When a person resident in Canada dies, the Income Tax Act deems that person to have disposed of and reacquired all of his or her property for fair market value immediately before death. The result of this deemed disposition and reacquisition is that the person (subject to some exceptions) will be required to pay tax on the increase in value of his or her property that accrued since he or she initially purchased such property. The person’s estate, and ultimately the beneficiaries of the estate, will receive the property with the increased cost base (i.e. at fair market value). From a policy perspective, this deemed disposition and reacquisition ensures that capital gains are taxed for the growth that accrues to each generation. The deemed disposition and reacquisition at death, however, can result in double taxation where a person dies owning shares in a corporation.
Commonly, in a closely-held corporation, the shareholders purchase shares from the corporation for a nominal amount such as $1.00 and on death those shares will be repurchased by the corporation for fair market value, leaving the remaining parties as the sole shareholders of the corporation. In such a scenario, the taxes that may arise are as follows:
- First layer of tax: This layer of tax arises from the deemed disposition of the shares on death, which results in tax payable by the deceased on the difference between the fair market value of those shares and the deceased’s cost of those shares.
- Second layer of tax: This layer of tax arises when the deceased’s shares are repurchased by the corporation from the deceased’s estate or beneficiaries, which results in dividend tax payable by the estate or beneficiaries on the difference between the fair market value and the amount the corporation received for the shares. This repurchase also creates a capital loss roughly equal to the amount of the capital gain realized by the deceased (which may or may not be usable).
(Note also that a third layer of tax may arise if the corporation needs to liquidate assets to fund the share repurchase and if such assets have an accrued gain.)
Fortunately, there are a few strategies available to mitigate the double-tax problem.
One of these strategies involves the corporation repurchasing the shares from the deceased’s estate in the year following death and filing an election so that all or part of the capital loss created from the repurchase of the shares can be carried back to offset the capital gain payable by the deceased (this is subject to several rules in the Income Tax Act that may prevent the use of the capital loss). If this strategy is used, the end result will be that dividend tax is payable by the deceased’s estate on the repurchase of the shares, and none or only a portion of the capital gain on the shares will be payable by the deceased.
Another strategy available to mitigate the double-tax problem is typically referred to as the “pipeline” strategy. To use this strategy, the deceased’s estate would incorporate a new holding corporation, transfer the shares of the original corporation to the new corporation in exchange for shares of the new corporation and a promissory note roughly equal to the value of the estate’s cost of the shares (i.e. the fair market value of the shares). The original corporation can then pay tax-free inter-corporate dividends to the new corporation, which can in turn be used to repay the promissory note, also on a tax-free basis. If this strategy is used, the end result will be that only capital gains tax will be payable by the deceased. It is important to note that the Canada Revenue Agency has recently been viewing this strategy unfavourably. It should only be used with caution and in certain circumstances, with the advice of a professional tax advisor.
Also, if the corporation has non-depreciable assets with a low cost and a high fair market value, it may be possible to increase the cost of those assets using a “bump” procedure. This also involves the incorporation by the estate of a new holding corporation, the transfer of the shares of the original corporation to the new corporation in exchange for a promissory note and then winding-up the original corporation into the new corporation. The cost of the non-depreciable assets may be increased as part of the winding-up, which may then be transferred tax-free to the beneficiaries of the estate to repay the promissory note.
Generally, it is best to have all strategies available to mitigate the double-tax problem so that the best course of action can be chosen at the relevant time. Tax rates, corporate tax accounts and the stop-loss rules all impact the strategy chosen and these can vary over time. It is therefore important that your corporate structure is flexible enough to accommodate these options. It is also very important to obtain tax and legal advice quickly following the death of a shareholder, as there are some time limits to using these strategies. Without the proper planning, the deceased and the deceased’s estate may be paying more tax than they should.
For more information on Tax Law, contact Melodie Lind at (250) 861-1210 or [email protected]
