Tax and Family Business Succession Planning — What's New

Please thank David Louis for this month's article, David is a tax partner with Minden Gross LLP, a member of MERITAS law firms worldwide. David's practices focus on tax and estate planning for entrepreneurs and their corporations.

This article is an excerpt from CCH's Wealth Management Times issue No. 54 dated June 2009.

In general, recent reductions in corporate tax rates, along with the eligible dividend rules, have resulted in a greater bias to retain profits at the corporate level rather than distributing them as salaries/bonuses, thus militating in favour of freezes.Note 2 In the last few years, this trend has continued. Changes stemming from the November 2007 federal announcements will result in decreasing corporate tax rates, until federal rates reach a mere 15% in 2012.Note 3 This year's Ontario Budget also removed barriers to retaining income at the corporate level.Note 4 In that province, the general corporate business rate in 2014 will be less than 53% of the applicable rate where income is bonused out.

Hardly a Week Goes By…

It is hard to remember a week that has gone by without a new development pertaining to the book. In the week before publication of this article, there were at least four relevant developments that I have come across (so far!). The Federal Court of Appeal released its decision on Copthorne;Note 5 to no one's surprise, the Court (which usually sides in favour of the CRA) upheld the lower Court's verdict that the paid-up capital inflation plan in question contravened GAAR. But the Court also strengthened the series of transactions anti-avoidance concept which is key to many planning manoeuvres, by pouring cold water on the notion that there must be a "strong nexus" between the series of transactions itself and transactions in contemplation of the series, instead looking to a "motivating factor" test.

An article by Richard Wise in the latest issue of Canadian Tax Highlights speaks to the value of an interest in a discretionary trust.Note 6 Another article in the same issueNotes 7 indicates that the 2009 federal Budget provisions to remedy the result in La SurvivanceNote 8 (which, for example, could play havoc with the capital gains exemption on a share sale to a public company or non-resident) has deficiencies when CCPC status of a target corporation is to be claimed on a "sign-and-close" transaction.Note 9 Propep Inc. v. The Queen,Note 10 a civil law case, seems to support a narrow interpretation of "beneficiary" e.g., for the purposes of the look through association rules in subsection 256(1.2).Note 11

Going further back in time, in the Frye case,Note 12 the Ontario Court of Appeal held that a specific bequest of shares "trumped" restrictions on ownership in a shareholders' agreement. Some other recent developments we will mention include CRA restrictions pertaining to stock dividend freezes,Note 13 technical interpretations pertaining to assets used in an active business for the purposes of the capital gains exemption, and developments in respect of distributions from trusts to non-resident beneficiaries.

APFF Stuff

Some of the most interesting new developments come from the Association de Planification Fiscal et Financière (APFF) Round Tables. In the APFF 2007 Round Table, there were a series of questions on the effect of freeze structures involving family trusts on the tax consequences of various situations pertaining to an operating business. The questions focused on the deductibility of bonuses, the tax treatment of a bad loan from a freezor to a frozen corporation, the deductibility of interest on a freezor's borrowings to make an interest-free loan to a frozen corporation, etc.Note 14 Another question, from the 2008 APFF Round Table, elaborates on an earlier technical interpretationNote 15 specifying that, for the purposes of the association rules, trustees are considered to own shares held by a trust.Note 16 Other recent APFF questions give an update on the CRA's views in respect of the attributes of estate freeze preferred shares,Note 17 and canvass the advisability of adding restrictions on the assignability of interests in certain trusts.Note 18

If you read this newsletter regularly, you will know that, in recent months, the "control premium" issue has surfaced—that is, whether there is a premium attributable to voting control in isolation (e.g., as would be the case for so-called "thin-voting" shares).Note 19 Originally, this seemed to be a local (west coast) issue; but more recent CRA statements—that a willing buyer will pay "some amount" for a control premium positionNote 20 —has put practitioners on notice that, in theory at least, this is a Canada-wide issue. At time of writing, the reaction of practitioners in dealing with this issue is still unfolding; and based on discussions with leading valuators, we think that the premium in a freeze structure—that is, where a freezor has access to only limited dividends—is modest, notwithstanding the CRA's apparent position.Note 21

While this issue is now well known, what might not be is that some of the methodology that might be used to counter a control premium gives rise to other technical issues. In particular, when shares pass in and out of an estate, there is presumably an acquisition of control, with the loss-streaming rules, etc., being potentially applicable. Happily, though, there are certain "saving rules" in subsection 256(7) that usually alleviate the acquisition of control issues in these situations. However, particularly where voting rights are designed to drop off on death, we think that there are some imperfections in these "saving rules".

Other Stuff
Another area that we intend to discuss in more detail is trusts and the association rules. For example, one specific rule deems shares held in a discretionary trust to be owned by each discretionary beneficiary;Note 22 another rule—also typically applicable to freezes using a family trust—deems common shares having more than 50% of the fair market value of all of the issued common shares to be a control block.Note 23 While these rules have been around for quite a while, there is a growing realization that, as the freeze "matures", association issues can sometimes become acute. Consider, for example, a situation where a freeze is done in favour of a discretionary trust with teenagers as beneficiaries. The prospect of their kids becoming successful business owners is probably the last thing that most freezors have on their minds. However, what with high-tech opportunities and the like, it is often not too long before the kids become successful in their own right. Of course, this may give rise to association issues if one or more of them controls his or her own company, including having to share the small business deduction and the potential loss of SR&ED credits. In the third edition, we will expand the discussion of strategies that can be used to deal with this issue.

In addition to a discussion of the capital gains exemption, including crystallization methodology, we intend to add a discussion of purification strategies that can result in the multiplication of the capital gains exemption, by being able to maintain the corporation as a qualifying small business corporation. Also added will be new materials pertaining to testamentary trust status, expanded discussion of family business shareholders' agreements, and many other features.

As discussed above, recent developments are putting more and more emphasis on a detailed knowledge of tax issues—especially pertaining to the taxation of private corporations. My personal belief is that the area of family business succession planning is steadily moving further into this realm.

Notes

1. For example, since the second edition was published, the Ontario Bar Association has presented two all-day sessions on the subject: "Taxation of Trusts and Estates: A Practical Approach", March 3, 2008 and "Tax For Succession Planning, Trusts and Estates Practitioners", March 3, 2009.

2. I.e., because of the increased death tax exposure attributable to retained earnings buildups.

3. As I have pointed out previously, dropping corporate tax rates have resulted in higher tax on eligible dividends, such that there will be very little difference between the federal taxation of eligible and ineligible dividends when the changes to corporate federal rates are fully phased-in by 2012.

4. Notably, the elimination of the "clawback"— a corporate tax in excess of 4%, applicable to corporate income between $500,000 and $1.5 million. The tax is sufficiently high to call into question the advisability of retaining profits at the corporate level, at least within this income range—obviously relevant to a great many Ontario businesses. Once the clawback is eliminated in July 2010, Ontario corporations will have a greater incentive to retain profits at the corporate level, especially since the general provincial corporate rate will be reduced from the current 14% rate to 10% by 2014, bringing the combined federal–provincial rate in Ontario to 25%. For further discussion, reference should be made to "Corporate Deferral Strategies, Dalton McGuinty and Joe the Plumber", by the author and Michael Goldberg, The Estate Planner No. 172, May 2009.

5. Copthorne Holdings Limited v. The Queen, 2009 FCA 163.

6. "Trust Interest Valuation", page 9. The author concludes: "In a discretionary trust, there is no definite economic interest in either an income or a capital interest unless the vendor happens to be the sole beneficiary in the trust income or capital; in any event, FMV is speculative at best."

7. "Part-Time CCPCs Again", Joel Nitikman and Michelle Moriartey, page 6.

8. La Survivance v. The Queen, 2007 DTC 5096, (FCA).

9. Because the deemed year-end at the commencement of the day of control change does not affect CCPC (and SBC) status, the target would not be a CCPC throughout the year in which control is acquired— i.e., because for these purposes, the change of status (if applicable) would occur later in the day.

10. 2007-1882(IT)G.

11. Essentially the case held that a "second ranking" beneficiary under the Civil Code of Quebec whose interest was conditional on the winding up of a corporation which was a "first ranking" beneficiary was not a beneficiary for the purpose of subparagraph 256(1.2)(f)(ii), indicating that "if a beneficiary's right is subject to a condition, the condition must be realized in order for the beneficiary to be able to exercise the right" (paragraph 41).

12. Frye v. Frye Estate, 2008 ONCA 606.

13. Doc. No. 2003-0004125, April 1, 2003—French only.

14. 2007 APFF Round Table, Question 14.

15. Doc. No. 2005-0111731E5, July 4, 2006.

16. Doc. No. 2008-0285021C6; 2008 APFF Round Table, Question 10.

17. Doc. No. 2008-0285241C6, 2008 APFF Round Table, Question 23.

18. Doc. No. 2008-0285071C6, 2008 APFF Round Table, Question 14.

19. See "Valuation and Family-Business Share Structures—Some Musings", by the author (The Wealth Management Times No. 50, October 2008).

20. See Income Tax Technical News No. 38, September 22, 2008.

21. However, exclusionary dividend structures may be another story—e.g., common-type shares on which open-ended dividends can be paid on one class to the exclusion of other classes—I believe that this feature, coupled with voting control, could potentially result in a considerably more significant premium. This may be problematic, for example, where non-voting exclusionary dividend shares are used in an attempt to multiply the capital gains exemption.

22. Subparagraph 256(1.2)(f)(ii).

23. Subparagraph 256(1.2)(c)(ii). Similarly, by virtue of subparagraph 256(1.2)(c)(i), there will be deemed control in respect of shares of any class having more than 50% of the fair market value of all of the issued shares.

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