The tax reform of 1987 introduced the term “taxable preferred shares” to curtail the tax advantage for non-taxpaying corporations using preferred share financing over debt financing. The result of this reform subjected the non-taxpaying corporation to a (current) 25 per cent tax on dividends that were paid on taxable preferred shares in excess of a specified dividend allowance. This tax imposed under the Income Tax Act is referred to as Part VI.1 tax.
So, if the purpose of this Part VI.1 tax is to negate the advantage derived by preferred share financing of non-taxpaying corporations, what does any of this have to do with estate planning? Well, the devil is in the details, and in the world of tax, that is where the problems exist.
Exception: substantial interest
When the Department of Finance (Finance) crafted the rules, they defined taxable preferred shares to be very inclusive capturing most issued preferred shares. In fact, the definition encompasses most of the typical preferred shares issued during an estate freeze, which seems like an overkill situation to deal with a very specific tax policy issue. In order to ensure that Part VI.1 tax was specific to certain preferred shares, Finance created a number of exceptions. One of the exceptions is where the shareholder receiving the dividend has a “substantial interest” in the dividend paying corporation by either being a related party to the corporation or by owning 25 per cent or more of the votes and value of the corporation. This exception exempts most privately held corporate structures from the application of Part VI.1 tax.
Once again, what does all this have to do with estate planning? Well, we are getting to that.
Under subparagraph (d)(ii) of subsection 191(3) of the Income Tax Act, a trust is deemed not to have a substantial interest in a dividend paying corporation unless all persons who are beneficially interested in the trust are “related”. For the purpose of this subparagraph, the definition of related is extended to include aunts, uncles, nieces, nephews and their respective descendants.
Beneficial interest in the estate
Now let’s envision an estate situation where a parent passes away while directly owning taxable preferred shares of a dividend paying corporation. Upon death, these shares would form part of the deceased parent’s estate which is essentially a trust. If one of the beneficiaries of the estate is a non-family member (i.e. friend or colleague), then not all persons beneficially interested in the estate would be related. This would result in the estate being deemed not to have a substantial interest in the dividend paying corporation and possibly subjecting the corporation to Part VI.1 tax. This situation can be even more complicated when dealing with in-laws or step-children as the Canada Revenue Agency has issued various rulings taking the position that the “in-law”  or “step-child”  relationship, in certain situations, can cease upon the death of the individual who created that “in-law” or “step-child” relationship.
If the trust does not have a substantial interest in a dividend paying corporation because not all beneficiaries are related to each other, then it becomes necessary to find a different exception to avoid Part VI.1 tax.
The underlying purpose of taxable preferred shares and the ensuing Part VI.1 tax can be easily forgotten when considering estate planning for clients. As with all tax rules it is the details that matter, and a good estate plan should always consider the details.
 For a detailed analysis of taxable preferred shares, see Joan Jung’s 2017 Ontario Tax Conference paper “The Taxable Preferred Share Rules and the Private Corporation”.
 A detailed review of the “related party” provisions is beyond the scope of this blog, but be cautioned that relationships, as defined in the Income Tax Act, are not always as they seem.
 The 25 per cent criteria is detailed in paragraph 191(2)(b) of the Income Tax Act and is more complex than simply owning 25 per cent of the total votes and value of the corporation.
 In IT Rulings’ documents 9426215, 2002-0176465 and 2008-0285271C6, the position taken is that the in-law relationship ceased upon the death of the child for purposes of the capital gains exemption for qualified farm property in section 110.6 of the Act.