In December, 2012 I successfully obtained a pipeline ruling from CRA. However prior to that I had written an article for the newsletter I edit titled "Privately Held Companies & Taxes", published on TaxnetPro, Carswell, a division of Thomson Reuters. I have reproduced the article with permission here and hope you find it as interesting as I did in writing it.
It is human nature to not contemplate the possibility of death even though it is a certainty rather than a possibility. Usually when a shareholder of Canadian Controlled Private Corporation (“CCPC”) contemplates estate planning such planning is often limited to an estate freeze and no consideration is given to post-mortem planning. Post-mortem planning is important because under the Income Tax Act (“ITA”) – a deceased shareholder of a CCPC and their beneficiary would otherwise be double taxed on his/her holding in such CCPC.
Double taxation at death
Upon death, shareholders are deemed to have disposed of all of their assets immediately before death at fair market value to the estate of the deceased shareholder. The tax on the capital gains triggered on the disposition is reflected on the terminal return of the deceased shareholder. As the estate is deemed to have acquired the deceased’s shares at fair market value (“FMV”) at time of death, the adjusted cost base (“ACB”) of such shares is bumped up to the FMV at time of death. If there is a purchaser for the shares then there would be no additional level of tax assuming that the acquisition would be at FMV equal to the FMV at time of death.
However, it may be difficult to find a purchaser for the shares of a CCPC thus requiring a distribution of the CCPC’s retained earnings to the beneficiaries of the deceased shareholder and subsequent wind-up of the CCPC. Winding up the corporation will trigger a second level of tax pursuant to subsection 84(2) of the ITA because a redemption of the shares will be deemed a taxable dividend. Subsection 84(2) comes into play because although the ACB of the deceased’s CCPC shares has increased, the paid up capital of such shares has not increased to reflect the fair market value at death. Nor would the ACB of the assets held by the corporation have increased. The sale of such assets and distribution of the proceeds will trigger a taxable dividend regardless of the recent capital gains paid on the shares on the terminal return of the deceased shareholder.
The following example best illustrates the double taxation that is levied on a deceased shareholder’s corporate assets:
1. Mr. A., a widower, dies owning all of the shares in Holdco, which is not a small business corporation. Holdco holds cash of $100,000. The fair market value of Holdco’s shares is $100,000 and Mr. A’s cost in the shares is $10.00. Mr. A leaves the company to his adult daughter S.
2. Under the deemed disposition rules of subsection 70(5) ITA, the estate is deemed to have acquired Mr. A’s shares at a tax cost of $100,000 triggering a capital gains on Mr. A’s terminal return of $99,900 . As a resident of Ontario, Mr. A.’s tax on the taxable capital gain of $49,995 at the top marginal rate on income under $500,000 of 46.41% would be $23,203 .
3. Assuming no further tax planning – S’s cost base in Holdco’s shares would be the FMV at which the estate acquired the shares A wind-up of Holdco would result in a taxable dividend pursuant to subsection 84(2) of the ITA to S.
Mr. A on his terminal return would have paid $23,203 on the $100,000 FMV of his shares which reflected the value of the assets held in the corporation at time of death. On the receipt of the distribution of $100,000 cash, the daughter of Mr. A. would have to pay $32,570 in tax at the top marginal rate on income under $500,000 resulting in the $100,000 value of the corporation being taxed twice.
The “pipe line” strategy is a strategy used to minimize exposure of the second level of tax pursuant to subsection 84(2).
The Pipe Line Strategy
The pipe line strategy avoids the triggering of a deemed dividend under subsection 84(2). It is a post-mortem strategy whereby only capital gains tax is payable at death under the deemed disposition rules of subsection 70(5) of the ITA. It allows for the extraction of assets equal to the gain realized on death on a tax-free basis. This is achieved by the estate transferring the inherited shares to a new holding company in exchange for a promissory note equal to the ACB of the shares transferred. In other words the pipe line strategy converts the ACB of the shares held by the estate into a loan allowing for the extraction on a tax-free basis the assets of the corporation equal to the ACB of the shares held by the estate.
The following example cited by the illustration of the 2009 APFF – Round Table on the taxation of financial strategies and instruments is as follows:
· Assume the taxpayer is holding all of the shares of a taxable Canadian corporation (hereafter called “ACO”), which is not a SBC, having a FMV of $100,000 and a cost of $100;
· ACO has cash totaling $100,000, no liabilities, $100 in capital stock and $99,900 in retained earnings;
· At his death, the taxpayer is deemed to have disposed of his shares for $100,000 and realizes a capital gain of $99,900;
· The estate of the taxpayer is deemed to have acquired the shares for an amount of $100,000, which corresponds to the cost and the fair market value of the shares for the estate;
· The estate incorporates a new taxable Canadian corporation (hereafter called “BCO”) and subscribes to 100 common shares therein for $100;
· The estate sells the shares of ACO to BCO for a price of $100,000 payable by the issuance of a non-interest bearing demand note. No tax arises from this.
· ACO is then wound-up into BCO and all of its property is transferred to BCO;
· Upon receipt of the property of ACO, including the cash totaling $100,000, BCO repays the note of $100,000 which is payable to the estate;
· BCO is then dissolved;
· Estate gives the amount of $100,000 which came from ACO to the heir(s).
However tax law is never predictable. Currently in order to obtain a favourable ruling not subjecting the distribution to subsection 84(2) or the GAAR provision of subsection 245(2), CRA has imposed a one year delay for the estate to wind the corporation up into the holding company. (See rulings 2002-0154223, 2005-0142111R3, Round table discussion at the 2009 APFF – CRA document no. 2009-0326961C6 and 2011 STEPs Roundtable, Q.5 2011 – 0401861C6).
This one year delay is not mandated in the ITA and has caused concern within the tax community. The one year wait would negatively affect cash companies as evidenced in at the 2011 Annual CTF Conference where CRA stated
“the context of a series of transactions designed to implement a post-mortem pipeline strategy, some of the additional facts and circumstances that in our view could lead to the application of subsection 84(2) and warrant dividend treatment could include the following:
•The funds or property of the original corporation would be distributed to the estate in a short time frame following the death of the testator.
•The nature of the underlying assets of the original corporation would be cash and the original corporation would have no activities or business ("cash corporation").”
Dr. Robert Macdonald v. The Queen, 2012 TCC 123
The validity of the one year waiting period was challenged in the recent case Dr. Robert Macdonald v. The Queen, 2012 TCC 123 (“Macdonald”). This case, although it did not deal with a deceased shareholder nonetheless employed the pipe line strategy to extract cash from a cash corporation. CRA challenged the transaction under subsection 84(2) (deemed dividend) and under the section 245(2) (GAAR) of the ITA.
The pipe line was engaged because the taxpayer Dr. MacDonald was moving to the United States and had ceased his Canadian residency on the 25th of June 2002. He had been unable to sell the shares of his medical professional corporation to a third party. The corporation held $525,068 in cash. Dr. MacDonald’s ACB in his professional medical corporation shares was only $101. The dilemma Dr. MacDonald faced was that the entire gain would be taxable in the United States due to his residency in the U.S. Although he had sufficient capital losses carried forward, (his capital losses accumulated while a resident in Canada), to offset the gain in Canada such losses could not be used to offset the gain now taxable in the US.
The doctor had a choice on whether to structure the extraction as a sale utilizing the pipe line strategy or through a windup meaning he would receive the cash as a dividend. The Tax Court of Canada (“TCC”) in considering the facts stated at paragraph 130:
The reality in this case is that aside from the Appellant’s use of losses, the tax on capital gains in New Brunswick in 2002 differed considerably compared to the tax on dividends. Indeed, in the case of a privately-held corporation, like PC, the lack of integration, at the time the subject transactions were undertaken, favoured capital gain treatment by some nine percent in New Brunswick relative to the tax on a dividend of the same amount.
The pipeline strategy was implemented by Dr. MacDonald’s advisors as follows:
1. J.S., Dr. MacDonald’s brother-in-law, incorporated a numbered company 601 Ltd on June 20, 2002.
2. On June 25, 2002, J.S. acquired Dr. MacDonald’s shares in his professional medical corporation (PC) by means of a promissory note to Dr. MacDonald.
3. 601 Ltd. acquired on the 25ht of June, 2002 the shares of PC from J.S. J.S. received as consideration shares in 601 Ltd. and a note payable by 601 Ltd. in the amount of $525,068.
4. PC declared two dividends on June 25, 2002, one in the amount of $500,000 and the other in the amount of $10,000. PC issued two cheques to 601 Ltd. as the PC shareholder at the time the dividend was declared in partial payment of the $500,000 dividend. 601 Ltd. in turn endorsed the cheques to J.S. as partial payment of the 601 note and J.S. in turn endorsed the cheques to Dr. MacDonald as partial payment of the J.S. note.
5. PC in conformity with the rules of the N.B. College of Physicians and Surgeons changed its name to a numbered company 509 N.B. Ltd as Dr. MacDonald was no longer a shareholder.
6. A final dividend was declared on September 1, 2002 equal to the amount still owing on the 601 Ltd. note and an amount equal to the unpaid portion of the dividend declared on June 25, 2002 was paid as an acknowledged indebtedness to J.S. booked by 509 NB on direction of J.S. as an indebtedness to Dr. MacDonald.
7. On July 15, 2002 509 NB paid by cheque 601 Ltd the amount of $10,000 which was deposited on the 27th of August, 2002.
509NB prepared Articles of dissolution on July 31, 2002 and was officially dissolved on February 4, 2005.
The TCC strongly rejected CRA’s argument for the court to look through the transfer to J.S. and deem Dr. Macdonald to be the ultimate beneficiary of the distribution pursuant to subsection 84(2) of the ITA on the basis that this section is not a re-characterization provision. The TCC at paragraph 61 and 62 held:
In any event, it is not the promise or foreseeability of a benefit while a shareholder that triggers the operation of subsection 84(2). The requirement of that provision is that there be a distribution or appropriation in any manner whatever for the benefit of a person who is a shareholder at the time of that distribution or appropriation. A structure undertaken while a shareholder that ensures, by a series of transactions, access to corporate funds to satisfy a debt created as a result of ceasing to be a shareholder, is not the same as being in receipt of such funds, or being in receipt of a benefit, qua shareholder. Accordingly, it remains my view that the words of subsection 84(2) do not impose a requirement to re-characterize payments to a creditor as payments to a shareholder.
The TCC rejected CRA’s imposed one year wait rule in paragraph 78 to 80 as follows:
The CRA has issued advance income tax rulings that such post-mortem pipeline transactions will not be subject to subsection 84(2) if the liquidating distribution does not take place within one year and the deceased’s company continues to carry on its pre-death activities during that period. This post-mortem plan clearly parallels the Appellant’s tax plan in the case at bar. Both plans provide access to a corporation’s earnings in a manner that avoids dividend treatment. As well, both situations deal with a time of reconciliation – death and departure from Canada. The conditions imposed on the post-mortem transactions, if imposed in the case at bar, would show that the CRA’s assessing practice was consistent in trying to apply subsection 84(2). The message seems to be: do the strip slowly enough to pass a contrived smell test and you will be fine.
This is not a satisfactory state of affairs in my view. The clearly arbitrary conditions imposed are not invited by the express language in subsection 84(2). I suggest that they are conditions imposed by the administrative need not to let go of, indeed the need to respect, the assessing practice seemingly dictated by RMM. Make it “look” less artificial and the threat of subsection 84(2) disappears. This unsatisfactory state of affairs more properly disappears once it is accepted that subsection 84(2) must be read more literally in all cases and GAAR applied in cases of abuse.
The TCC further concluded that GAAR did not apply as subsection 84(2) did not expressly identify a tax benefit. The fact is that the taxpayer, Dr. Macdonald, had a choice to extract the retained earnings by ways of a dividend or by way of as capital gains. The TCC concluded at paragraph 132:
The tax avoidance and tax benefit resulting from a lack of integration in this case is systemic. There is no unintended tax slippage in this sense, and in such circumstances GAAR cannot be used to prevent a tax planned approach to accessing retained earnings. Said differently, neither nor GAAR can be used to fill a gap between two approaches to taxing an individual shareholder’s realization of accumulated after-tax funds in a company. There must be more. does not employ language that attacks tax abuse issues arising from surplus strips. Section 245 does. As stated earlier in these Reasons – it is a better litmus test to identify strips that offend the spirit and objects of the Act read as a whole. Unless, an abusive tax benefit results from the avoidance series of strip transactions, the tax result stands undiminished. Avoidance transactions alone do not frustrate the principles set out in the Duke of Westminster.
What does this all mean? Macdonald advocates that the post-mortem pipe line does not invoke subsection 84(2) as it is not a re-characterization provision authorizing a look-through of the steps undertaken to ensure the first shareholder is not ultimately subject to subsection 84(2). That said it is prudent to follow existing CRA rulings which currently mandate the one year waiting period and to still obtain a ruling to substantiate that position. After all, although the Tax Court’s decision is very convincing, its decision is being appealed. On April 17, 2012 an appeal of the decision was filed with the Federal Court of Appeal.
The one year waiting period ensuring that the business continues to be carried on is essential to obtaining a favourable ruling. As such when planning is undertaken, a shareholder of a CCPC must contemplate the corporation’s survival for one year after death and ensure that his or her heirs is aware of this requirement.