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Chris Falk Stefanie Morand <strong>McCarthy</strong> Tétrault LLP How and When Capital Loss Carry-Back Planning and Pipeline Planning are Used As noted above, capital loss carry-back planning typically involves the winding-up of the corporation owned by the estate and/or a redemption of all or some portion of the estate’s shares therein, within the first taxation year of the estate. In effect, pursuant to the provisions of subsection 164(6), the capital gain realized on the deceased’s death can be offset wholly or in part by a capital loss triggered in the estate’s first taxation year on the winding-up or redemption. The winding-up or redemption will generally trigger corporate level tax on the disposition of assets and deemed dividends to the shareholders; however, where such dividends can be paid on a tax-efficient basis (e.g., paying capital dividends out of the corporation’s capital dividend account or paying dividends that give rise to a dividend refund to the corporation), capital loss carry-back planning is frequently beneficial. If dividends cannot be paid on a tax-efficient basis, a pipeline strategy may be more effective, particularly if the corporation in question has cash or other assets with nominal gains. 15 Pipelines may be particularly attractive in Ontario where there is a very substantial difference between the highest marginal rate applicable to an individual on capital gains (i.e., 23.99%, given the 50% inclusion rate on capital gains and the top marginal rate of 47.97%) and on 16, 17 dividends that are not eligible dividends (i.e., 34.52%). In concept, pipeline planning preserves the capital gain on death while permitting assets of the corporation to be effectively distributed to the ultimate shareholder without adverse tax consequences to the shareholder. The planning may be illustrated by way of a simple example: 18 • Mr. X dies owning all of the shares of a private corporation, XCo. • The shares of XCo were held by Mr. X as capital property for purposes of the Act and had an ACB to Mr. X of $100,000 and an FMV immediately prior to Mr. X’s death of $1,000,000. Accordingly, the deemed disposition of the XCo shares would give rise to a $900,000 capital gain in Mr. X’s terminal year (assuming no rollover to Mr. X’s spouse or to a spouse trust). • To create a “pipeline”, Mr. X’s estate would incorporate a new corporation, Newco, for nominal consideration. The estate would sell the shares of XCo to Newco for $1,000,000 (assuming no accrued gain or loss in the estate since Mr. X’s death). 19 The 15 16 17 18 19 Pipeline planning may also be more effective where a “bump” can be used to increase the ACB of nondepreciable capital assets. See note 14, above. The highest marginal rate on eligible dividends is 31.69% in Ontario for 2012. These rates include the 2% surtax on income above $500,000. Prior to the introduction of the 2% surtax, the highest marginal rates in Ontario were 46.41% on interest and regular income, 23.21% on capital gains (given the 50% inclusion rate), 29.54% on eligible dividends and 32.57% on non-eligible dividends. These rates continue to apply for income over $132,406 up to $500,000. Private corporations that are or were formerly carrying on business and that have significant retained earnings (that did not give rise to capital dividends or to refundable tax) are often corporations in respect of which pipeline planning can be attractive. In this example, XCo and Newco are assumed to be taxable Canadian corporations as defined in subsections 248(1) and 89(1). A section 85 rollover could, of course, be used if there were an accrued gain in the hands of the estate. 560600/422632 MT DOCS 11864055v1G 4
Chris Falk Stefanie Morand <strong>McCarthy</strong> Tétrault LLP sale proceeds payable by Newco would be a non-interest bearing demand promissory note payable by Newco in the amount of $1,000,000. 20 • XCo would be wound-up into Newco on a tax-deferred basis. 21 • Newco would use cash-on-hand (or other assets with only nominal gains) to repay all or part of the promissory note held by the estate. But for recent comments from the CRA suggesting that such a transaction might trigger a deemed dividend to the estate, tax practitioners had generally understood that the estate would receive proceeds on the promissory note on a tax-free basis given that the promissory note would have an ACB to the estate equal to its face amount. CRA’s Position Regarding Pipelines Concern that the CRA might take the position that a basic pipeline such as that described above could give rise to a deemed dividend to the estate pursuant to subsection 84(2) was raised in a CRA Round Table at the 2009 APFF Conference. 22 In the Round Table, the CRA did not take the position that subsection 84(2) applied in the example considered but, rather, declined to comment on the possible application of subsection 84(2) in the absence of more detailed facts than had been provided. The example considered in the Round Table assumed that a taxpayer, immediately prior to death, owned all of the shares of a taxable Canadian corporation, ACo, which had an FMV of $100,000 and an ACB of $100. ACo was assumed to have cash of $100,000, no liabilities, $100 in capital stock and $99,900 in retained earnings. Given the lower rates applicable to capital gains, it was proposed to use a pipeline in which the shares of ACo would be sold to a new taxable Canadian corporation, BCo, incorporated by the estate, for a non-interest bearing demand note in the amount of $100,000. Thereafter, ACo would be wound up into BCo, BCo would repay the $100,000 note payable to the estate and BCo would be dissolved. The pipeline transactions were intended to result in the estate acquiring the $100,000 subject only to tax on the capital gain on the ACo shares in the hands of the deceased taxpayer, as opposed to the estate receiving and being taxable upon a $99,900 deemed dividend if capital loss carry-back planning had instead been undertaken by way of a simple winding up of ACo into the estate pursuant to subsection 88(2). 23 20 21 22 23 This example assumes that the $1,000,000 ACB to the estate is “hard ACB” for purposes of section 84.1 (i.e., generally ACB not derived from pre-1972 gains or through the use of the capital gains exemption (subsection 84.1(2))). Instead of a promissory note, Newco could issue redeemable, retractable preferred shares with a redemption amount and stated capital of $1,000,000. Alternatively, an amalgamation such as a short-form vertical amalgamation under section 87 could be undertaken. CRA Document No. 2009-0326961C6, dated October 9, 2009. Simplified, if ACo were wound up into the estate, assuming that the shares of ACo had PUC for purposes of the Act of $100, subsection 84(3) would deem the estate to have received a dividend of $99,900 (i.e., the $100,000 paid less the $100 PUC). This deemed dividend would be excluded from the estate’s proceeds of disposition pursuant to the provisions of section 54 and, accordingly, the estate would have a capital loss of $99,900 given 560600/422632 MT DOCS 11864055v1G 5
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