The Federal budget for 2020-2021 was initially scheduled to be presented in the House of Commons on March 30, 2020. This was of course delayed as a result of Covid-19. Fast forward to January 2021, and a lot has changed with Canada’s economic situation. Are tax increases coming? Most likely. The Federal government has been very open that the typical “1%”, or anyone with any significant wealth for that matter, are likely to be targeted. So what can be done? There are several strategies that can be used (at least until the budget date, which is currently unknown but will likely be in March, 2021) to help lower the overall tax burden. In particular, the capital gains strategy (outlined in No. 3) has become increasingly popular over the past several years as it can produce (currently anyway) tax savings in 15%-20% range.
Please keep in mind that this article does not represent tax or legal advice and is for informational purposes only.
1. Estate Planning Basics ( click for diagram)
In many cases, it will make sense for mom and dad (Generation 1) to implement and estate freeze in favour of their children and possibly grandchildren (Generations 2 and 3). Typically, a family trust with a corporate beneficiary would be used as part of the estate freeze structure. Some of the benefits of this type of planning include:
- Tax deferral on future accrued capital gains (26% tax deferral on future gains);
- Probate savings (1.5% of estate value).
- Purification for the Capital Gains Exemption and also for an “excluded amount” from the TOSI rules;
- Possible multiplication of the Capital Gains Exemption;
- Maybe possible depending on the client situation to achieve income splitting, although a detailed review of the TOSI rules would be required;
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/.
(a) Passive Assets
Let’s assume the inherent capital gain of an investment portfolio 90 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.
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.
2. Prescribed Rate Loan
This strategy involves making a loan (typically cash is used) to a spouse or family trust. In most cases we would use a family trust such that control is not lost over the assets being lent. In order to achieve income splitting, the person making the loan must charge interest at a minimum of the prescribed rate in effect at the time the loan 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 is 1%. 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 lent to a family trust which earned an 8% return, and the trust allocated the 7% net return (after paying the 1% interest cost) to beneficiaries of the trust who had no other income (say three minor children), the tax savings would be approx. $18,000 per year.
This type of planning should be considered where there is significant investment income being earned by a single taxpayer and there are other family members (typically spouses, children, and grandchildren) with little or no income.
3. Capital Gains Planning (click for diagram)
As the personal tax rates have increased (and likely to continue to increase), the tax spread between dividend income and capital gains has grown. As a result, planning has developed whereby a taxpayer creates a capital gain as a means of extracting corporate funds. For example, if an individual taxpayer where to extract $1,000,000 of corporate funds as a capital gain, instead of paying a non-eligible dividend, the tax savings would be $206,400.
|Capital Gain||Eligible Dividend||Non-Eligible Dividend|
|Amount to be distributed||$1,000,000||$1,000,000||$1,000,000|
|Amount received by individual||$732,400||$606,600||$526,000|
This type of planning is very technical and not necessarily free from CRA scrutiny. Although the case law that has evolved in this area over time has generally been in favor of taxpayers, there are number of technical mishaps that could occur that could result in CRA challenge.
This planning can be particularly effective where a taxpayer has a large shareholder loan balance (or anticipates a large balance) owing to the company that needs to be repaid to avoid an income inclusion.
4. Post-Mortem Pipeline Planning (click for diagram)
Similar to the capital gains planning described above, the post-mortem pipeline planning is a mechanism where the deceased’s estate can extract corporate funds at capital gains rate. This type of planning is generally accepted by the CRA, provided certain technical requirements are followed. Other post-mortem planning may also be appropriate, such as a loss carryback or bump transaction. Depending on the client situation, the TOSI rules may need to be considered as part the planning.
This type of planning should be considered where an executor of an estate is looking to wind up and distribute corporately owned assets to the deceased’ s beneficiaries.
5. 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.
6. 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.