A sound tax-saving strategy for high net-worth clients
by Kevin Wark and Glenn Stephens, November/December 2010
Many high net-worth Canadians have holding companies with significant assets such as shares of private corporations, publicly traded securities and real estate. In these circumstances, there is the possibility of double taxation. First, the individual may be subject to tax on a disposition of the holding company (Holdco) shares, either on death or on an actual sale of the shares. Second, the Holdco itself may be taxable on a sale of its assets. Fortunately, there is a strategy commonly known as “pipeline planning,” which may be used after the shareholder’s death to eliminate one layer of tax.
The pipeline strategy can be best illustrated using the following example:
- Arnie, a Canadian resident who recently died, owned Holdco shares with a fair market value of $6 million and an adjusted cost base (ACB) of $2 million.
- Holdco’s assets consist of a portfolio of publicly traded securities, which we will also assume have a fair market value of $6 million and an ACB of $2 million.
- Arnie was not married and therefore had a deemed disposition of his Holdco shares on death, with tax consequences that will be addressed below.
Arnie has three adult children who are sharing equally in his estate. They do not wish to continue to hold the securities in Holdco after Arnie’s death, as this would require them to make group decisions regarding such matters as investment policy and the payment of dividends by Holdco. It would also restrict each child’s ability to do his or her own estate planning. The estate is therefore considering selling the securities, after which Holdco would be wound up and the after-tax sale proceeds distributed for the benefit of the children.
Taxation on Death
As mentioned, Arnie’s death would cause a deemed disposition of his Holdco shares for their fair market value of $6 million. Since the ACB of the shares is $2 million, Arnie will realize a $4 million capital gain in his final tax return, with a tax liability in the range of $900,000. Arnie’s estate would acquire the shares at an ACB of $6 million.
At this point, Holdco could liquidate its assets and distribute the cash to Arnie’s estate and/or distribute assets in specie, after which his children could each take a one-third share. The sale or transfer of the investments, however, would generate capital gains at the Holdco level and result in more tax payable within Arnie’s estate. This would create the double taxation problem referenced above.
In order to avoid this additional tax, the following transactions could be implemented:
- The estate would incorporate a new company (Newco), subscribing for shares at a nominal subscription price.
- The estate would then transfer its Holdco shares to Newco for their fair market value of $6 million (ignoring possible changes in the market value of the investments after Arnie’s death). The purchase price would be paid using a $6 million promissory note issued to the estate by Newco. This would be reflected on Newco’s books as a loan owing to a shareholder. There would be no capital gain or loss to the estate on the transfer of the Holdco shares to Newco as the purchase price/fair market value would equal the ACB of the shares.
- Following the above transaction, Newco would own 100 per cent of the Holdco shares. Immediately thereafter, however, Holdco and Newco would be amalgamated to form Amalco. (A similar result could also be achieved by having Holdco wound up into Newco.)
Amalco would now own all the investments originally owned by Holdco, and would assume Newco’s obligations under the $6 million promissory note. In conjunction with the amalgamation, the Income Tax Act permits the ACB of the investment assets to be “bumped” from $2 million to $6 million without tax cost. This increase in the ACB of the investment portfolio eliminates the double taxation.
Amalco’s investments can now be distributed to the estate without further tax. Any distributions to the estate would be treated as a tax-free payment against the amount owed by Amalco to the estate. A number of securities can be sold in order to generate the $900,000 needed to pay Arnie’s tax bill. These sales would not result in any tax, regardless of ongoing market fluctuations. The balance of the assets ($5.1 million) can be distributed to Arnie’s three children as beneficiaries of the estate without further tax cost.
Life insurance is often the most cost-effective means of funding tax liability arising on death. In Arnie’s case, the availability of life insurance might have made the sale of some of the investment assets in order to pay his tax liability unnecessary. Although the pipeline strategy makes the sale of the securities tax-effective, the forced sale of the assets after Arnie’s death may not be desirable because of market conditions.
Perhaps the most effective use of life insurance in cases like Arnie’s is to have Holdco as owner and beneficiary of the policy. Insurance proceeds received by Holdco (net of the policy’s ACB) would be credited to Holdco’s capital dividend account (CDA). The availability of the CDA, which allows for the payment of tax-free dividends, provides even more opportunities for tax savings.
Kevin Wark, LLB, CLU, TEP, is the senior vice-president, business development, at PPI Financial. Glenn Stephens, LLB, is a planning services consultant with PPI Financial.
This article was published in the November/December 2010 issue of FORUM magazine. Posted with permission from the Financial Advisors Association of Canada (Advocis).
These resources are provided for reference only and do not necessarily represent the opinions of Guilfoyle Financial Inc. Please consult your own tax and legal advisors.