The Double Taxation Problem

When a Canadian resident individual dies and does not have a spouse to whom they can transfer their assets, the deceased taxpayer is deemed to have disposed of their assets at fair market value.

This deemed disposition can be a particular problem when a taxpayer dies holding shares of a private corporation. When this happens, there is a double taxation problem. Firstly, the taxpayer is deemed to have disposed of their shares of the private corporation at fair market value, and so may have a capital gain. Secondly, the beneficiaries of the taxpayer need to get the assets out of the corporation, and in doing so they are taxed on a dividend.

Consider a simple example:

Mr. Anderson dies owning 100% of the shares of Anderson Corporation. Anderson Corporation’s only asset is cash of $2 million. Mr. Anderson started this company when he was younger and, as is common, only paid $1.00 to set up the initial shares of the company. Mr. Anderson has one son, Junior, who is his only beneficiary.

When Mr. Anderson dies, he is deemed to have disposed of the shares of the company at their fair market value, which is $2 million. He has a capital gain of $2 million, because his initial cost of the shares when he incorporated the company was nominal.

Junior inherits the shares of Anderson Corporation. Junior would now like to get the $2 million of cash out of the company. Anderson Corporation pays Junior a dividend of $2 million and Junior pays personal tax on the divided.

When the double taxation problem arises, there are two methods of post-mortem tax planning commonly used to mitigate.

Windup and Loss Carry-Back (Section 164(6) carry-back)

The 164(6) carry-back is the simpler of the two tax planning alternatives.

This method requires the estate of the deceased individual to “wind up” the company. Technically speaking, the corporation redeems and cancels all of its shares, and distributes all of its assets to the beneficiaries of the estate.

When this “wind up” occurs, the estate incurs a capital loss equal to its cost of the shares of the corporation. When the estate acquires the shares from the deceased taxpayer at fair market value on death, the estate’s cost of the shares is equal to the fair market value at the time the individual taxpayer died. Therefore, the estate will generally have a capital loss equal to the capital gain incurred by the deceased taxpayer.

If certain conditions are met, the estate can carry this loss back in time and apply it to the capital gain the deceased taxpayer incurred, effectively eliminating tax on the capital gain and leaving only the dividend tax on the distribution of assets.

Using the example above, the Section 164(6) carry-back would be applied as follows:

  1. Mr. Anderson dies and has a deemed disposition of the shares of Anderson Corporation. Mr. Anderson incurs a $2 million capital gain on this disposition.
  2. Mr. Anderson’s estate acquires the shares of Anderson Corporation at fair market value of $2 million.
  3. Anderson Corporation “winds up”, distributing $2 million to Junior.
  4. Junior has a $2 million taxable dividend on the cash he received.
  5. Anderson Corporation has a $2 million capital loss on its shares of Anderson Corporation which were wound up
  6. Anderson Corporation carries back its $2 million capital loss to offset Mr. Anderson’s $2 million capital gain.

Post-Mortem “Pipeline”

A post-mortem pipeline is a complex transaction which requires a corporate restructuring.

The purpose of the pipeline is to eliminate the second level of tax on distribution of assets from the corporation, and to leave the capital gain taxed in the hands of the deceased taxpayer. Again using the example mentioned above, a post-mortem pipeline transaction would be enacted as follows:

  1. Mr. Anderson dies and has a deemed disposition of the shares of Anderson Corporation. Mr. Anderson incurs a $2 million capital gain on this disposition.
  2. Mr. Anderson’s estate acquires the shares of Anderson Corporation at fair market value of $2 million.
  3. Mr. Anderson’s estate incorporates a new company (“Newco”).
  4. Mr. Anderson’s estate transfers the shares of Anderson Corporation to Newco in exchange for a promissory note in the amount of $2 million.
  5. Anderson Corporation repurchases its shares held by Newco, resulting in a deemed dividend from Anderson Co to Newco. This dividend will not be subject to tax.
  6. Newco pays back the $2 million promissory note to Mr. Anderson’s Estate.

Conclusion

It may be possible to avoid the double taxation issue altogether with appropriate up-front planning. Trusts can be powerful estate planning tools but generally need to be implemented prior to death.

Both post-mortem tax planning tools discussed here have significant risks and pitfalls, as well as specific qualification criteria. Neither method should be undertaken before seeking professional advice from a tax expert.

 

Written by:  Chris Brien, CPA, CA

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