A Canadian Tax Lawyer’s Guide and Case Study
Background tax pipeline planning
A “pipeline map” or “pipeline schedule” are expert terms Canadian tax planning lawyers use to identify a post-mortem tax planning technique. The idea behind the pipeline is to reduce taxes payable on death by having accrued gains on the shares taxed as a capital gain in the estate, rather than a deemed dividend on redemption. Generally, capital gains have privileged tax consequences due to the inclusion rate of ½. This means that only half of the capital gain is considered taxable capital gains. Therefore, the non-taxable portion of the capital gain is fully exempt from tax. On the other hand, dividends, including deemed dividends, are fully taxable.
The 50% tax inclusion rate creates a preference for taxpayers for capital gains. The purpose of tax planning, of course, is to reduce overall tax payable and, if tax planning creating capital gains instead of dividends would reduce taxes, so it may be advisable to employ a pipeline plan technique.
The Base Case: Stock Buyback Without a Pipeline Tax Plan
To understand the benefit of a pipeline plan, it is important to present the alternative – the base case. In the base case, the testator (“T”) dies while owning shares of a company (“Opco”). Assume the fair market value (FMV) of the shares is $100. However, the adjusted cost base (ACB) of the shares as well as the paid-up capital (PUC) of the shares is $0. The adjusted cost base is the amount the buyer paid for the stock. On the other hand, PUC is a calculation that starts with the stated capital. Stated capital is a corporate law term that represents the initial total amount paid to the Company to acquire the outstanding shares.
To take an example, if A pays Yesco $10 for 10 shares of Yesco, then the shares’ CV and ACB will both be $100, or $10 per share. If B comes in and buys 5 shares of A starting at $20, B’s ACB will be $20, but the CV of the shares does not change. This is because the CV represents (usually) the stated capital of the company, or the amount that shareholders actually paid for the company’s treasury shares. To use the same example, if C purchased 10 newly issued shares of Yesco for $20, the total The CV would be $300 ($100 from the purchase of A and $200 from the purchase of C for a total of $300). Since the PUC is an average per share, you would take the total PUC and divide it between the total number of shares: $300 / 20 shares = $15 per share. Even though B has never purchased shares of the company, B’s shares also have a CV of $15 per share.
Using the same example, assume A is the sole shareholder of Yesco. Yesco’s FMV is $100 and CV and ACB are $0. If A were to die, subsection 70(5) of the Income Tax Act (ITA) deems a disposition of all of A’s capital property. Therefore, the shares are deemed to be “sold” at their FMV . Now, instead of A owning the shares, A’s estate owns the shares. Since the estate received them after the tax was paid, the ACB of the estate in the shares is now also $100. However, since no additional funds were paid to the company, the CV remains at $0.
At this point, the Domain has a significant problem. In order to distribute funds, he will have to sell or redeem the shares. If the shares are sold to a third party, no problem arises. However, since Yesco is a small, private company, an investor is unlikely to want to buy the company. Thus, the estate has no choice but to redeem the shares. In accordance with 84(3) of the ITA, the estate must pay a dividend equal to the amount that the redemption ($100) exceeds the PUC ($0) of the shares. As such, the estate must pay taxes on the full value of the dividend. As a result, A paid substantial sums capital gains tax upon death, and A’s estate is liable to pay tax on the dividends paid as a result of the redemption. This is not an optimal scenario because there is double taxation.
Before moving on to the intricacies and benefits of a pipeline plan, it is important to note that there is a caveat to the problem of double taxation. Subsection 164(6) (see our article on the subject) allows the estate to use the redemption proceeds to offset the capital gains of the taxpayer (A). In our example, there is a deemed dividend on the amount that the redemption proceeds ($100) exceed the PUC ($0), = $100. In addition, the redemption also results in a disposition of the shares by the estate for proceeds of disposition equal to the redemption price ($100) less the deemed dividend ($100) = ($0). Now, since there is $100 of ACB in the shares of the estate, the proceeds of disposition ($0) of the ACB of the shares must be reduced to determine if there is a potential capital gain or loss. Here, there is a capital loss of $100 for the estate. Subsection 164(6) allows the estate to use this loss to offset the taxpayer’s initial capital gain. Therefore, Taxpayer A does not incur a capital gain, but the estate incurs tax on the deemed dividend.
Unfortunately, although there is a reduction in tax resulting from capital gains, the result is paying tax on dividends when it is possible to pay capital gains instead. A pipeline plan is a tool used to avoid paying tax on dividends and instead pay capital gains tax.
Using the Pipeline: A Case Study
At its core, the pipeline contains a simple strategy: pay taxes on capital gains rather than dividends. After the deemed disposition 70(5) due to the death of A, the shares are held by the estate. Since A has paid taxes on the accrued gains, the estate acquires the shares with an increase in cost base up to the amount of tax paid. In our example, A would have a $100 capital gain or a $50 taxable capital gain. Similarly, since the gain has been paid, the estate will acquire the shares with an ACB of $100. However, the paid-up capital remains at $0, because the shares were not purchased from the company and there was no capitalization (the shareholder providing the funds is an asset of the company).
At this point, the base case, treasury stock method would redeem the shares and thus result in a dividend. The pipeline plan, however, works as follows:
- A new company, Holdco, is incorporated. Usually, Holdco has a face value, such as $1. This means that the CV and ACB of Holdco shares are also nominal. Suppose there is 1 share for FMV, ACB and CV of $1.
- Yesco shares are sold to Holdco in exchange for a promissory note. It is important to value the promissory note equal to the value of the shares. Otherwise, there may be tax consequences such as a shareholder benefit, which is taxable.
- Yesco declares a dividend and distributes the dividend to Holdco. Since intercorporate dividends (a dividend between corporations) are generally tax-free, no tax is paid on the dividend passed from Yesco to Holdco.
- Holdco uses the dividend to repay the promissory note to the estate.
The result is that the funds were withdrawn from Yesco to the estate (through Holdco) and the promissory note was redeemed. Although Holdco and Yesco exist, they have minimal value because the money was taken from the estate.
The result is that the value of the Yesco operating business was taken from the estate without paying tax on the dividend. Instead, the only tax paid results from the deemed disposition as a result of the taxpayer’s death. Because of the inclusion rate, it is likely that A’s and A’s estate reduced their respective tax bills by a significant amount, justifying the use of the pipeline.
David J Rotfleisch, CPA, JD is the founding tax attorney of Taxpage.com and Rotfleisch & Samulovitch PC, a Toronto-based business tax law firm and is a Certified Tax Specialist who completed CICA’s in-depth tax planning. Classes. He appears regularly in print, on radio and television and on blogs extensively.
With over 30 years of experience as a lawyer and chartered professional accountant, he has assisted start-ups, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning. , testamentary and succession, voluntary disclosures and taxation. dispute resolution, including tax audit representation and tax litigation. Visit www.taxpage.com and email David at [email protected] Read it original article on Mondak. Photo David Rotfleisch courtesy Rotfleisch & Samulovitch PC