In the wake of the COVID-19 crisis, we want to remind our clients about potential tax planning opportunities that may help to mitigate the damage many business owners are facing today.
Potential for an Estate Freeze
An estate freeze is a tax planning technique that is used to minimize tax consequences upon death. It is also used to multiply the capital gains exemption amongst trust beneficiaries on a future sale of the company. It is a way to “freeze” the current value of shares on a tax-free basis, so that the shareholder avoids additional capital gains tax upon death. A company is always “frozen” at its fair market value, meaning the initial shareholder retains non-participating freeze shares, which have a redemption value equal to the fair market value at the time they were frozen. When that individual dies, they pay tax only on the gain accruing to these freeze shares, while the additional growth value that accumulated since the freeze accumulates in favour of the next generation. Similarly, when a trust is introduced as a shareholder the increase in the value of the company accrues to the trust. This technique allows the capital gain realized by the trust on a sale of the shares of the company to be sprinkled amongst the beneficiaries who can shelter the gain by claiming their capital gains exemption.
In times of crisis, the values of many companies may decrease significantly. It is precisely at this time that we should be considering for our clients: Is this the appropriate time to freeze (or re-freeze at a lower value) the shares of the company, so that our clients defer the maximum amount of capital gains tax to the next generation or maximize the claim of the capital gains exemption? An estate freeze is a simple tool which is generally not too expensive to implement, but can equate to huge tax savings in the future.
Keeping this in mind, now would be an opportune time for us to verify companies’ schedules of classes of share capital to ensure that there are appropriate classes available to implement a freeze, and, if not, obtain Articles of Amendment now to add some appropriate classes of shares. This would then allow a company to implement a freeze (hopefully at the lowest value) any time after the Articles of Amendment are obtained. Should there not be an appropriate class of freeze shares available and should Articles of Amendment not be obtained to add some, the opportunity to freeze or re-freeze at the lowest value may be lost.
Loss Utilization Strategies
One potential loss utilization strategy available for married individuals is to transfer a capital loss from spouse to spouse, via a sale of shares. The selling spouse elects out of the spousal rollover, so that attribution does not apply. The recipient spouse holds the shares for at least 30 days. The loss will thus be a “superficial loss” and deemed to be nil. The ACB of the shares for the recipient spouse is increased by the superficial loss the selling spouse incurred. As a result, on a subsequent disposition of these shares, the recipient spouse will realize a capital loss on the disposition.
It is also possible for an individual to transfer investments in a loss position to a corporation. The superficial loss rules generally deny the recognition of a capital loss when a taxpayer transfers capital property and an affiliated party acquires it within 30 days of the disposition. If a taxpayer transfers capital property to an affiliated corporation, the corporation adds the amount of the denied loss to the adjusted cost base of the property received. As a result, the adjusted cost base for the company of those securities equals the fair market value of the securities so transferred, plus the amount of the denied loss.
The general rule with respect to in-house loss consolidation transactions undertaken between affiliated parties is that they generally do not attract GAAR audits, as long as the transactions are legally effective and do not seek to circumvent loss transfer provisions in the Act.
There is always an opportunity available to use inter-company charges for the use of assets or for the provision of services. The goal of inter-company charges is to consolidate income and expenses within the corporate group, and it is relatively simple and easy to implement. However, the charges must be reasonable and for bona-fide services in order to be deductible, and arm’s-length (fair market value) pricing must be used. In addition, there should be invoices and work descriptions to back up the amounts charged. It must also be considered whether sales taxes must be charged and remitted on such transactions.
Preferred Share Loan Transactions
Another mechanism to consolidate profits and losses within a corporate group is the preferred share loan transaction, which is implemented as follows:
As a result of the above, if structured properly, the interest expense is deductible to ProfitCo since the loan was taken out for the purpose of earning income on a preferred share investment. ProfitCo is also paid a tax-free intercorporate dividend which is deductible. Finally, LossCo uses the interest income to offset its existing losses.
In order for this plan to work, the rate of the dividends paid must be higher than the interest rate on the bank loan in order for ProfitCo to actually earn a profit. The amount of the bank loan must also be commercially reasonable. Finally, LossCo must have an independent source of profit, since the rate of the dividends paid is higher than the interest rate. This technique may be useful in the coming weeks, since the government has recently discussed extending credit to businesses more freely and with a lower interest rate due to the ongoing COVID-19 crisis. The CRA has confirmed that GAAR should not apply to these types of transactions. Note that this plan may be restricted by safe income issues.
Amalgamations and Wind-ups
Depending on the situation, tax-deferred amalgamations or wind-ups can be used to offset income with losses in an affiliated group. The downside of an amalgamation is that it causes a deemed year-end, which should be considered as there may be a stub year-end. Care should also be taken to avoid an acquisition of control. Additionally, non-capital losses and net capital losses incurred by the newly amalgamated company (AmalCo) can only be carried back to a taxation year of ProfitCo where ProfitCo is amalgamated with a “wholly-owned subsidiary”. In the case of a wind-up, there is no deemed year-end. However, the shares of the subsidiary are deemed to be disposed of for deemed proceeds. As a result, prior to winding up, consideration should be given as to whether this creates a gain or a loss. This should not be an issue when a wholly-owned Canadian subsidiary is wound-up into its parent company.
The Use of Partnerships in Corporate Groups
It is not always possible to amalgamate or wind-up several entities into one. An alternate solution is to transfer the business into a partnership. The partnership structure allows corporate groups to access losses and income. For example, where ProfitCo owns 100% of the issued and outstanding shares of LossCo, the following transaction could be implemented:
As a result of the above, the existing non-capital losses of LossCo become non-capital losses of ProfitCo. The future losses of the business can also be allocated to ProfitCo at the end of the taxation year, subject to the “at risk” rules.