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Tax Notes/Estate Planner - October

Succession Planning - Intergenerational Cash-Outs

 

Note: This article is adapted from the soon-to-be-published third edition of Tax and Family Business Succession Planning, by David Louis, Samantha Prasad and new co-author Michael Goldberg[1] (CCH Canadian Limited).

 

While the cornerstone of family business succession planning is the estate freeze[2], in some cases, it may be desired that the founder of the business be paid for his or her interest, within a freeze structure (usually by liquidating the freeze shares) or otherwise.  If so, there are special opportunities to defer tax on an intergenerational cash-out within a family, which are not available in respect of third-party sales.

 

10-Year Reserve for Intergenerational QSBC Share Transfer[3]

Per subsection 40(1.1) of the Act, the normal five-year reserve is extended to ten years, where qualifying small business corporation shares are transferred to a Canadian-resident child or grandchild,[4] so that the minimum rate of recognition of the gain is 10% per year.[5] (Qualifying small business corporation shares are discussed in Chapter 4 — these are shares which are eligible for the $750,000 capital gains exemption, and generally include freeze shares.)

To qualify for the 10-year reserve, the transferee of the shares must be the child or grandchild.  This appears to rule out a transfer of a qualifying corporation by a taxpayer’s holding company or other indirect transfer. Likewise, it appears that the intergenerational transfer would not be available to a spouse, alter ego or joint partner trust.  However, if shares were left outright to a spouse or common law partner (or an encroachment consisting of the shares were made from the aforementioned trusts), the reserve would be available if the surviving spouse effected an otherwise-qualifying intergenerational transfer.   Also, there is no provision for a transfer to a trust in favour of such individuals, or to a holding company. However, since there is no holding period requirement, there appears to be no reason why the child or grandchild could not roll the shares into a holding company (in fact, this may be advantageous — see below).

 

The reserve on the unrecognized gain will be taxed on death,[6] but effectively can be ‘‘rolled over’’ to a surviving spouse or qualifying spouse trust.[7] While claiming the subsection 40(1.1) reserve will, of course, accelerate tax, the provision can nevertheless be quite useful in the right circumstances. One example, of course, is where ‘‘the business deal’’ is that there be an inter-vivos sale of shares to a child or grandchild. It should also be noted that, notwithstanding the reserve, the transferee would presumably obtain a full cost base in the shares. Unless a reserve was claimed in connection with a capital gains exemption claim,[8] the ability to use the cost base to access the corporation’s assets on a tax-efficient basis will not be blocked by section 84.1. Therefore, it appears that (subject to possible GAAR considerations) the transferee could use the increased cost base to access corporate‑level assets on a tax-efficient basis, e.g., by transferring his or her shares to a Holdco.[9]

Finally, it should not be forgotten that qualifying small business corporation shares may also qualify for the $750,000 lifetime capital gains exemption, which can be used in combination with the 10-year reserve discussed above.

Inter-Generational Corporate Cash Out[10]

Another tax-effective way for the Freezor to exit from the operating structure could involve Freezor transferring his or her frozen Opco shares to a Holdco on a tax-deferred basis and then causing Opco to redeem the frozen shares held by Holdco.  This planning would permit Holdco to invest the redemption proceeds in such manner as Freezor desired without leaving the assets subject to creditors of Opco. Provided that the frozen corporate group is comprised solely of related persons[11] inter-corporate redemptions will generate deemed dividends, which should not be subject to recharacterization as capital gains under subsection 55(2)[12].  Also, although it may be possible to redeem all of the Freezor’s shares from the outset of the transaction, for corporate reasons[13] this may not be practical and, in addition, without careful planning, in some situations a full inter-corporate redemption may reduce the effectiveness of pre and post-mortem planning strategies intended to enable Freezor to minimize his or her death taxes.[14]

Rather than roll all of the freeze shares into a Holdco, one obvious variation is to retain sufficient freeze shares to utilize Freezor’s capital gains exemption through an inter-vivos sale, or on death. 

Special Opportunities from Eligible Dividends[15]. 

 

Where Opco has generated GRIP, the benefits may be enhanced by designating the deemed dividend as an eligible dividend out of GRIP, so that future dividends from Holdco to Freezor may qualify for lower tax rates.  (It should be noted that the combined corporate/personal tax when income is taxed at full corporate tax rates and distributed as an eligible dividend is generally more or less equal to the tax that would be incurred had the income been earned directly by an individual, so this process will ultimately be largely tax-efficient.  But until earnings are distributed to the individual shareholder as eligible dividends, there will be a significant element of tax deferral, so that the foregoing arrangement is quite beneficial where Freezor is cashing out.)

Of course, the ability of Freezor to cash out on a tax-efficient basis could be important if there are special cash requirements resultant from disability.  In this and other cases where subsection 55(2) has not applied, the proceeds of the inter-corporate redemption will presumably be invested at the Holdco level, so as to preserve the deferral.  The investment income may well generate RDTOH, with the earnings periodically distributed to fund personal and living expenses.  In this case, the availability of GRIP – i.e., which may be resultant from the deemed dividend from the intercorporate redemptions between Opco and Holdco - will enable the dividend from Holdco to trigger a dividend refund, yet still maintain its status as an eligible dividend[16]. 

 

Tax and Family Business Succession Planning, 3rd Edition, may be ordered on the CCH website at www.cch.ca, or by Googling “Tax and Family Business Succession Planning”.