There are are at least 5 strategies that can be executed under existing tax legislation to use COVID-19 to generate tax relief. These strategies were originally posted by us 7 weeks ago on March 19th. In particular, strategy No. 5 discussed below anticipated a reduction in the prescribed interest rate to 1% from the current rate of 2%, which will now be in effect as of July 1st.
1. ESTATE FREEZE
An estate freeze limits the value, and therefore the capital gain (calculated as Fair Market Value less Adjusted Cost Base), to the value at the date that the freeze is implemented. Any capital gain on the future growth in value after the date of the freeze is deferred (typically to children/grandchildren either directly or through a family trust).
An estate freeze is an effective strategy where the value of a business or other investment assets are expected to increase over time. More information on how an estate freeze works can be found at https://spectrumlawyers.ca/estate-freeze/.
In today’s economic conditions resulting from the uncertainty of COVID-19, the valuations of practically all portfolio investments will have decreased significantly. Similarly, given the recession that the world will likely have to endure for the foreseeable future, the valuations of active businesses will also likely be depressed.
(a) Passive Assets
Let’s assume the inherent capital gain of an investment portfolio 30 days ago was at $1M and today it has dropped by 40% to $600,000. For estate planning purposes (learn more about tax on death at https://spectrumlawyers.ca/planning-techniques-to-eliminate-the-double-triple-levels-of-tax-after-death-of-a-corporate-owner/), the income tax payable on death 30 days ago (assume no surviving spouse) would have been approx. $260,000. Today, the income tax payable on death is reduced to $156,000. This represents a decrease in taxes owing of approx. $104,000, in additional to a $6,000 decrease in the Ontario estate administration tax payable (known as probate). (https://spectrumlawyers.ca/changes-to-the-estate-administration-tax-effective-january-1-2010/)
By implementing an estate freeze today, the taxpayer’s estate has saved $110,000 (the probate tax can be reduced even further by $9,000 if primary/secondary Wills are used). Assuming the inherent capital gain in the investment portfolio increases back to $1M (or beyond) over time, the additional tax on the investment assets can be deferred until they are sold and in some cases the taxes can be spread among other taxpayers which can reduce the over tax burden.
(b) Active Businesses
For taxpayers who operate active businesses through Canadian controlled private corporations (CCPC), the tax savings are even more impressive. In addition to the deferral/savings of the taxes that would otherwise have been payable on death, there is an additional level of savings on a sale of the business in the future.
Let’s assume a business 30 days ago was valued at $1.77M and in 60 days from now is valued at $885,000 as result of the economic fallout from COVID-19. Had the shares of the corporation that operates the business been sold 30 days ago, total taxes payable would have been approx. $230,000 (assuming the company was eligible for the lifetime capital gains exemption). By implementing an estate freeze and introducing a spouse or child as a new shareholder (either directly or more commonly through a family trust) at the lower valuation of $885,000, assuming the value of the business returns to $1.77M, the taxes payable on a share sale is reduced to nil. In other words, each additional capital gains exemption that can be claimed represents approx. $230,000 of tax savings. In many cases a two year holding period is required in order to benefit from the additional capital gains exemptions, however, in some cases with proper structuring this two year period can be eliminated.
In addition, to the tax savings on a sale, there could also be other income splitting opportunities prior to the sale, such as paying dividends to lower income family members. Income splitting through dividends is still possible in some cases, however, a careful review of the rules related to tax on split income (TOSI) needs to be undertaken before dividends are paid. (https://spectrumlawyers.ca/tax-planning-in-2019/)
In a refreeze transaction, the preferred shares issued in a previous freeze transaction are revalued at the today’s lower fair market value. Essentially, a refreeze provides a taxpayer with the tax relief (described above) associated with the reduced values as a result of COVID-19. In other words, taxpayers who may have previously executed a freeze transaction at higher values aren’t penalized and can still take advantage of the current economic situation. A careful review of corporation’s share structure needs to be undertaken.
3. GENERATE LOSSES
With reduced valuations, there is an opportunity to realize losses (either income or capital). This strategy can be particularly useful where tax has been previously paid on gains. Losses generated today can be carried back to prior tax years or carried forward to future tax years (with certain restrictions in both cases). For example, if a taxpayer generated a $100 capital gain in 2019, taxes payable would be $26. If the same taxpayer generates a capital loss in 2020 and carries it back to 2019, the taxpayer will receive a refund of $26.
4. GIFT ASSETS TO ADULT CHILDREN/GRANDCHILDREN
As part of typical estate planning for Canadian taxpayers, assets are often gifted to children and grandchildren. The gift is either during the lifetime of the person making the gift (known as an inter vivos gift) or is made on death through the person’s Will (known as a testamentary gift). https://spectrumlawyers.ca/multiple-wills/
One disadvantage to gifting assets on death is that there is likely to be an increased capital gain on the assets being gifted at the time of death. Since date of death is unknown, so to is the associated tax liability that will arise. By gifting assets today at a lower fair market value, the tax payable can be reduced or even eliminated in some cases.
Where the assets being gifted are income producing (i.e., portfolio investments, rental properties, shares of investment companies, etc.) its important that the child/grandchild receiving the gift be at least 18 years old. Otherwise, certain attribution rules can apply to attribute future income on those assets back to the transferor.
5. TRANSFER ASSETS TO A FAMILY TRUST
This strategy involves transferring assets to a family trust in exchange for a interest-bearing promissory note owing by the trust back to the transferor. Family trusts are often used as a means to maintain control over the assets being transferred (https://spectrumlawyers.ca/family-trusts-101-common-uses-common-traps/). Typically, cash would be used in this strategy since any gains on the assets being transferred must be realized on the sale (or loan) to the trust. Where an asset has a significant accrued capital gain, this strategy would likely not be used.
Again, as discussed above, the reduced valuations as a result of COVID-19 provide an opportunity for a taxpayer to transfer assets to a family trust with a reduced (or perhaps nil) capital gain that would otherwise have been realized. If a loss is realized on the transfer (i.e., fair market value is below the adjusted cost base), certain loss restriction rules need to be reviewed. In other words, the current economic environment provides an opportunity to now execute this type of planning that may have been too tax costly in the past.
In addition to the tax savings on death that has been already discussed, this strategy provides an additional opportunity for income splitting with lower income taxpayers (typically spouses, children, grandchildren). In order to achieve income splitting, the transferor must charge interest at a minimum of the prescribed rate in effect at the time the transfer is made. As a result of the TOSI rules, it is important that the family trust not be viewed as carrying on a related business.
Currently, the prescribed rate that must be paid on the promissory note is 2%, which will decrease to 1% as of July 1st. Income splitting is achieved where the trust allocates its investment income (in excess of the 1% interest cost) to lower income beneficiaries. For example, if $500,000 was transferred by a high rate taxpayer (53.53% marginal rate) to a family trust which earned an 8% return on the $500,000, and the trust allocated the 7% net return (after paying the 1% interest to the high rate taxpayer) to beneficiaries of the trust who had no other income (say a spouse and two minor children), the tax savings would be approx. $18,500 per year. In order for this strategy to be effective, it is crucial that the interest be paid (journal entries are not enough) by January 30th of the following year.
Although all of the challenges that COVID-19 will bring to Canadians is still unknown, the tax strategies described above may prove to be very beneficial in the longer term. Now that the immediate health concerns are for the most part behind us, taxpayers and their advisors should turn their minds to the planning opportunities that are available. The information described above is meant to be informative but does not constitute tax or legal advice. Please contact me at any time to discuss.