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June 2011, Presenter David R. Baxter


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Succession Planning For Private Enterprise - Thorsteinssons LLP Tax Lawyers

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June 2011, Presenter David R. Baxter

  2. 2. Introduction <ul><li>Tax planning should be proactive , not reactive </li></ul><ul><ul><li>proactive planning may be accomplished tax-free </li></ul></ul><ul><ul><li>reactive planning may result in tax implications (ex. divisive reorganizations and ITA 55(2)) </li></ul></ul><ul><li>Tax planning should be fully integrated with non-tax considerations </li></ul><ul><ul><li>asset protection  segregated holding corporations </li></ul></ul><ul><ul><li>wealth preservation  discretionary family trusts </li></ul></ul><ul><ul><li>business succession  integrate trusts and corps </li></ul></ul><ul><li>Identify exit strategies for owner-managers of privately-owned businesses </li></ul>
  3. 3. Agenda <ul><li>Structuring private enterprises </li></ul><ul><li>Capital gains exemption for QSBCS </li></ul><ul><li>Purifications and divisive reorganizations </li></ul><ul><li>Estate freezes </li></ul><ul><ul><li>internal freeze </li></ul></ul><ul><ul><li>external freeze </li></ul></ul><ul><ul><li>stock dividend freeze </li></ul></ul><ul><ul><li>wasting freeze </li></ul></ul><ul><li>Use of trusts </li></ul><ul><ul><li>discretionary family trusts </li></ul></ul><ul><ul><li>21 year rule </li></ul></ul><ul><li>Post-mortem planning </li></ul>
  4. 4. Structuring Private Enterprise <ul><li>Factors to consider: </li></ul><ul><ul><li>tax efficient distribution of retained earnings </li></ul></ul><ul><ul><ul><li>defer personal taxation for as long as possible </li></ul></ul></ul><ul><ul><ul><li>avoid refundable taxes on inter-corporate dividends (Part IV) </li></ul></ul></ul><ul><ul><ul><li>avoid anti-stripping rules (ITA 55(2)) </li></ul></ul></ul><ul><ul><li>tax efficient exit strategy </li></ul></ul><ul><ul><ul><li>maximize capital gains exemptions </li></ul></ul></ul><ul><ul><li>asset protection (ex. trade creditors, matrimonial) </li></ul></ul><ul><ul><ul><li>utilize holding corporations and trusts </li></ul></ul></ul><ul><ul><li>flexible wealth management and estate planning </li></ul></ul><ul><ul><ul><li>income splitting </li></ul></ul></ul><ul><ul><ul><li>family governance </li></ul></ul></ul><ul><ul><ul><li>avoiding fixed entitlements with trusts </li></ul></ul></ul>
  5. 5. Distribution Strategy: Inter-Corporate Dividends <ul><li>Dividends generally pass between corporations without Part I tax </li></ul><ul><ul><li>Opco can pay a dividend to a corporate shareholder (Holdco) </li></ul></ul><ul><ul><li>Holdco not subject to Part I tax on dividend if connected to Opco </li></ul></ul><ul><ul><li>Holdco accumulates retained earnings </li></ul></ul><ul><ul><li>Defer personal tax otherwise payable by individual shareholders </li></ul></ul><ul><li>Holdco can be subject to refundable Part IV tax (33 ⅓ %) on dividends </li></ul><ul><ul><li>portfolio dividends (i.e., from non-connected corporations) </li></ul></ul><ul><ul><li>dividends from connected corporations if RDTOH refund to payor </li></ul></ul><ul><li>Connected corporations </li></ul><ul><ul><li>related corporations </li></ul></ul><ul><ul><li>Holdco owns >10% votes and equity value of Opco </li></ul></ul><ul><ul><ul><li>no look-through rules with trusts </li></ul></ul></ul>
  6. 6. Exit Strategy: Capital Gains Exemption for Qualified Small Business Corporation Shares <ul><li>Only available to individuals </li></ul><ul><ul><li>look-through rules for personal trusts </li></ul></ul><ul><li>Small business corporation (“SBC”) at time of disposition </li></ul><ul><ul><li>CCPC </li></ul></ul><ul><ul><li>“ All or substantially all” (90%) active business assets </li></ul></ul><ul><ul><li>Shares/indebtedness of “connected“ SBC </li></ul></ul><ul><li>24 month hold period / 50% test </li></ul><ul><ul><li>abridging the hold period (ITA 110.6(14)) </li></ul></ul><ul><li>Gross asset value test </li></ul><ul><li>$750,000 lifetime limit per individual </li></ul><ul><ul><li>reduced if used $100,000 exemption prior to elimination </li></ul></ul><ul><ul><li>combine with exemptions for qualified farm property and fishing property </li></ul></ul><ul><li>AMT implications </li></ul><ul><li>ABIL / CNIL </li></ul>
  7. 7. Example: QSBC Gross Asset Value <ul><li>FMV business assets: $550,000 </li></ul><ul><li>Less: business liabilities: (50,000) _________ </li></ul><ul><li> Net: $500,000 </li></ul><ul><li>FMV investments (gross): $450,000 </li></ul><ul><li>Less: investments liabilities: (425,000) ________ </li></ul><ul><li> Net: $25,000 </li></ul><ul><li> ________ </li></ul><ul><li>Total Net Value: $525,000 </li></ul><ul><li>Gross asset value is $1,000,000 </li></ul><ul><li>Shares would not be eligible for the QSBCS exemption </li></ul><ul><ul><li>business assets represent less than 90% of the gross asset value </li></ul></ul><ul><ul><li>irrelevant that >90% of the net value derived from business assets </li></ul></ul>
  8. 8. Basic Corporate Structure <ul><li>Some asset protection for John and spouse </li></ul><ul><ul><li>business carried on through a limited-liability corporation </li></ul></ul><ul><ul><li>subject to personal guarantees, gross negligence, etc. </li></ul></ul><ul><li>QSBCS exemption available on share sale </li></ul><ul><ul><li>subject to Opco not accumulating passive assets </li></ul></ul><ul><ul><li>shelter a maximum of $1,500,000 capital gains </li></ul></ul><ul><li>No ability to defer personal taxes on distributions of retained earnings from Opco </li></ul>Opco active business John Spouse
  9. 9. Holdco Ownership Structure <ul><li>Retained earnings from Opco can be distributed to Holdco by way of inter-corporate tax-free dividends </li></ul><ul><li>Holdco can invest the dividends and accumulate significant investments </li></ul><ul><li>Holdco shares will meet the 50% test but not the 90% test </li></ul><ul><li>Holdco shares owned by John / Spouse will not qualify for QSBCS capital gains exemption </li></ul><ul><ul><li>must first purify Holdco by a divisive reorganization or otherwise </li></ul></ul>John Holdco Opco active business ($1,500,000) Investment portfolio ($500,000) Spouse
  10. 10. Trust Ownership Structure <ul><li>Beneficiaries of the discretionary family trust would include both individuals and Holdco </li></ul><ul><li>Dividends paid by Opco to the trust could be allocated to Holdco as an income distribution from trust </li></ul><ul><ul><li>deemed inter-corporate dividends </li></ul></ul><ul><li>Capital gains realized on the sale of Opco shares could be distributed to individual beneficiaries so that they could claim their QSBCS exemptions </li></ul><ul><li>Beware of Part IV tax on dividends allocated to Holdco </li></ul><ul><ul><li>ITA 186(2) & (4): “connected” </li></ul></ul><ul><li>Trust could be a shareholder of Holdco </li></ul><ul><ul><li>beware of reversionary rules </li></ul></ul><ul><li>Flexible asset management </li></ul>Opco Holdco Trust purifying dividends family members beneficiaries allocation $ $
  11. 11. Divisive Reorganization: Purification <ul><li>Objective: distribute certain corporate assets (usually cash or investments) to a non-arm’s length corporation </li></ul><ul><li>Principal reasons: </li></ul><ul><ul><li>qualify for QSBCS exemption </li></ul></ul><ul><ul><ul><li>non-active business to be removed to satisfy 50% / 90% tests </li></ul></ul></ul><ul><ul><ul><li>non-working capital and investments will not qualify </li></ul></ul></ul><ul><ul><li>segregate different businesses (or real estate) into separate corporations to facilitate a future sale </li></ul></ul><ul><ul><li>asset protection (creditor proofing) </li></ul></ul><ul><li>Considerations </li></ul><ul><ul><li>trigger the realization of capital gains on disposition of appreciated assets </li></ul></ul><ul><ul><li>ITA 55(2) recharacterization of inter-corporate dividends into proceeds of disposition (or gains) </li></ul></ul>
  12. 12. Divisive Reorganization <ul><li>Tax-free distribution of corporate-owned assets between corporations </li></ul><ul><li>Beware of ITA 55(2) </li></ul><ul><ul><li>complex anti-surplus stripping rule </li></ul></ul><ul><ul><li>prevents tax-free distribution of corporate surplus by way of inter-corporate dividends </li></ul></ul><ul><li>Two categories of reorganizations </li></ul><ul><ul><li>related person reorganizations </li></ul></ul><ul><ul><li>“ butterfly reorganizations (split vs. spin) </li></ul></ul><ul><ul><ul><li>continuity of shareholding </li></ul></ul></ul><ul><ul><ul><li>continuity of business enterprise </li></ul></ul></ul><ul><ul><ul><li>pro rata distribution of each type of asset </li></ul></ul></ul><ul><li>Safe income </li></ul><ul><ul><li>ITA 55(2) not applicable to distributions of tax-paid retained earnings </li></ul></ul>
  13. 13. Divisive Reorganization: Related Person Exemption <ul><li>ITA 55(3)(a): related person reorganization </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>certain FMV transfers to unrelated persons permissible </li></ul></ul><ul><ul><li>siblings deemed to be unrelated </li></ul></ul><ul><li>Since siblings deemed to be unrelated, undertake reorganization while related person (ex. parent) in control </li></ul><ul><ul><li>after control acquired by children, reorganization would be taxable (unless undertake a butterfly distribution) </li></ul></ul>
  14. 14. Example: Related Party “Purification” Reorganization <ul><li>Mrs. X owns 300 common shares of Opco. </li></ul><ul><li>The shares have a nominal cost </li></ul><ul><li>Mrs. X wants to purify Opco to segregate cash and near-cash from its business assets </li></ul>Mrs. X 300 shares Opco business assets ($200,000) cash & near-cash ($100,000)
  15. 15. Example: Related Party Reorganization (cont.) <ul><li>Mrs. X transfers 100 common shares to a newly-formed holding company (Holdco) on a rollover basis </li></ul><ul><li>Shares are then redeemed by Opco for $100,000; cash and near-cash distributed to Holdco as a tax-free inter-corporate dividend </li></ul><ul><li>Subsection 55(2) will not apply because all parties are related </li></ul><ul><li>Cannot undertake as part of a series of transactions that includes a sale to an unrelated person </li></ul>Mrs. X 200 shares Opco business assets ($200,000) cash & near-cash ($100,000) Holdco shares
  16. 16. Butterfly Reorganization <ul><li>ITA 55(3)(b): butterfly reorganization </li></ul><ul><ul><li>e ach shareholder gets proportionate share of each category of assets </li></ul></ul><ul><ul><li>categories: c ash/investments/business assets </li></ul></ul><ul><ul><li>c onsolidated look-through approach </li></ul></ul><ul><ul><li>g ross vs. net </li></ul></ul><ul><li>“ spin” reorganization vs. “split” reorganization </li></ul>
  17. 17. Butterfly Reorganization (cont.) <ul><li>General requirements: </li></ul><ul><ul><li>1. continuity of shareholdings </li></ul></ul><ul><ul><li>2. continuity of assets </li></ul></ul><ul><li>Generally no sale of shares or assets of the distributing corporation or a transferee corporation to an unrelated person as part of same series </li></ul><ul><li>No acquisition of control of distributing corporation as part of same series </li></ul><ul><li>Restrictions on assets that can be acquired by the distributing corporation prior to the distribution (i.e., no stuffing) </li></ul>
  18. 18. Example: Butterfly (Split) <ul><li>Before: </li></ul><ul><li>cash = 100 </li></ul><ul><li>investments = 200 </li></ul><ul><li>business = 200 </li></ul><ul><li>Opco 1, Opco 2 and Opco 3 receive a proportional amount of cash, investments and business assets of Opco </li></ul><ul><li>After: </li></ul>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%
  19. 19. Example: Butterfly (Spin) <ul><li>Before: </li></ul><ul><li>Newco receives a proportional amount of cash (along with Asset 2) </li></ul><ul><li>After: </li></ul>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
  20. 20. Estate Freezes <ul><li>Mitigate against deemed disposition on death and future growth to heirs </li></ul><ul><li>Exchanging common shares for preferred shares </li></ul><ul><li>CRA criteria for preferred “freeze” shares </li></ul><ul><ul><li>redeemable at the option of the holder; </li></ul></ul><ul><ul><li>carry voting rights in respect of matters which pertain to such class of shares; </li></ul></ul><ul><ul><li>first preference on any distribution of assets of the corporation on its liquidations, winding up or dissolutions; </li></ul></ul><ul><ul><li>no restriction on transferability (other than as required by the governing corporate law); and </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><li>Internal freeze </li></ul><ul><ul><li>ITA 51/86 exchange </li></ul></ul><ul><ul><li>ITA 85: crystallization of capital gains exemption or capital losses available </li></ul></ul>
  21. 21. Internal Estate Freeze <ul><li>Patriarch owns common shares of Opco currently worth $5,000,000 (nominal cost) </li></ul><ul><li>Patriarch has adult children who are his sole heirs. </li></ul><ul><li>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 </li></ul><ul><li>Patriarch’s children subscribe for new common shares for nominal amount </li></ul><ul><li>Future growth in Opco will accrue to the children (as the common shareholders) </li></ul>Opco Patriarch Children C/S P/S C/S
  22. 22. External Estate Freezes <ul><li>utilize a holding corporation </li></ul><ul><li>ITA 85 election to be filed </li></ul><ul><li>may be appropriate if Opco has multiple shareholders (some of whom are not freezing) </li></ul><ul><li>may also be utilized as part of a “purification” divisive reorganization (perhaps in contemplation of an eventual share sale in the distant future) </li></ul>Opco heirs freezor Holdco other shareholder C/S 100 C/S 100 C/S P/S
  23. 23. Estate Freeze: Benefits and Risks <ul><li>Benefits </li></ul><ul><ul><li>Proprietary interest to heirs without significant investment </li></ul></ul><ul><ul><li>Reduce probate fees and estate duties </li></ul></ul><ul><ul><li>Income-splitting among family members </li></ul></ul><ul><li>Risks if implemented without a trust </li></ul><ul><ul><li>Relinquish some control </li></ul></ul><ul><ul><li>Freezor’s financial wealth capped </li></ul></ul><ul><ul><li>Possible acceleration of taxable gains if death of heir </li></ul></ul><ul><ul><li>Exposing assets to creditor/marital risks of heirs </li></ul></ul><ul><ul><li>Corporate attribution </li></ul></ul>
  24. 24. Stock Dividend Freeze <ul><li>Opco issues fixed-value preferred shares to holder of common shares (freezor) as a stock dividend </li></ul><ul><ul><li>nominal par value (stated capital) so nominal dividend received by shareholder </li></ul></ul><ul><ul><li>aggregate redemption amount = net asset value of Opco </li></ul></ul><ul><ul><li>Freezor then disposes of common shares to heirs or trust (freezee) </li></ul></ul><ul><li>Advantages: </li></ul><ul><ul><li>manages ITA 74.4(2) corporate attribution </li></ul></ul><ul><ul><li>may abridge 24 month hold period for QSBCS for freezee </li></ul></ul><ul><ul><li>minimize clearance certificate issues for non-resident freezor </li></ul></ul><ul><li>Disadvantages: </li></ul><ul><ul><li>negate application of a price adjustment clause? </li></ul></ul><ul><ul><li>alleviate with follow-up freeze </li></ul></ul>Opco freezor stock dividend common shares
  25. 25. Wasting Freeze <ul><li>Redemption of preferred shares during lifetime </li></ul><ul><ul><li>ITA 84(3): deemed dividend </li></ul></ul><ul><ul><li>Reduce gains which are taxable at death </li></ul></ul><ul><li>Integration of corporate and personal tax </li></ul><ul><ul><li>Active business income in excess of SBD (including recaptured CCA) historically caused disintegration </li></ul></ul><ul><ul><li>New enhanced dividend tax credit to reduce disintegration for “high tax” corporate business income (i.e., eligible dividends) </li></ul></ul><ul><ul><li>Specified investment income/RDTOH </li></ul></ul><ul><ul><ul><li>little net “additional” tax from paying dividend </li></ul></ul></ul><ul><li>Realization of gains when common shares (or underlying corporate property) sold by heirs </li></ul>
  26. 26. 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%
  27. 27. Refreezing <ul><li>Consider if significant post-freeze devaluation of frozen corporation </li></ul><ul><li>Results in benefits accruing move quickly to freezee(s) </li></ul><ul><li>CRA acceptance so long as devaluation not a consequence of distributing corporate assets </li></ul><ul><ul><li>Technical Interpretation #9229905 (June 3, 1997) </li></ul></ul><ul><ul><li>Technical Interpretation #2000-0029115 (Nov. 17, 2000) </li></ul></ul>
  28. 28. Advantages of Discretionary Family Trust <ul><li>Asset management and control </li></ul><ul><li>Multiply capital gains exemptions </li></ul><ul><li>Reversible freeze </li></ul><ul><ul><li>thaw the freeze by distributions back to freezor as beneficiary </li></ul></ul><ul><li>Minimizing value on death </li></ul><ul><ul><li>contrary to CRA views based on Sagl v. Sagl (Ont. Gen. Div., 1997) </li></ul></ul><ul><li>Avoid corporate attribution </li></ul><ul><ul><li>springing beneficiaries (ITA 74.4(4)) </li></ul></ul><ul><li>Insulating assets from matrimonial claims </li></ul><ul><li>Beware of 21 year rule </li></ul><ul><ul><li>ITA 104(4)(b): deemed disposition </li></ul></ul><ul><ul><li>avoid by tax-free “rollover” distribution to Cdn. resident beneficiary </li></ul></ul>
  29. 29. Create Trust 21 Year Distribute property to beneficiaries Year 1 21 Year Rule <ul><li>Discretionary trusts generally deemed to dispose of their assets every 21 </li></ul><ul><li>years for FMV proceeds </li></ul><ul><li>Trigger the realization of any capital gain </li></ul><ul><li>Most common solution is a tax-free capital distribution on the eve of the 21 st </li></ul><ul><li>anniversary </li></ul>Trust
  30. 30. Managing the 21 year rule <ul><li>Share exchanges prior to 21 st anniversary </li></ul><ul><ul><li>exchange trust’s common shares for multiple classes of sprinkling shares </li></ul></ul><ul><ul><li>ITA 51/86: tax-free rollover exchange </li></ul></ul><ul><ul><li>distribute sprinkling shares to multiple beneficiaries </li></ul></ul><ul><ul><li>avoid fixed entitlements in any particular beneficiary </li></ul></ul><ul><li>Redemption-sprinkling preferred shares </li></ul><ul><li>Staggered trust ownership structure </li></ul><ul><ul><li>effectively defer deemed disposition for additional 21 years </li></ul></ul><ul><ul><li>GAAR? </li></ul></ul>
  31. 31. Tax Implications on Death <ul><li>Capital gain for deceased / deemed dividend to estate on redemption </li></ul><ul><li>ITA 164(6) election: avoiding double taxation </li></ul><ul><ul><li>Estate’s Capital loss applied against deceased’s capital gain </li></ul></ul><ul><ul><li>must be done within estate’s first taxation year </li></ul></ul><ul><li>Can delay redemption to three years with alter ego trust, etc. </li></ul>Opco Deceased Shareholder Estate $ transfer on death redeem
  32. 32. Tax Implications on Death (cont.) <ul><li>Compare tax on redemption vs. sale to Holdco </li></ul><ul><ul><li>rather than redeem, estate sells Opco shares to a holding corporation </li></ul></ul><ul><ul><ul><li>no gain on estate </li></ul></ul></ul><ul><ul><li>holding corporation redeems Opco shares </li></ul></ul><ul><ul><ul><li>tax-free inter-corporate dividend </li></ul></ul></ul><ul><ul><li>beware of ITA 84.1 (if Opco shares have “soft” cost) </li></ul></ul><ul><ul><ul><li>overall taxation may be reduced if deceased did not use capital gains exemptions </li></ul></ul></ul>
  33. 33. Tax Implications on Death: Life Insurance on Death <ul><li>ITA 70(5.3): valuing shares at death </li></ul><ul><li>Insurance proceeds added to capital dividend account </li></ul><ul><ul><li>Distribute as tax-free capital dividends </li></ul></ul><ul><ul><li>File election </li></ul></ul><ul><li>ITA 112(3.2): stop-loss rule on redemption </li></ul><ul><ul><li>Grandfathered vs. non-grandfathered policies </li></ul></ul><ul><ul><li>100% vs. 50% capital loss on redemption </li></ul></ul><ul><li>If non-grandfathered policy, maybe sell to heirs rather than redeem </li></ul><ul><ul><li>Trade-off: bump in ACB vs. 50% capital loss </li></ul></ul>