw tax paid capital from the corporation without incurring additional tax by tinkering with the ACB of the assets. The new rules introduced respecting the taxation of trusts and estates directly affect the ability to use the loss carry back and hybrid strategies. Consequently, the pipeline and bump strategies will likely become the more common strategies to use in dealing with the double tax problem. While both methods are useful means to avoid the double tax on death, the hybrid plan, which combines both the loss carry back approach and pipeline approach, not surprisingly and as demonstrated above, typically yields the lowest overall tax to the estate. This is evident where the appropriate attributes can be identified and the right method is used.