SUCCESSION PLANNING FOR PRIVATE ENTERPRISES

June 2, 2011

David R. Baxter

Introduction

Tax planning should be proactive, not reactive proactive planning may be accomplished tax-free reactive planning may result in tax implications (ex.

divisive reorganizations and ITA 55(2)) Tax planning should be fully integrated with non-

tax considerations asset protection segregated holding corporations wealth preservation discretionary family trusts business succession integrate trusts and corps

Identify exit strategies for owner-managers of privately-owned businesses

Agenda

Structuring private enterprises Capital gains exemption for QSBCS Purifications and divisive reorganizations Estate freezes

internal freeze external freeze stock dividend freeze wasting freeze

Use of trusts discretionary family trusts 21 year rule

Post-mortem planning

Structuring Private Enterprise

Factors to consider: tax efficient distribution of retained earnings

defer personal taxation for as long as possible avoid refundable taxes on inter-corporate dividends (Part IV) avoid anti-stripping rules (ITA 55(2))

tax efficient exit strategy maximize capital gains exemptions

asset protection (ex. trade creditors, matrimonial) utilize holding corporations and trusts

flexible wealth management and estate planning income splitting family governance avoiding fixed entitlements with trusts

Distribution Strategy: Inter-Corporate Dividends Dividends generally pass between corporations without Part I

tax Opco can pay a dividend to a corporate shareholder (Holdco) Holdco not subject to Part I tax on dividend if connected to Opco Holdco accumulates retained earnings Defer personal tax otherwise payable by individual shareholders

Holdco can be subject to refundable Part IV tax (33⅓%) on dividends portfolio dividends (i.e., from non-connected corporations) dividends from connected corporations if RDTOH refund to payor

Connected corporations related corporations Holdco owns >10% votes and equity value of Opco

no look-through rules with trusts

Exit Strategy: Capital Gains Exemption for Qualified Small Business Corporation Shares

Only available to individuals look-through rules for personal trusts

Small business corporation (“SBC”) at time of disposition CCPC “All or substantially all” (90%) active business assets Shares/indebtedness of “connected“ SBC

24 month hold period / 50% test abridging the hold period (ITA 110.6(14))

Gross asset value test $750,000 lifetime limit per individual

reduced if used $100,000 exemption prior to elimination combine with exemptions for qualified farm property and fishing property

AMT implications ABIL / CNIL

Example: QSBC Gross Asset Value

FMV business assets: $550,000Less: business liabilities: (50,000) _________

Net: $500,000

FMV investments (gross): $450,000Less: investments liabilities: (425,000) ________

Net: $25,000 ________

Total Net Value: $525,000

Gross asset value is $1,000,000 Shares would not be eligible for the QSBCS exemption

business assets represent less than 90% of the gross asset value irrelevant that >90% of the net value derived from business assets

Basic Corporate Structure

Some asset protection for John and spouse business carried on through a

limited-liability corporation subject to personal guarantees,

gross negligence, etc. QSBCS exemption available on

share sale subject to Opco not accumulating

passive assets shelter a maximum of $1,500,000

capital gains No ability to defer personal taxes

on distributions of retained earnings from Opco

Opco

active business

John Spouse

Holdco Ownership Structure

Retained earnings from Opco can be distributed to Holdco by way of inter-corporate tax-free dividends

Holdco can invest the dividends and accumulate significant investments

Holdco shares will meet the 50% test but not the 90% test

Holdco shares owned by John / Spouse will not qualify for QSBCS capital gains exemption must first purify Holdco by a

divisive reorganization or otherwise

John

Holdco

Opco

active business ($1,500,000)

Investment portfolio ($500,000)

Spouse

Trust Ownership Structure

Beneficiaries of the discretionary family trust would include both individuals and Holdco

Dividends paid by Opco to the trust could be allocated to Holdco as an income distribution from trust deemed inter-corporate dividends

Capital gains realized on the sale of Opco shares could be distributed to individual beneficiaries so that they could claim their QSBCS exemptions

Beware of Part IV tax on dividends allocated to Holdco ITA 186(2) & (4): “connected”

Trust could be a shareholder of Holdco beware of reversionary rules

Flexible asset management

Opco

Holdco

Trust

purifying dividends

family members

beneficiaries

allocation

$

$

Divisive Reorganization: Purification

Objective: distribute certain corporate assets (usually cash or investments) to a non-arm’s length corporation

Principal reasons: qualify for QSBCS exemption

non-active business to be removed to satisfy 50% / 90% tests non-working capital and investments will not qualify

segregate different businesses (or real estate) into separate corporations to facilitate a future sale

asset protection (creditor proofing) Considerations

trigger the realization of capital gains on disposition of appreciated assets

ITA 55(2) recharacterization of inter-corporate dividends into proceeds of disposition (or gains)

Divisive Reorganization

Tax-free distribution of corporate-owned assets between corporations

Beware of ITA 55(2) complex anti-surplus stripping rule prevents tax-free distribution of corporate surplus by way of inter-

corporate dividends Two categories of reorganizations

related person reorganizations “butterfly reorganizations (split vs. spin)

continuity of shareholding continuity of business enterprise pro rata distribution of each type of asset

Safe income ITA 55(2) not applicable to distributions of tax-paid retained earnings

Divisive Reorganization: Related Person Exemption

ITA 55(3)(a): related person reorganization no disposition of property to unrelated person or significant

increase in interest in any corporation by unrelated person as part of same series of transactions

certain FMV transfers to unrelated persons permissible siblings deemed to be unrelated

Since siblings deemed to be unrelated, undertake reorganization while related person (ex. parent) in control after control acquired by children, reorganization would be

taxable (unless undertake a butterfly distribution)

Example: Related Party “Purification” Reorganization

Mrs. X owns 300 common shares of Opco.

The shares have a nominal cost

Mrs. X wants to purify Opco to segregate cash and near-cash from its business assets

Mrs. X

300 shares

Opco

business assets ($200,000)

cash & near-cash ($100,000)

Example: Related Party Reorganization (cont.)

Mrs. X transfers 100 common shares to a newly-formed holding company (Holdco) on a rollover basis

Shares are then redeemed by Opco for $100,000; cash and near-cash distributed to Holdco as a tax-free inter-corporate dividend

Subsection 55(2) will not apply because all parties are related

Cannot undertake as part of a series of transactions that includes a sale to an unrelated person

Mrs. X

200 shares

Opco

business assets ($200,000)

cash & near-cash ($100,000)

Holdco

shares

Butterfly Reorganization

ITA 55(3)(b): butterfly reorganization each shareholder gets proportionate share of each

category of assets categories: cash/investments/business assets consolidated look-through approach gross vs. net

“spin” reorganization vs. “split” reorganization

Butterfly Reorganization (cont.)

General requirements:

1. continuity of shareholdings

2. continuity of assets Generally no sale of shares or assets of the distributing

corporation or a transferee corporation to an unrelated person as part of same series

No acquisition of control of distributing corporation as part of same series

Restrictions on assets that can be acquired by the distributing corporation prior to the distribution (i.e., no stuffing)

Example: Butterfly (Split)

Before:

cash = 100

investments = 200

business = 200

Opco 1, Opco 2 and Opco 3 receive a proportional amount of cash, investments and business assets of Opco

After:

X ZY

Opco Opco 1 Opco 3Opco 2

YX Z

cash = 40 investment = 80 business = 80

cash=30 investment = 60 business = 60

cash = 30 investment = 60 business = 60

100% 100%100%40% 30%30%

Example: Butterfly (Spin)

Before:

Newco receives a proportional amount of cash (along with Asset 2)

Opco

X Y

50% 50%

Cash ($200)

Asset 1 ($100)

Asset 2 ($300)

After:

YX

50%

50%50%

50%

Asset 1 ($100)

Cash ($50)

Asset 2 ($300)

Cash ($150)

Opco Newco

Estate Freezes

Mitigate against deemed disposition on death and future growth to heirs Exchanging common shares for preferred shares CRA criteria for preferred “freeze” shares

redeemable at the option of the holder; carry voting rights in respect of matters which pertain to such class of shares; first preference on any distribution of assets of the corporation on its

liquidations, winding up or dissolutions; no restriction on transferability (other than as required by the governing

corporate law); and restrict the corporation from paying dividends on all other classes of shares if

doing so would result in insufficient assets being available to pay the redemption amount of the preferred shares.

Internal freeze ITA 51/86 exchange ITA 85: crystallization of capital gains exemption or capital losses available

Internal Estate Freeze

Patriarch owns common shares of Opco currently worth $5,000,000 (nominal cost)

Patriarch has adult children who are his sole heirs. Patriarch exchanges common shares for preferred shares with a fixed redemption

amount of $5,000,000; the exchange occurs on a tax-free rollover basis Patriarch’s children subscribe for new common shares for nominal amount

Future growth in Opco will accrue to the children (as the common shareholders)

Opco

Patriarch Children

C/S P/S C/S

External Estate Freezes

utilize a holding corporation ITA 85 election to be filed may be appropriate if Opco

has multiple shareholders (some of whom are not freezing)

may also be utilized as part of a “purification” divisive reorganization (perhaps in contemplation of an eventual share sale in the distant future)

Opco

heirsfreezor

Holdco other shareholder

C/S

100 C/S100 C/S

P/S

Estate Freeze: Benefits and Risks

Benefits Proprietary interest to heirs without significant investment Reduce probate fees and estate duties Income-splitting among family members

Risks if implemented without a trust Relinquish some control Freezor’s financial wealth capped Possible acceleration of taxable gains if death of heir Exposing assets to creditor/marital risks of heirs Corporate attribution

Stock Dividend Freeze

Opco issues fixed-value preferred shares to holder of common shares (freezor) as a stock dividend nominal par value (stated capital) so nominal dividend received by shareholder aggregate redemption amount = net asset value of Opco Freezor then disposes of common shares to heirs or trust (freezee)

Advantages: manages ITA 74.4(2) corporate attribution may abridge 24 month hold period for QSBCS for freezee minimize clearance certificate issues for non-resident freezor

Disadvantages: negate application of a price adjustment clause? alleviate with follow-up freeze

Opco

freezor

stock dividend common shares

Wasting Freeze

Redemption of preferred shares during lifetime ITA 84(3): deemed dividend Reduce gains which are taxable at death

Integration of corporate and personal tax Active business income in excess of SBD (including recaptured

CCA) historically caused disintegration New enhanced dividend tax credit to reduce disintegration for “high

tax” corporate business income (i.e., eligible dividends) Specified investment income/RDTOH

little net “additional” tax from paying dividend

Realization of gains when common shares (or underlying corporate property) sold by heirs

Wasting Estate Freeze (cont.): Integration

Specified Investment Income

Taxable Dividend

44.67%(26.67%) 18.00%

CCPC

Individual

Total Tax

44.67%(26.67%) 18.00% 27.64% 45.64%

Investment Income Individual 43.7%

Refreezing

Consider if significant post-freeze devaluation of frozen corporation

Results in benefits accruing move quickly to freezee(s)

CRA acceptance so long as devaluation not a consequence of distributing corporate assets Technical Interpretation #9229905 (June 3, 1997) Technical Interpretation #2000-0029115 (Nov. 17, 2000)

Advantages of Discretionary Family Trust Asset management and control Multiply capital gains exemptions Reversible freeze

thaw the freeze by distributions back to freezor as beneficiary Minimizing value on death

contrary to CRA views based on Sagl v. Sagl (Ont. Gen. Div., 1997) Avoid corporate attribution

springing beneficiaries (ITA 74.4(4)) Insulating assets from matrimonial claims Beware of 21 year rule

ITA 104(4)(b): deemed disposition avoid by tax-free “rollover” distribution to Cdn. resident beneficiary

Trust

Create Trust

21 Year

Distribute propertyto beneficiaries

Year 1

21 Year Rule Discretionary trusts generally deemed to dispose of their assets every 21 years for FMV proceeds Trigger the realization of any capital gain Most common solution is a tax-free capital distribution on the eve of the 21st anniversary

Managing the 21 year rule

Share exchanges prior to 21st anniversary exchange trust’s common shares for multiple classes of

sprinkling shares ITA 51/86: tax-free rollover exchange distribute sprinkling shares to multiple beneficiaries avoid fixed entitlements in any particular beneficiary

Redemption-sprinkling preferred shares Staggered trust ownership structure

effectively defer deemed disposition for additional 21 years

GAAR?

Tax Implications on Death

Capital gain for deceased / deemed dividend to estate on redemption ITA 164(6) election: avoiding double taxation

Estate’s Capital loss applied against deceased’s capital gain must be done within estate’s first taxation year

Can delay redemption to three years with alter ego trust, etc.

Opco

Deceased Shareholder Estate

$

transfer on deathredeem

Tax Implications on Death (cont.)

Compare tax on redemption vs. sale to Holdco rather than redeem, estate sells Opco shares to a

holding corporation no gain on estate

holding corporation redeems Opco shares tax-free inter-corporate dividend

beware of ITA 84.1 (if Opco shares have “soft” cost) overall taxation may be reduced if deceased did not

use capital gains exemptions

Tax Implications on Death: Life Insurance on Death ITA 70(5.3): valuing shares at death Insurance proceeds added to capital dividend account

Distribute as tax-free capital dividends File election

ITA 112(3.2): stop-loss rule on redemption Grandfathered vs. non-grandfathered policies 100% vs. 50% capital loss on redemption

If non-grandfathered policy, maybe sell to heirs rather than redeem Trade-off: bump in ACB vs. 50% capital loss