Today’s blog was written by Pritika Deepak, Associate at Fasken LLP
This is the last part of a three-part blog series which provides a broad overview of some of the tax implications to consider, with respect to certain assets held at death. Part I, which addresses RRSPs can be found here: https://www.allaboutestates.ca/what-happens-when-a-taxpayer-dies-with-a-registered-retirement-savings-plan/ and Part II, which addresses exempt Life Insurance Policies can be found here: https://www.allaboutestates.ca/tax-implications-for-exempt-life-insurance-policies/.
Part III of this blog focuses on shares of a private corporation. Particularly, this article will: (i) identify and consider a few tax issues surrounding the treatment of private company shares on the death of a shareholder; and (ii) offer a few planning techniques to mitigate such tax consequences.
*Please note that this article is for general informational purposes only. Given the complexity of the tax issues involved, which are wholly dependent on specific facts and circumstances, it is essential that readers contact their tax advisors to obtain the appropriate advice.
Tax Implications on Death of a Shareholder
Paragraph 70(5)(a) of the Income Tax Act (RSC, 1985, c. 1 (5th Supp.)) (“ITA”) provides that a taxpayer is deemed to have disposed of all capital property immediately before death for proceeds equal to its fair market value (“FMV”) at such time. Capital property includes shares of a private corporation. As a result, half of the capital gain (if any) resulting from the difference between the deceased taxpayer’s adjusted cost base (“ACB”) of the private company shares and the FMV is taxed in the deceased taxpayer’s terminal return, subject to some exceptions.
One of the main exceptions to the deemed disposition rule is subsection 70(6) of the ITA, which provides for a deferral of capital gains tax where the capital property is, as a consequence of death, transferred or distributed to the taxpayer’s spouse or a qualifying spousal trust (“QST”). Such a transfer can occur on a ‘rollover’ basis where the deceased taxpayer is deemed to have disposed of their shares at cost instead of FMV. As a result, any accrued capital gains on the shares transferred or distributed to a spouse or QST are deferred until the earlier of the date of death of the surviving spouse or the date the spouse or trustee of the QST, as the case may be, disposes of the shares. It is important to note that in order for the rollover to be available, the capital property must vest indefeasibly in the spouse or the QST within 36 months of the date of death of the taxpayer.
Tax Issues Surrounding Shares of a Private Corporation on Death – Double Taxation
There are several issues which may arise when dealing with shares of a private corporation after the death of a shareholder, including, issues regarding an acquisition of control, challenges with valuation of private company shares, and potential double taxation.
This article will focus on the most common issue, namely, double taxation.
The issue of double taxation arises when the estate extracts assets of the underlying private corporation, in the form of a dividend or a deemed dividend, and upon the subsequent wind-up of the private corporation.
As mentioned, any capital gains triggered pursuant to subsection 70(5) of the ITA must be reported on the deceased taxpayer’s terminal return. This is the first level of tax. The estate of the deceased is then deemed to have acquired such shares at FMV resulting in a ‘bump up’ of the ACB for the estate.
When a corporation is wound up or liquidated, its assets are sold, liabilities paid and any remaining cash and cash equivalents are distributed to the shareholders resulting in a cancellation of its shares. Pursuant to subsection 84(2) of the ITA, upon the corporation’s liquation, any property or cash distributed to the shareholder in excess of the shares’ paid-up capital (“PUC”) is deemed to be a dividend. Consequently, the redemption of the estate’s shares or a liquidation and distribution of assets from the corporation, may trigger a deemed dividend to the estate. This is the second level of tax.
Depending on the circumstances, the deemed dividend on the second level of tax may create a capital loss and an opportunity for some planning techniques, as outlined below.
Consider the following simplified example:
Mr. X owns 100% of the shares of ABC Inc., a private corporation. ABC Inc. holds cash and securities worth $10 million dollars at the time of the Mr. X’s death. Let’s assume the ACB and PUC are nominal (i.e. $1.00), which is often the case for owner-manger corporations.
Immediately before Mr. X’s death, he is deemed to dispose of his shares in ABC Inc. for proceeds equal to FMV. This will result in a capital gain of $9,999,999 (i.e. $10 million less $1) for Mr. X’s terminal return. Mr. X’s estate is deemed to acquire the shares of ABC Inc. at $10 million. Assuming that the estate subsequently winds-up ABC. Inc. and distributes its assets, there is a deemed dividend to the estate. The deemed divided is the difference between the distribution (generally FMV) and the PUC of the shares. In this case, that would result in a deemed dividend of $9,999,999 (i.e. $10 million less $1).
As a result Mr. X’s estate will pay tax twice. Once on the capital gain of $9,999,999 and again on the deemed dividend of $9,999,999.
There are planning techniques which may be effected to prevent or mitigate the double taxation outlined above. The most common planning techniques used in such situations are the capital loss carry-back strategy and the pipeline strategy.
(i) Capital Loss Carry-back
Subsection 164(6) of the ITA provides a solution to avoid double taxation. Essentially, subsection 164(6) allows a graduated rate estate to “carry-back” a capital loss from the first taxation year of the estate to the deceased’s terminal tax return to offset against the deceased’s capital gains. This includes any capital gains which result from the application of the deemed disposition rules in subsection 70(5) of the ITA.
A capital loss carry-back is generally implemented by distributing corporate assets (typically by way of dividend or redemption) of the private corporation and subsequently winding up the corporation within a year of the taxpayer’s death. The redemption of shares and/or wind-up of the corporation (after its assets are sold and liabilities are paid) may trigger a deemed dividend for tax-purposes. Under subsection 84(2) of the ITA, upon the corporation’s liquidation or wind-up, any property or cash distributed to a shareholder in excess of the shares’ PUC triggers a deemed dividend. Subsection 84(3) of the ITA addresses redemptions and states that a shareholder is deemed to have received a dividend to the extent that the redemption proceeds exceed the shares’ PUC.
The redemption of shares or a wind-up of a corporation also results in the disposition and ultimate cancellation of the shares. When a deemed dividend is triggered upon redemption, the proceeds of disposition received by the estate are then adjusted in accordance with section 54 of the ITA. Section 54 of the ITA provides that the proceeds of disposition shall be reduced by the amount (if any) of any deemed dividends triggered pursuant to subsection 84(2) or 84(3) of the ITA. Capital gains or capital losses resulting from the redemption are then determined by calculating the difference between the adjusted proceeds of disposition of the shares and the ACB of the shares to the shareholder. A resulting capital loss may then be “carried back” to the deceased’s terminal return pursuant to subsection 164(6).
Continuing with the simplified example above:
For the purposes of this example, let’s assume that ABC Inc. is redeeming its shares held by the estate for $10,000,000. First, we calculate the deemed dividend under subsection 84(3) of the ITA. The deemed dividend is $9,999,999, which is the difference between the proceeds of redemption ($10,000,000) and the PUC ($1) of the estate’s shares of ABC Inc. The second element is to calculate the resulting capital gain or loss on the disposition of the estate’s shares in ABC Inc. Here, the proceeds of disposition ($10,000,000) are reduced by the deemed dividend ($9,999,999) resulting in adjusted proceeds of disposition of $1. The difference between the adjusted proceeds of disposition ($1) and the ACB ($10,000,000) results in a capital loss of $9,999,999.
Assuming that Mr. X’s estate is a graduated rate estate which incurred the capital loss within one year from Mr. X’s date of death, the estate can carry back the $9,999,999 capital loss to offset the capital gains triggered in Mr. X’s terminal return.
*Please note that this is a very simple example for illustrative purposes only and does not reference the stop-loss rules which may apply to reduce or restrict the use of the capital loss.
A typical ‘pipeline’ strategy is usually implemented after the taxpayer’s death. It is generally effected in the following manner:
- The estate incorporates a new corporation (“Newco”);
- Newco acquires shares of the private corporation held by the estate (in our example, ABC Inc.);
- Newco issues a non-interest bearing promissory note to the estate in an amount equal to the FMV of the private company shares (in our example, the FMV of ABC Inc.’s shares);
- Newco is then amalgamated with the private corporation to form ‘Amalco’ (in our example, Newco and ABC Inc. would amalgamate);
- Amalco would use its assets to repay the promissory note to the estate.
Generally, the sale of the private company shares in step 2 from the estate to Newco would not result in any capital gain being realized by the estate as, following the deemed disposition immediately before death, the ACB of the shares to the estate would be equal to the FMV at the time immediately before the taxpayer’s death (in our example, $10,000,000). Once step 4 is complete and Newco has amalgamated with the private corporation to form Amalco, Amalco could use the underlying assets of the private corporation to pay off the note issued in step 3 to the estate. Repayment of the promissory note would not result in any tax to the estate. Once the assets have been fully distributed to the estate, Amalco would be dissolved.
The purpose of a ‘pipeline’ strategy is to avoid triggering a deemed dividend under subsection 84(2) or 84(3) of the ITA to avoid double taxation. Conceptually, the pipeline converts the ACB of the shares held by the estate into a loan. This allows the estate to extract the corporation’s assets on a tax-free basis up to the amount of the loan.
Care should be taken when implementing the ‘pipeline’ strategy as the Canada Revenue Agency has, in the past, challenged some of these transactions and disallowed the corresponding tax benefits.
The tax issues which arise on the death of a shareholder owning private company shares are complex. Proper planning involving private corporations requires a great degree of technical knowledge and expertise of both tax and estate laws. It is crucial that individuals engage the appropriate legal and tax advisors to optimize efficient tax planning.
 For the purposes of this example, it is assumed that there are no credits or notional tax accounts.
 A graduated rate estate is an estate that meets certain conditions outlined in subsection 248(1) of the ITA, including that the estate trustee must designate the estate as a ‘graduated rate estate’ of the deceased individual.