Estate planning - corporations

Post-mortem
planning using
life insurance
Presented by:
Patrick E. Uzan, BA, CA, TEP
National Estate and Tax Planning Consultant
Prairie Regional Marketing Centre

Important information
The information provided is based on current tax legislation
and interpretations for Canadian residents and is accurate to
the best of our knowledge as of the date of publication. Future
changes to tax legislation and interpretations may affect this
information. This information is general in nature, and is not
intended to be legal or tax advice. For specific situations, you
should consult the appropriate legal, accounting or tax advisor.
Information for advisors. This material is not intended for use
with clients.
January, 2013

Objective
To gain a better understanding of how
corporately held life insurance can be
used by the estate of a shareholder
as a tax-minimization tool.

Some concepts to understand
• ACB - Adjusted cost base (as it applies to shares):
generally, the cost of acquiring the shares
• Looked at from the point of view of the current owner of
the shares
• PUC - Paid up capital: generally, the price or value at which
the shares were subscribed for
• Looked at from the point of view of the corporation

Example: ACB and PUC
• Mr. A forms a new corporation and subscribes for
common shares at a subscription price of $10
• Mr. A holds shares with an ACB and PUC of $10
• Twenty years later, Mr. A sells his shares to Mr. B
for $1 million
• ACB of the shares to Mr. B is $1 million
• PUC of the shares is still $10

Capital dividend account (CDA)
• The CDA is a notional account that keeps track of various
tax-free surpluses accumulated by a private corporation
• If a private corporation has a balance in its capital dividend
account at a point in time, it has the ability to elect to pay
tax-free dividends out of its capital dividend account
(i.e. capital dividends)
• When a corporation is the owner and beneficiary of a life
insurance policy, its CDA gets credited by an amount equal
to net proceeds of a life insurance policy less the adjusted
cost basis of the policy

The capital dividend account
(cont’d)
Tax-free amounts from
sale of eligible capital
property
Tax-free amounts from
sale of eligible capital
property
Non-taxable portion of
capital gains net of
non-allowable portion
of capital losses
Non-taxable portion of
capital gains net of
non-allowable portion
of capital losses
Capital dividends
received from other
Canadian private
corporations or trusts
resident in Canada
Capital dividends
received from other
Canadian private
corporations or trusts
resident in Canada
Life insurance death
benefits less ACB of
the policy to the
corporation
Life insurance death
benefits less ACB of
the policy to the
corporation
Capital dividend account (CDA)Capital dividend account (CDA) -
CDA balance (if any)CDA balance (if any)
+ ++ +
Capital
dividends to
shareholders
Capital
dividends to
shareholders

Understanding the deemed disposition at death
• Deemed disposition rules in the Income Tax Act
generally state that a taxpayer’s capital property is
deemed disposed of, for its fair market value immediately
before death
• Private company shares are one type of capital property
• The deemed sale triggers realization of accrued capital
gains, which in turn triggers a tax liability
• Capital gain/loss = proceeds, or deemed proceeds,
minus adjusted cost base (ACB)
OH 2-2

Example of capital gains on death
• Steve is 65 years old, divorced, and has two adult
children (both will be successors to the business)
• Steve owns all of the preferred shares of Steveco, which
carries on an active business, and his two children own
the common shares
• Steve dies suddenly due to an unfortunate accident
• His preferred shares are worth $2,000,010 at the time of
his death
• The adjusted cost base and paid-up capital of the shares
is $10
• The shares are not “qualified small business corporation
shares” for purposes of the capital gains exemption

Capital gains on death
(cont’d)
• Steve is deemed to dispose of his shares of Steveco
immediately before death for proceeds of $2,000,010
• Capital gain: $2,000,010 - $10 = $2,000,000
• At the current highest marginal tax rate for an individual
resident in Alberta, tax on the capital gain will be $390,000
(i.e. 19.5%)
• Important point: the rules also indicate that the estate,
or any person who has acquired the property as a
result of Steve’s death, is deemed to acquire the
shares at their FMV at time of death

Pop quiz
• What is the ACB of the shares to the estate?
• What is the PUC of the shares to the estate?
• This is the key to understanding the double-taxation issue
that arises on death of a shareholder
OH 2-3
$2,000,010
$10

Understanding the double-taxation issue
Terminal tax return for Steve
Taxable capital gain
(50% of actual gain) $1,000,000
Highest marginal rate (Alberta) 39%
Tax $ 390,000
12

(cont’d)
• What if subsequently, the estate or the beneficiaries want
to draw on the underlying assets of the corporation?
• Intuitively, we would think the fair result is that this can be
done free of tax since the value of the shares, represented
by the underlying value of the assets, is now tax paid
• However, if this value is extracted by way of a dividend, it
will be taxed again as a dividend
• If this value is extracted by redeeming the shares, the rules
specify that a deemed dividend arises, equal to the
redemption proceeds less the PUC of the shares

(cont’d)
Steve’s estate tax return
Proceeds on redemption of shares $2,000,010
Less: PUC 10
Deemed dividend 2,000,000
Tax rate 27.71%
Tax $ 554,200
Total tax: $390,000 + $554,200 = $944,200 (47.21%)
(If assets with accrued gains exist in the corporation, may be still another level of
corporate tax depending on whether those assets are distributed on redemption)

Solving the double-taxation issue
BUT…
Something else happens for tax purposes in the estate
• A redemption of shares is also considered a
disposition of those shares
• When there is a disposition, we have to perform a
capital gain or loss calculation (i.e. proceeds less
ACB)
• However, the rules say that when a deemed dividend
is also triggered on a disposition of shares, the
calculation of proceeds is adjusted downward by the
deemed dividend

(cont’d)
Steve’s estate tax return – calculating the capital loss
Actual proceeds of disposition of shares
on redemption $2,000,010
Less: previously recognized deemed dividend (2,000,000)
Deemed proceeds 10
Less: ACB (2,000,010)
Capital loss $(2,000,000)
Allowable capital loss (50% of actual loss) $(1,000,000)

(cont’d)
• Capital losses, generally, can only be used against
capital gains
• The capital loss in this case is reported on the estate
return, but the capital gain is reported on Steve’s
terminal return – how can one offset the other?
• Answer: the rules recognize the double-tax issue and ss.
164(6) of the Income Tax Act allows for a transfer of the
loss in the estate return to the terminal return, provided
the loss is triggered (i.e. in this case through a
redemption) within 1 year after death

(cont’d)
Result of solving the double-tax issue:
Steve’s terminal return
Taxable capital gain (50% of actual gain) $1,000,000
Less: allowable capital loss in estate transferred
under ss. 164(6) (1,000,000)
Net taxable capital gain $ 0
Tax $ 0
Steve’s estate return (first year after death)
Redemption proceeds $2,000,010
Less: PUC 10
Deemed dividend $2,000,000
Tax $ 554,200
Total tax: $0 + $554,200 = $554,200 (27.71%)
18

- the “pipeline” strategy
• In the previous example, we see that the post-mortem
redemption strategy solves the double-taxation issue, with
the ultimate result being tax payable at the dividend tax rate
• However, another post-mortem strategy, the “pipeline”
strategy, may be effective in solving the double-taxation
issue with the ultimate result being tax payable at the
capital gains tax rate
• The pipeline strategy is more complex and costly to
implement
19

One example of the pipeline strategy
Estate
Promissory note = $2,000,010
Newco
Steveco
Step 1: Estate forms
Newco, subscribes for
shares for a nominal price
Step 2: Estate transfers
the Steveco shares to
Newco in exchange for a
promissory note
Step 3: Newco and
Steveco are amalgamated
Step 4: Promissory note is
settled with assets in
Amalco
Amalco
End result: Only tax on the capital gain in
the terminal return

Pipeline planning
• CRA has issued rulings in the past that indicated that a
particular subsection of the Income Tax Act [i.e., ss. 84(2)]
may apply to impose dividend taxation to the estate when a
pipeline strategy is implemented if the business is
liquidated within a year and does not continue its business
for at least a year following death
• Comments made in obiter by the Court in the recent Tax
Court case, MacDonald v. R., expressed the view that
CRA’s views are untenable
• “The clearly arbitrary conditions imposed [by CRA] are
not invited by the express language in subsection
84(2).”
• But the case was appealed to the FCA and CRA was
successful

Pipeline planning (cont’d)
• Status of pipeline planning uncertain depending on the
situation and questions remain
• When does a distribution from a corporation, however
circuitous, occur on the “winding-up of its business”?
• If not, how long a period would the business need to
continue?
• Has the FCA applied too broad an approach to
interpreting ss. 84(2)?
• Will have to see if the taxpayer requests leave to appeal to
the Supreme Court of Canada and whether the Supreme
Court will grant leave to appeal

Summary of results
Quick comparisons so far:
Tax with no insurance in place and no
post-mortem planning $944,200 47.21%
Tax with no insurance in place and post-
mortem redemption $554,200 27.71%
mortem pipeline planning $390,000 19.5%

Introducing…life insurance
• A post-mortem insured redemption strategy is done by
carrying out the same type of strategy as described in the
first example, except that corporately-owned insurance is in
place
• The benefit of the corporately-owned insurance is that the
deemed dividend triggered on redemption of shares may
be designated as a tax-free capital dividend to the estate
• Let’s keep the same example, but assume Steveco held a
universal life insurance policy
• Assume the death benefit paid out is $2,000,000 and the
ACB of the policy is nil (i.e. CDA credit of $2,000,000)

Insured redemption
Steve’s estate return again
Deemed dividend calculation:
Proceeds on redemption of shares $2,000,010
Less: PUC (10)
Deemed dividend
(elect as a capital dividend) $2,000,000
Tax rate 0%
Tax $ 0

Insured redemption
(cont’d)
Steve’s estate tax return – calculating the capital loss
Actual proceeds of disposition of shares
on redemption $2,000,010
Less: previously recognized deemed dividend (2,000,000)
Deemed proceeds 10
Less: ACB (2,000,010)
Capital loss $(2,000,000)
Allowable capital loss (50% of actual loss) $(1,000,000)

Stop-loss rule: loss realized by estate
• If certain grandfathering rules do not apply, then under the
estate stop-loss rule, the loss to the estate is reduced by
the amount by which the lesser of:
• Capital dividends received on the shares, and
• The amount of the loss otherwise determined minus
taxable dividends received on the shares
Exceeds 50% of the lesser of:
• The amount of the loss otherwise determined, and
• The deceased’s capital gain from the disposition of the
shares on the terminal return
• In our example, the loss reduction is [$2 million – (50% of
$2 million)] = $1,000,000. (i.e. $500,000 allowable)

Stop-loss rule
(cont’d)
Steve’s estate tax return – effect of stop-loss rule
Capital loss otherwise computed $(2,000,000)
Reduction due to stop-loss rule 1,000,000
Adjusted loss $(1,000,000)
Allowable capital loss (50% of adjusted loss) $(500,000)

Stop-loss rule
(cont’d)
Result of the stop-loss rule:
under ss. 164(6) (500,000)
Net taxable capital gain $ 500,000
Tax (39%) $ 195,000
Redemption proceeds $2,000,010
Less: PUC 10
Deemed dividend (elect as capital dividend) $2,000,000
Tax $ 0
Total tax: $195,000 + $0 = $195,000 (9.75%)
29

Summary of results
Tax with insurance in place and post-mortem
redemption $195,000 9.75%

Can we do better?
• Using the insured redemption strategy where all of the
deemed dividend is declared as a capital dividend will
deplete the capital dividend account
• Question: would it make sense to reduce the amount of
deemed dividend in Steve’s estate that is tax-free in order
to preserve some of the capital dividend account for
surviving shareholders (i.e. his two children)?
• Let’s look at what we call the 50% solution, but only at a
very high level – we won’t focus on the mechanics of how
both taxable and non-taxable deemed dividends are
generated in the estate

The 50% solution
• As we saw, the result of not using the 50% solution is that
some tax will be payable on the capital gain reported on the
terminal return; no tax is payable on the deemed dividend in
the estate; and the CDA is fully depleted
• The 50% solution implement steps to trigger both a taxable
dividend and a non-taxable capital dividend in the estate, so
the operation of the stop-loss calculation does not restrict any
of the loss
• Therefore, under the 50% solution, some tax will be paid in
the estate on the taxable deemed dividend; no net capital
gain on the terminal return; but 50% of the CDA will be
available to surviving shareholders, instead of depleting it all
32

50% solution
(cont’d)
• Applying the loss reduction formula when using the 50%
solution in our example:
• Capital dividends received on the shares ($1,000,000),
and
• The amount of the loss otherwise determined minus
taxable dividends received on the shares ($1,000,000)
Exceeds 50% of the lesser of:
• The amount of the loss otherwise determined
($2,000,000), and
• The deceased’s capital gain from the disposition of the
shares on the terminal return ($2,000,000)
• Result – loss reduction is nil

50% solution
(cont’d)
Result of the 50% solution:
under ss. 164(6) (1,000,000)
Net taxable capital gain $ 0
Tax $ 0
Taxable deemed dividend $1,000,000
Tax rate 27.71%
Tax $ 277,100
Total tax: $0 + $277,100 = $277,100 (13.855%),
What about the benefit of $1 million CDA left over?
34

50% solution
(cont’d)
• The 50% solution yields $82,100 more in tax on that estate
return than a full non-taxable redemption:
($277,100 - $195,000 = $82,100)
• However, we have only used $1,000,000 of the CDA,
leaving $1,000,000 available to Steve’s two children as
surviving shareholders
• In absolute dollars, the value of $1,000,000 of CDA can be
$277,100 (the tax cost of otherwise extracting $1 million of
retained or future profits as taxable dividends, rather than
non-taxable dividends)
• Thus, in certain situations the overall benefit of the CDA
preservation may be viewed as offsetting the tax to the
estate

Summary of results
redemption $195,000 9.75%
redemption using 50% solution $0* 0%*
*?(potentially)*?

Roll and Redeem Strategy: Surviving spouse
• We have seen that proper post-mortem planning when
corporately-owned life insurance is in place can
significantly reduce taxation on death
• The “roll-and-redeem” strategy also has the potential for a
zero tax result on death of a shareholder
• The right circumstances must be in place:
• corporately-owned life insurance coverage; and
• a surviving spouse

Roll and redeem (cont’d)
• The steps are:
• The private corporation purchases and funds the
premiums for a policy on the life of the shareholder of
which it is the owner and beneficiary
• The private corporation shares are bequeathed to the
spouse in the shareholder’s Will
• The tax rules allow for a tax-free rollover of the shares
to a surviving spouse upon the death of the shareholder
• A tax-free redemption of the shares now held by the
surviving spouse can be funded from the life insurance
proceeds received by corporation

Example: Roll and redeem
OPCO
(life insurance)
Freeze shares
Founding
shareholder
Children
(successors)
Common
shares
Surviving
spouse
Tax-free
redemption
using CDA
Freeze shares

Roll and redeem (cont’d)
• It is extremely important that the shareholders’ agreement
provide the proper provisions for the roll and redeem to be
effective
• Notably, the shareholders’ agreement buy-sell provisions
must not thwart the requirement that the deceased’s shares
must “vest indefeasibly” in the spouse

Revisiting the pipeline strategy
• If a post-mortem share redemption appears to be more tax-
effective in the case of corporately-owned insurance, when
is pipeline planning relevant?
• It is relevant when the insurance coverage is less than the
amount required to redeem the shares
• In such a case, capital gains tax rates can apply, rather
than dividend tax rates, to the portion of the share value not
“covered” by insurance through pipeline planning

Possible “hybrid” post-mortem planning
$2,000,000 (share value)
$700,000 (insurance coverage)
Pipeline planning
(19.5%)
Insured
redemption
planning (9.75%),
or with 50%
solution or roll
and redeem (0%)

Conclusions
• Post-mortem planning options can be varied and complex
• Corporately-held life insurance used in conjunction with
post-mortem planning can be used to reduce the
testamentary tax liability and preserve more estate value

Estate planning - corporations

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