Wasting Freezes Now Less Attractive in Ontario
Canadian Tax Foundation, Jesse Brodlieb
Increases to Ontario tax rates have made it less attractive in some estate freeze situations to withdraw corporate value through share redemptions (rather than on death, as a capital gain).
In a typical estate freeze, the holder of a private corporation's common shares (the freezor) exchanges the shares on a tax-deferred basis for non-participating, redeemable, retractable preferred shares of the corporation having a redemption amount equal to the FMV of the common shares immediately before the exchange (the freeze shares). New participating shares (the growth shares) are then subscribed for by the freezor's children, for example.
Although the corporation will usually have the ability to pay dividends on the freeze shares, in many cases it will redeem that portion of the freezor's freeze shares in any given year so that the freezor's lifestyle can be maintained, subject to the company's own cash requirements. In this way, as the years go by, the freezor slowly reduces ("wastes") his or her interest in the company, resulting in less (or, ideally, no) tax arising under subsection 70(5) on his or her death because the freeze shares will have been fully redeemed. In the case of a company that is a CCPC earning investment income, such a wasting freeze has for the last several years been accretive to the overall family asset base, since the dividend refund to the corporation under subsection 129(1) would, in many cases, exceed the personal income tax owed by the shareholder on the deemed dividend arising as the result of the redemption of the freeze shares.
In 2011, before the imposition of the "high earner" surtax in Ontario, the tax on a taxable dividend other than an eligible dividend at the highest marginal rate applicable to an individual was 32.57 percent. Accordingly, the family as a whole would have been better off redeeming the frozen shares, since an amount equal to 33.33 percent of the dividend would have been refunded to the company (assuming that the company had investment income earning RDTOH).
However, changes in the tax rates may have changed the assumptions underlying the classic wasting freeze. For a taxpayer in Ontario who pays tax at the highest marginal rate for 2013 (that is, a person earning more than $509,000 in income), the tax on the deemed dividend arising on a redemption of the freeze shares will be 36.57 percent, whereas the corporation will receive a dividend refund of only 33.33 percent. The situation for 2014 is even worse: the combined federal-Ontario personal tax rate on non-eligible dividends for taxpayers who are in the second-highest bracket (those who earn between approximately $137,000 and $518,000 in taxable income) will be 34.9 percent, putting a number of additional taxpayers (not just the so-called high earners) into a position where the tax on the dividend exceeds the refund to the corporation. For those who pay tax at the highest marginal rate, the rate will be 38.6 percent, more than 5 percent more than the corporation will receive as a refund.
Accordingly, there is now material leakage associated with redeeming freeze shares in this way. Although each family's situation is unique, it may make sense in certain cases not to waste the freeze and pay tax on the capital gain arising upon the death of the freezor. Of course, the freezor will still need income to fund personal expenses, and a mix of salary and dividends may need to be considered.
Dentons Canada LLP, Toronto
This article appeared on the Canadian Tax Foundation website. It is reprinted with permission.
Read the full article here.
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.