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.
Introduction
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 subsection 84(2) 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. Subsection 84(2) 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.
Conclusion
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.
