In Canada, the passing of a loved one brings not only emotional challenges but also complex tax considerations. One of the critical issues faced by executors and beneficiaries is addressing the potential double taxation of corporate assets when a shareholder dies. A “pipeline transaction” is a strategy often employed in post-mortem tax planning by tax lawyers to mitigate this double taxation. This article explores the mechanics, benefits, and potential pitfalls of pipeline transactions.
Understanding the Problem of Double Taxation
When a Canadian resident shareholder dies owning shares of a private corporation, the Income Tax Act (“ITA”) deems the shares to be disposed of at their fair market value (“FMV”) immediately before death, triggering a capital gain. This capital gain is reported on the deceased’s final tax return. If the corporation subsequently distributes its retained earnings to the estate or beneficiaries as a dividend, a second layer of tax arises at the shareholder level. This double taxation—on the capital gain and the dividend—can significantly erode the value of the estate.
For example, let’s say that A dies owning all the issued shares of his operating company (“Opco”) with nominal adjusted cost base (“ACB”) and paid-up capital (“PUC”). Opco has retained earnings of $1 million at the time of A’s death. In this case, under the ITA, A will be deemed to dispose of the shares of Opco at the FMV of those shares, which will be close to or equal to $1 million. As such, A’s final tax return will include a capital gain of $1 million. Note that the ACB of the shares of Opco held by A’s estate will be stepped-up to $1 million following such deemed disposition, but not the PUC. However, if Opco then redeems the shares held by A’s estate to transfer its retained earnings of $1 million to the estate so that the estate may distribute the funds to the beneficiaries, the estate will be deemed to have received a dividend equal to the redemption value of $1 million, notwithstanding the stepped-up ACB of the shares. This is because the PUC of those shares is still nominal, and under the ITA if shares of the corporation are redeemed by the corporation itself, any amount in excess of the PUC of the shares is deemed to be a dividend rather than tax-free return of capital.
It is important to note here that the deemed dividend will also result in a capital loss to the A’s estate on the redemption of Opco’s shares, which it may carry back and adjust against the capital gain included in A’s final tax return on those shares. However, there is a strict time limitation before which the loss must be carried back, and the tax on deemed dividend is considerably higher than tax on capital gain.
What Is a Pipeline Transaction?
A pipeline transaction is a tax-efficient strategy used by tax lawyers designed to avoid this double taxation by restructuring the flow of funds from the corporation to the estate or beneficiaries. The goal is to access the corporation’s retained earnings as a tax-free return of capital rather than as a taxable dividend.
Mechanics of a Pipeline Transaction
- Step 1: Shareholder’s Death- Upon the death of the shareholder, the deceased’s estate acquires the shares of the private corporation with an ACB equal to their FMV at the time of death.
- Step 2: Creation of a New Corporation- The estate incorporates a new corporation (“Newco”) and transfers the shares of the private corporation to Newco in exchange for a promissory note. The note’s value equals the FMV of the shares at the time of death.
- Step 3: Amalgamation or Winding-Up- Over time, Newco can withdraw funds from the private corporation, typically by way of a tax-free return of capital. These funds are used to repay the promissory note issued to the estate or beneficiaries. This process avoids triggering taxable dividends.
- Step 4: Repayment of the Promissory Note- The promissory note is repaid to the estate or beneficiaries without incurring additional tax, effectively allowing access to the retained earnings of the private corporation.
Key Benefits of Pipeline Transactions
- Avoidance of Double Taxation: The strategy ensures that the same economic value is not taxed twice.
- Preservation of Estate Value: Beneficiaries receive more value from the estate due to reduced tax liabilities.
- Simplicity in Execution: When executed correctly, a pipeline transaction can be straightforward and efficient.
Potential Risks and Considerations
While pipeline transactions are widely used and recognized, they are subject to scrutiny by the Canada Revenue Agency (“CRA”). Some potential risks and considerations include:
- Anti-Avoidance Rules: The General Anti-Avoidance Rule (“GAAR”) under the ITA could apply if the CRA views the transaction as abusive tax avoidance.
- Timing Issues: The CRA may require a waiting period, generally one year, between the steps of the transaction to ensure that the arrangement is not purely tax motivated. Additionally, it is imperative that the corporation continues to carry on its business throughout this period.
- Professional Advice: Errors in execution can result in unintended tax consequences. It is crucial to work with experienced tax professionals to design and implement the pipeline strategy.
Conclusion – Is a Pipeline transaction right for me?
Pipeline transactions are a valuable tool in the arsenal of tax lawyers, particularly for addressing the issue of double taxation in post-mortem scenarios. By leveraging the stepped-up ACB of shares received by the deceased’s estate and carefully structuring the flow of corporate funds, executors and beneficiaries can preserve and maximise the value of the estate. That being said, given the complexity of tax laws and the potential for CRA scrutiny, professional guidance is essential to ensure compliance and achieve the desired outcomes. Properly executed, a pipeline transaction can provide significant tax savings and financial peace of mind during a challenging time.
Speak to our tax lawyers to see if a pipeline transaction is right for you.
