On a number of occasions, I have stated that a good estate freeze structure should stand the test of time.  However, there has been such a flurry of new developments pertaining to estate freezes in recent weeks that some of these structures will be lucky to last a few weeks, let alone years into the future.  

The three items I will discuss all relate to situations where there is a share sale of a frozen company.  My comments on the first two developments will be fairly brief, as an article on them by Michael Goldberg, my tax partner at Minden Gross, appears in the latest issue of The Estate Planner[1] - and was more recently summarized in the National Post[2].  But there are a few things I would like to stress. 

BR #23 – Capital Gains Splitting with Minors 

The first development, Budget Resolution #23 of the March Federal Budget, seems to be a wide-ranging attack on capital gains splitting with minors.  Briefly, the proposal results in deemed (non-eligible) dividend status for would-be capital gains from a disposition of shares of a corporation by a minor[3], if part of a series of transactions that includes the acquisition of such shares by a non-arm’s length person. The provision applies if the minor would be subject to tax on split income (i.e., the “kiddie tax”) in respect of dividends paid on such shares - included are shares of a private corporation.  The kiddie tax applies to the deemed dividend, so that it is taxed at top marginal rates.[4]  

Not only does it appear that a standard estate freeze would be caught by these rules, but one may even get the impression that the wording of BR #23 itself is focused on these structures:  This can be seen by remembering that, by virtue of paragraph 251(1)(b) of the Income Tax Act, a beneficiary of a trust is deemed not to deal at non-arm’s length with it.  Thus, in a standard freeze structure, the growth shares would be acquired by a person – i.e., the family trust - who is not at arm’s length with a minor.  Furthermore, BR #23 appears to catch freezes implemented prior to the Budget date (March 22nd), provided that the sale takes place on or after the Budget and the sale is part of the same series as the implementation of the freeze itself.

The commentary on this resolution on page 265 of the Budget papers (as opposed to the resolution itself) suggests that the proposal would apply to a more restricted situation: a “disposition of shares to a person who does not deal at arm’s length with the minor”.  An example would include where a trust owned shares in an Opco and it is desired to crystallize the exemption of beneficiaries who are minors by a sale to a parent.[5]  Looking to the wording of the resolution, this situation would indeed be caught by the proposal, but the resolution itself has a wider scope.  

Happily, only sales by minors are specifically caught by BR #23.  If a freeze structure was put in place when beneficiaries were minors and capital gains on a subsequent sale are allocated to a person who is 18 or over in the year, the Budget resolution would not apply.  But the bad news is that another new development may: 

APFF Question 34 – Family Trusts and the Capital Gains Exemption 

In Question 34 of the 2010 APFF Round Table, the CRA was asked to comment on situations in which family trusts are misused and could attract the general anti-avoidance rule.  Not surprisingly, the CRA identified sequestering capital gains offshore and inter-provincial tax planning as abusive[6].  However, it appears that the CRA also finds the multiplication of the capital gains deduction to be abusive.  More specifically, where in the context of a disposition of a taxpayer’s shares, a structure comprising a family trust and participation of accommodating parties[7] is put in place with the goal of avoiding tax on capital gains resulting from the disposition of the shares through the utilization of the capital gains deduction, the CRA would view the structure as abusive.  The CRA gives no guidance as to whether there are situations in which any degree of capital gains multiplication in respect of a family trust would be acceptable, nor did the CRA confine its remarks to minors claiming the exemption. 

For both of the foregoing, the issue is exactly when a freeze structure that turns into a sale will be caught.  For BR #23 to apply, the sale must be part of the same series of transactions as the implementation of the freeze. Of course, whether or not this is the case is debatable and largely fact dependent, although the Supreme Court’s judgment in Copthorne Holdings will hopefully shed light on this issue when it is released.[8]  Trouble is, if the proposal does apply, there is a downside vis-à-vis capital gains status.  Apart from the possibility of losing the capital gains exemption, the effect of the resolution is to impose tax on the basis of a non-eligible dividend subject to the kiddie tax, which will attract a higher tax rate than even a non-exempt capital gain.[9]  In respect of APFF #34, the CRA seems to say[10] that GAAR may apply if the structure is put in place to avoid tax on capital gains.  

Undervalued Freeze Shares and the Reversionary Trust Rules  

The latest salvo is a CRA Headquarters letter to the Aggressive Tax Planning Audit Section in Calgary.[11]  While the letter is not specific, it may well be the case that it pertains to a freeze into an Alberta trust.  It seems that the value of the freeze shares was set at a lower amount than a formal valuation report.  Because of this, the CRA indicated that the reversionary trust rules in subsection 75(2) would apply to the arrangement, so that the capital gain would be taxable to the freezor rather than the trust.  The CRA’s rationale is that there had been a transfer of property to the trust[12] by virtue of the undervaluation; therefore, the reversionary trust rules are engaged, since the individual is a beneficiary of the trust[13] and is also the sole trustee[14]. 

The CRA’s reasoning is largely based on the Garron case[15], involving an offshore freeze structure where the growth shares were held by holding companies which were in turn held by Barbados trusts.  The Federal Court of Appeal indicated that the undervaluation of the freeze shares resulted in an acquisition of property by the trusts from the Canadian holders of the freeze shares, so as to trigger the offshore trust rules in paragraph 94(1)(b) of the Act.  Also analogous to Garron, the CRA document indicates that the existence of a price adjustment clause in the share purchase agreement would not be of assistance because “at no time were the original proceeds represented by the freeze shares adjusted pursuant to it.”[16]

Because of the effect of the reversionary trust rules, the result of the CRA document would appear to have an effect which is presumably similar to APFF 34: the capital gain from the sale of shares would be taxed in the hands of the freezor, rather than the trust - although one may question the correctness of the CRA’s views[17].  

What I find interesting is that the CRA seems to be quite willing (eager?) to expand the indirect transfer of property concept in the Garron case beyond the realm of offshore trusts.   In this context, I might also mention that the CRA appears to have become enamoured with the sham doctrine, as espoused by the Federal Court of Appeal in the Antle offshore trust case[18] (the actual holding of the case was that the trust in question was not validly constituted[19]).  In addition to more well-known recent cases involving this doctrine[20], in J.R. Saint & Associates Insurance Agencies Limited v. MNR[21], the CRA successfully attacked the exclusion of EI and CPP from EPSP contributions in respect of arm's length employees on the basis that the EPSP itself was a sham.[22].

It is becoming more and more apparent that the CRA will be motivated to apply such doctrines to what it considers to be aggressive tax planning, be it international or domestic.  This now appears to encompass the use of a family trust for multiplication of the capital gains exemption (at least).  Therefore, even structures that manage to survive BR #23 could be in jeopardy of a challenge based on such anti-avoidance doctrines.

David Louis, tax partner, Minden Gross LLP, a member of MERITAS law firms worldwide. David's practice focuses on tax and estate planning for entrepreneurs and their corporations (dlouis@mindengross.com).