When a person dies, they are deemed to dispose of most of their capital properties at fair market value. This deemed disposition may trigger capital gains or losses, depending on the tax cost of the properties relative to their current fair market value.
The person who acquires the property as a result of the person’s death, which can include the deceased’s estate, acquires the property at a tax cost equal to that fair market value. (However, if the deceased’s spouse or common-law partner inherits the property, a tax-free rollover is available.)
As a result, there is normally no double taxation in respect of any accrued gains on the property. For example, if the estate sells the property, it will have a stepped-up tax cost so that there will be no further capital gain, except to the extent that the property has increased in value since the time of death.
However, a potential double tax problem can occur where the property is shares in a corporation, and where the corporation’s cash or other assets are subsequently distributed to the estate. In this case, there may be a deemed capital gain for the deceased, and a subsequent deemed dividend for the estate.
Fortunately, there are some ways to avoid this double tax problem.
First, there is a rule in the Income Tax Act that allows an estate’s capital losses in its first taxation year to be carried back to the deceased’s final taxation year. Those capital losses can be used to offset the deceased’s capital gains at death that arose under the deemed disposition rule.
Example 1
X died, owning all the shares in a corporation “Xco”. X’s adjusted cost base of the shares was $1,000, the paid-up capital of the shares was $1,000, and their fair market value at the time of death was $500,000. (The paid-up capital of the shares, which involves a fairly technical calculation, generally reflects the after-tax capital that was originally used to acquire the shares.)
X will have a deemed disposition of the shares for proceeds of $500,000, which will result in a capital gain of $499,000 ($500,000 proceeds minus the $1,000 adjusted cost base). One-half of that gain will be included in X’s income as a taxable capital gain. The capital gains exemption does not apply.
In the estate’s first taxation year, Xco distributes $500,000 to the estate upon the redemption of the shares. The estate will have a deemed dividend of $499,000 ($500,000 minus the $1,000 paid-up capital of the shares). However, under the share redemption rules in the Income Tax Act, the estate will have a corresponding capital loss of $499,000, which can be carried back to X’s final year to offset the capital gain in the year of death.
Result: The estate is taxed on the deemed dividend of $499,000, but X has a net capital gain of zero so that there is no double taxation.
Although this strategy is normally effective, it comes with at least a couple of potential issues.
First, if the deemed dividend is sufficiently large, as in the above example, the tax on the dividend for the estate will normally be greater than the tax on the deemed capital gain at death that would otherwise be payable for the deceased. If so, although double taxation is avoided, the procedure comes with some additional tax cost.
Second, if Xco has assets with accrued gains, and those assets are distributed to the estate as part of the dividend, Xco may be subject to tax on those accrued gains. As well, the estate will be subject to tax on the dividend. Although there is a mechanism that may reduce Xco’s tax when it pays the deemed dividend (using a corporation’s so-called the corporation’s “refundable dividend tax on hand”), the mechanism does not always completely alleviate the potential double tax problem.
If the foregoing issues are problematic, a “pipeline” and / or “bump-up” strategy can be employed.
Under the pipeline strategy, the estate incorporates a new corporation (“Newco”) and transfers the Xco shares to Newco on a tax-free basis, assuming the value of the Xco shares has not increased since the death. But even if the Xco shares have increased in value, a tax-free transfer can be implemented using a “section 85 election”. The estate would receive at least one share in Newco and a promissory note reflecting the value of the shares.
Next, there are a couple of options.
First, to the extent Xco’s assets have a high tax cost (or are cash), it can distribute those assets to Newco as a tax-free inter-corporate dividend. Since the assets have a high tax cost (little accrued capital gain), Xco should pay little or no tax on the payment of the dividend. Newco will then use the assets to pay off the promissory note to the estate, which should result in no further tax.
Example 2 (regular pipeline)
Assume the same facts as Example 1. The assets in Xco have a high tax cost and/or consist of cash. The estate incorporates Newco and transfers its shares in Xco to Newco, taking back consideration consisting of one common share and a promissory note for $500,000.
Xco distributes its assets, including the cash, to Newco as a tax-free inter-corporate dividend. Newco pays off the $500,000 promissory note by distributing the assets to the estate. Little or no further tax should be payable. The only significant tax that may be payable by X, the deceased, is in respect of the capital gains resulting in the year of death.
Alternatively, if the assets in Xco have a low tax cost relative to their fair market value, and therefore have significant accrued gains, Xco could be wound up into Newco or amalgamated with Newco. This can be done on a tax-free basis. Furthermore, under a special rule in the Income Tax Act, the tax cost of Xco’s non-depreciable properties can often be “bumped up” to their fair market value (this is a very general description, as there are various technical issues to be considered). Then, when the properties are distributed to the estate for the payment of the promissory note, Newco should incur little or no tax. The estate also should incur no tax on that payment. Unfortunately, the bump-up does not apply to depreciable properties, so that if their fair market value exceeds their tax cost, there may be some tax payable on their distribution.
Example 3 (pipeline with bump-up)
Assume the same facts as in Example 1, except in this case the non-depreciable assets in Xco have a low tax cost and therefore have accrued gains. As with Example 2, the estate incorporates Newco and transfers its shares in Xco to Newco, taking back consideration consisting of one common share and a promissory note for $500,000.
After some time, Xco is wound up into, or amalgamated with, Newco. Under the special rule discussed above, the tax costs of the assets of Xco will normally be bumped up to their fair market value (although there may be some limitations). Then, Newco pays off the $500,000 promissory note by distributing the assets to the estate. As with Example 2, little or no further tax should be payable.
The Potential Problem
The potential problem involves subsection 84(2) of the Income Tax Act, which may apply to pipeline strategies. Under this provision, where funds or property of a corporation have been distributed to or for the benefit of a shareholder of the corporation on the winding up, discontinuance, or reorganization of its business, there is a deemed dividend for the shareholder, generally equal to the value of the funds or property in excess of the amount that the paid-up capital of the shares is reduced on the distribution. If the provision applies, the estate in the pipeline examples might be subject to tax on a deemed dividend.
The Canada Revenue Agency (CRA) has issued favourable rulings or opinions on pipeline transactions, but they generally require at least a 12-month wait period before the funds or assets are distributed to the estate. The CRA has stated:
“…in the context of certain post-mortem pipeline strategies, some of the additional facts and circumstances that in our view could lead to the application of subsection 84(2) and warrant dividend treatment could include the following elements:
The funds or property of the original corporation [Xco in the above examples] would be distributed to the estate in a short time frame following the death of the testator.
The nature of the underlying assets of the original corporation would be cash and the original corporation would have no activities or business (“cash corporation”).
Where such circumstances exist, resulting in the application of subsection 84(2) and dividend treatment on the distribution to the estate, we believe that double taxation at the shareholder level could still be mitigated with the implementation of the subsection 164(6) capital loss carryback strategy [that used in Example 1 above], provided the conditions of the provision would apply in the particular facts and circumstance.
Accordingly, in cases where we have issued favourable rulings [on pipelines strategies], the particular taxpayer’s facts and proposed transactions, amongst other things, did not involve a cash corporation and contemplated a continuation of the particular business for a period of at least one year following which a progressive distribution of the corporation’s assets would occur over a period of time. Consequently, one or more of the conditions in subsection 84(2) were not met.” (emphasis added)
Although the CRA’s views are not binding law, it is usually prudent to follow their guidelines to avoid potential assessments and tax litigation.