June 2011, Presenter David R. Baxter

SUCCESSION PLANNING FOR PRIVATE ENTERPRISES June 2, 2011 David R. Baxter

Introduction
Tax planning should be proactive , not reactive
proactive planning may be accomplished tax-free
reactive planning may result in tax implications (ex. divisive reorganizations and ITA 55(2))
Tax planning should be fully integrated with non-tax considerations
asset protection  segregated holding corporations
wealth preservation  discretionary family trusts
business succession  integrate trusts and corps
Identify exit strategies for owner-managers of privately-owned businesses

Agenda
Structuring private enterprises
Capital gains exemption for QSBCS
Purifications and divisive reorganizations
Estate freezes
internal freeze
external freeze
stock dividend freeze
wasting freeze
Use of trusts
discretionary family trusts
21 year rule
Post-mortem planning

Structuring Private Enterprise
Factors to consider:
tax efficient distribution of retained earnings
defer personal taxation for as long as possible
avoid refundable taxes on inter-corporate dividends (Part IV)
avoid anti-stripping rules (ITA 55(2))
tax efficient exit strategy
maximize capital gains exemptions
asset protection (ex. trade creditors, matrimonial)
utilize holding corporations and trusts
flexible wealth management and estate planning
income splitting
family governance
avoiding fixed entitlements with trusts

Distribution Strategy: Inter-Corporate Dividends
Dividends generally pass between corporations without Part I tax
Opco can pay a dividend to a corporate shareholder (Holdco)
Holdco not subject to Part I tax on dividend if connected to Opco
Holdco accumulates retained earnings
Defer personal tax otherwise payable by individual shareholders
Holdco can be subject to refundable Part IV tax (33 ⅓ %) on dividends
portfolio dividends (i.e., from non-connected corporations)
dividends from connected corporations if RDTOH refund to payor
Connected corporations
related corporations
Holdco owns >10% votes and equity value of Opco
no look-through rules with trusts

Exit Strategy: Capital Gains Exemption for Qualified Small Business Corporation Shares
Only available to individuals
look-through rules for personal trusts
Small business corporation (“SBC”) at time of disposition
CCPC
“ All or substantially all” (90%) active business assets
Shares/indebtedness of “connected“ SBC
24 month hold period / 50% test
abridging the hold period (ITA 110.6(14))
Gross asset value test
$750,000 lifetime limit per individual
reduced if used $100,000 exemption prior to elimination
combine with exemptions for qualified farm property and fishing property
AMT implications
ABIL / CNIL

Example: QSBC Gross Asset Value
FMV business assets: $550,000
Less: business liabilities: (50,000) _________
Net: $500,000
FMV investments (gross): $450,000
Less: investments liabilities: (425,000) ________
Net: $25,000
________
Total Net Value: $525,000
Gross asset value is $1,000,000
Shares would not be eligible for the QSBCS exemption
business assets represent less than 90% of the gross asset value
irrelevant that >90% of the net value derived from business assets

Basic Corporate Structure
Some asset protection for John and spouse
business carried on through a limited-liability corporation
subject to personal guarantees, gross negligence, etc.
QSBCS exemption available on share sale
subject to Opco not accumulating passive assets
shelter a maximum of $1,500,000 capital gains
No ability to defer personal taxes on distributions of retained earnings from Opco
Opco active business John Spouse

Holdco Ownership Structure
Retained earnings from Opco can be distributed to Holdco by way of inter-corporate tax-free dividends
Holdco can invest the dividends and accumulate significant investments
Holdco shares will meet the 50% test but not the 90% test
Holdco shares owned by John / Spouse will not qualify for QSBCS capital gains exemption
must first purify Holdco by a divisive reorganization or otherwise
John Holdco Opco active business ($1,500,000) Investment portfolio ($500,000) Spouse

Trust Ownership Structure
Beneficiaries of the discretionary family trust would include both individuals and Holdco
Dividends paid by Opco to the trust could be allocated to Holdco as an income distribution from trust
deemed inter-corporate dividends
Capital gains realized on the sale of Opco shares could be distributed to individual beneficiaries so that they could claim their QSBCS exemptions
Beware of Part IV tax on dividends allocated to Holdco
ITA 186(2) & (4): “connected”
Trust could be a shareholder of Holdco
beware of reversionary rules
Flexible asset management
Opco Holdco Trust purifying dividends family members beneficiaries allocation $ $

Divisive Reorganization: Purification
Objective: distribute certain corporate assets (usually cash or investments) to a non-arm’s length corporation
Principal reasons:
qualify for QSBCS exemption
non-active business to be removed to satisfy 50% / 90% tests
non-working capital and investments will not qualify
segregate different businesses (or real estate) into separate corporations to facilitate a future sale
asset protection (creditor proofing)
Considerations
trigger the realization of capital gains on disposition of appreciated assets
ITA 55(2) recharacterization of inter-corporate dividends into proceeds of disposition (or gains)

Divisive Reorganization
Tax-free distribution of corporate-owned assets between corporations
Beware of ITA 55(2)
complex anti-surplus stripping rule
prevents tax-free distribution of corporate surplus by way of inter-corporate dividends
Two categories of reorganizations
related person reorganizations
“ butterfly reorganizations (split vs. spin)
continuity of shareholding
continuity of business enterprise
pro rata distribution of each type of asset
Safe income
ITA 55(2) not applicable to distributions of tax-paid retained earnings

Divisive Reorganization: Related Person Exemption
ITA 55(3)(a): related person reorganization
no disposition of property to unrelated person or significant increase in interest in any corporation by unrelated person as part of same series of transactions
certain FMV transfers to unrelated persons permissible
siblings deemed to be unrelated
Since siblings deemed to be unrelated, undertake reorganization while related person (ex. parent) in control
after control acquired by children, reorganization would be taxable (unless undertake a butterfly distribution)

Example: Related Party “Purification” Reorganization
Mrs. X owns 300 common shares of Opco.
The shares have a nominal cost
Mrs. X wants to purify Opco to segregate cash and near-cash from its business assets
Mrs. X 300 shares Opco business assets ($200,000) cash & near-cash ($100,000)

Example: Related Party Reorganization (cont.)
Mrs. X transfers 100 common shares to a newly-formed holding company (Holdco) on a rollover basis
Shares are then redeemed by Opco for $100,000; cash and near-cash distributed to Holdco as a tax-free inter-corporate dividend
Subsection 55(2) will not apply because all parties are related
Cannot undertake as part of a series of transactions that includes a sale to an unrelated person
Mrs. X 200 shares Opco business assets ($200,000) cash & near-cash ($100,000) Holdco shares

Butterfly Reorganization
ITA 55(3)(b): butterfly reorganization
e ach shareholder gets proportionate share of each category of assets
categories: c ash/investments/business assets
c onsolidated look-through approach
g ross vs. net
“ spin” reorganization vs. “split” reorganization

Butterfly Reorganization (cont.)
General requirements:
1. continuity of shareholdings
2. continuity of assets
Generally no sale of shares or assets of the distributing corporation or a transferee corporation to an unrelated person as part of same series
No acquisition of control of distributing corporation as part of same series
Restrictions on assets that can be acquired by the distributing corporation prior to the distribution (i.e., no stuffing)

Example: Butterfly (Split)
Before:
cash = 100
investments = 200
business = 200
Opco 1, Opco 2 and Opco 3 receive a proportional amount of cash, investments and business assets of Opco
After:
X Z Y Opco Opco 1 Opco 3 Opco 2 Y X Z cash = 40 investment = 80 business = 80 cash=30 investment = 60 business = 60 cash = 30 investment = 60 business = 60 100% 100% 100% 40% 30% 30%

Example: Butterfly (Spin)
Before:
Newco receives a proportional amount of cash (along with Asset 2)
After:
Opco X Y 50% 50% Cash ($200) Asset 1 ($100) Asset 2 ($300) Y X 50% 50% 50% 50% Asset 1 ($100) Cash ($50) Asset 2 ($300) Cash ($150) Opco Newco

Estate Freezes
Mitigate against deemed disposition on death and future growth to heirs
Exchanging common shares for preferred shares
CRA criteria for preferred “freeze” shares
redeemable at the option of the holder;
carry voting rights in respect of matters which pertain to such class of shares;
first preference on any distribution of assets of the corporation on its liquidations, winding up or dissolutions;
no restriction on transferability (other than as required by the governing corporate law); and
restrict the corporation from paying dividends on all other classes of shares if doing so would result in insufficient assets being available to pay the redemption amount of the preferred shares.
Internal freeze
ITA 51/86 exchange
ITA 85: crystallization of capital gains exemption or capital losses available

Internal Estate Freeze
Patriarch owns common shares of Opco currently worth $5,000,000 (nominal cost)
Patriarch has adult children who are his sole heirs.
Patriarch exchanges common shares for preferred shares with a fixed redemption amount of $5,000,000; the exchange occurs on a tax-free rollover basis
Patriarch’s children subscribe for new common shares for nominal amount
Future growth in Opco will accrue to the children (as the common shareholders)
Opco Patriarch Children C/S P/S C/S

External Estate Freezes
utilize a holding corporation
ITA 85 election to be filed
may be appropriate if Opco has multiple shareholders (some of whom are not freezing)
may also be utilized as part of a “purification” divisive reorganization (perhaps in contemplation of an eventual share sale in the distant future)
Opco heirs freezor Holdco other shareholder C/S 100 C/S 100 C/S P/S

Estate Freeze: Benefits and Risks
Benefits
Proprietary interest to heirs without significant investment
Reduce probate fees and estate duties
Income-splitting among family members
Risks if implemented without a trust
Relinquish some control
Freezor’s financial wealth capped
Possible acceleration of taxable gains if death of heir
Exposing assets to creditor/marital risks of heirs
Corporate attribution

Stock Dividend Freeze
Opco issues fixed-value preferred shares to holder of common shares (freezor) as a stock dividend
nominal par value (stated capital) so nominal dividend received by shareholder
aggregate redemption amount = net asset value of Opco
Freezor then disposes of common shares to heirs or trust (freezee)
Advantages:
manages ITA 74.4(2) corporate attribution
may abridge 24 month hold period for QSBCS for freezee
minimize clearance certificate issues for non-resident freezor
Disadvantages:
negate application of a price adjustment clause?
alleviate with follow-up freeze
Opco freezor stock dividend common shares

Wasting Freeze
Redemption of preferred shares during lifetime
ITA 84(3): deemed dividend
Reduce gains which are taxable at death
Integration of corporate and personal tax
Active business income in excess of SBD (including recaptured CCA) historically caused disintegration
New enhanced dividend tax credit to reduce disintegration for “high tax” corporate business income (i.e., eligible dividends)
Specified investment income/RDTOH
little net “additional” tax from paying dividend
Realization of gains when common shares (or underlying corporate property) sold by heirs

Wasting Estate Freeze (cont.): Integration Specified Investment Income Taxable Dividend 44.67% (26.67%) 18.00% CCPC Individual Total Tax 44.67% (26.67%) 18.00% 27.64% 45.64% Investment Income Individual 43.7%

Refreezing
Consider if significant post-freeze devaluation of frozen corporation
Results in benefits accruing move quickly to freezee(s)
CRA acceptance so long as devaluation not a consequence of distributing corporate assets
Technical Interpretation #9229905 (June 3, 1997)
Technical Interpretation #2000-0029115 (Nov. 17, 2000)

Advantages of Discretionary Family Trust
Asset management and control
Multiply capital gains exemptions
Reversible freeze
thaw the freeze by distributions back to freezor as beneficiary
Minimizing value on death
contrary to CRA views based on Sagl v. Sagl (Ont. Gen. Div., 1997)
Avoid corporate attribution
springing beneficiaries (ITA 74.4(4))
Insulating assets from matrimonial claims
Beware of 21 year rule
ITA 104(4)(b): deemed disposition
avoid by tax-free “rollover” distribution to Cdn. resident beneficiary

Create Trust 21 Year Distribute property to beneficiaries Year 1 21 Year Rule
Discretionary trusts generally deemed to dispose of their assets every 21
years for FMV proceeds
Trigger the realization of any capital gain
Most common solution is a tax-free capital distribution on the eve of the 21 st
anniversary
Trust

Managing the 21 year rule
Share exchanges prior to 21 st anniversary
exchange trust’s common shares for multiple classes of sprinkling shares
ITA 51/86: tax-free rollover exchange
distribute sprinkling shares to multiple beneficiaries
avoid fixed entitlements in any particular beneficiary
Redemption-sprinkling preferred shares
Staggered trust ownership structure
effectively defer deemed disposition for additional 21 years
GAAR?

Tax Implications on Death
Capital gain for deceased / deemed dividend to estate on redemption
ITA 164(6) election: avoiding double taxation
Estate’s Capital loss applied against deceased’s capital gain
must be done within estate’s first taxation year
Can delay redemption to three years with alter ego trust, etc.
Opco Deceased Shareholder Estate $ transfer on death redeem

Tax Implications on Death (cont.)
Compare tax on redemption vs. sale to Holdco
rather than redeem, estate sells Opco shares to a holding corporation
no gain on estate
holding corporation redeems Opco shares
tax-free inter-corporate dividend
beware of ITA 84.1 (if Opco shares have “soft” cost)
overall taxation may be reduced if deceased did not use capital gains exemptions

Tax Implications on Death: Life Insurance on Death
ITA 70(5.3): valuing shares at death
Insurance proceeds added to capital dividend account
Distribute as tax-free capital dividends
File election
ITA 112(3.2): stop-loss rule on redemption
Grandfathered vs. non-grandfathered policies
100% vs. 50% capital loss on redemption
If non-grandfathered policy, maybe sell to heirs rather than redeem
Trade-off: bump in ACB vs. 50% capital loss

June 2011, Presenter David R. Baxter

by FVCAA on Sep 22, 2011

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June 2011, Presenter David R. Baxter — Presentation Transcript