A recent Tax Court of Canada decision held that a post mortem “pipeline” strategy didn’t work. Why?
Sean Rheubottom, B.A., LL.B., TEP
In administering an estate that holds private corporation shares, a “pipeline” strategy can be used to limit the tax on the shares to the relatively low capital gains rate, instead of the higher dividend tax rate that applies when other strategies are used. But certain tax rules, and the CRA’s interpretations of the rules, try to stick the estate with a higher dividend tax rate even where a “pipeline” is used. To avoid this, the executor must pay careful attention to the way the CRA has interpreted the relevant tax rules. If the pipeline is done incorrectly, the tax result may be punitive.
In administering a deceased person’s estate, we seek to minimize tax to the deceased and the estate if possible. We often refer to this as “post mortem tax planning.”
When a private company’s owner dies, taxes are payable on the deemed disposition of the owner’s shares on death, and taxes are payable again when the funds are withdrawn. This is effectively a double tax on the value of the shares. Canadian tax rules allow certain post mortem liquidation strategies to be implemented to mitigate the double tax burden. Some strategies (often called “pipeline” transactions) can result in tax to the deceased at the relatively low capital gains tax rate (maximum 23.75% in Saskatchewan currently). However, the CRA would generally prefer that we use post mortem strategies (often called “executor year” strategies) that result in tax to the estate at the higher dividend tax rate (maximum 41.82% in Saskatchewan currently). If we use a pipeline strategy, the CRA may still try to force tax at the dividend rate rather than at the capital gains rate, by interpreting the the tax rules in a certain way.
“Pipeline” (capital gains) strategy compared to “executor year” (dividends) strategy
Simplified, a “pipeline” transaction involves, some time after the death, transferring the deceased’s private corporation (“InvestCo”) shares on which the deceased already realized a capital gain, from the estate to a Newco in exchange for a promissory note. InvestCo can be liquidated as it transfers all its assets to NewCo, and NewCo then uses those assets to repay the promissory note it owes to the estate. The result is that the deceased’s tax is limited to tax on the capital gain that happened in the terminal year. There is no dividend to the estate.
An “executor year” strategy involves liquidating InvestCo directly into the estate. On death, as noted, the deceased realizes a capital gain on the InvestCo shares in the terminal year. The shares pass to the estate with full “adjusted cost base” (ACB) since all the gains have been realized. The InvestCo shares are liquidated or “redeemed” in the estate by causing InvestCo to pay its assets to the estate as a taxable “deemed dividend” to the estate. Certain tax rules effectively say that generally, when shares with high ACB are redeemed, a capital loss results, to the extent the payment was deemed to be a dividend. Another tax rule provides that if this capital loss is triggered in the estate within one year of the death, the capital loss may be carried back and applied against the terminal tax return of the deceased, reducing or eliminating the deceased’s capital gain. The double tax is eliminated, but the estate has a taxable dividend.
Subsection 84(2) - CRA’s anti-pipeline strategy
Subsection 84(2) of the Income Tax Act may force the estate to realize a taxable dividend even where the pipeline strategy is used. The CRA seeks to use this rule against us in post mortem tax planning. Simplified, this rule says that if the repayment of the promissory note to the estate can be considered to have been distributed on the winding-up of the business of the corporation, the amount is deemed to be a dividend, ruining the pipeline strategy and possibly creating a punishing total tax burden.
The CRA has interpreted subsection 84(2) as applying to a pipeline where the distribution to the estate occurs in a short time frame following the death. They have issued administrative rulings that tell us how they think it should be done to avoid a deemed dividend.
In a recent case heard in the Tax Court of Canada, the pipeline was completed within seven months of the death - a much shorter time period than any under published CRA rulings. The payment to the estate was recharacterized by the CRA as a taxable dividend under subsection 84(2). In the court decision, the Tax Court judge noted a number of ways this case differed from a well-known previous court decision in which 84(2) was held to apply. Nonetheless, the court felt bound by the previous court decision, and upheld the CRA’s dividend treatment. The court allowed the executor to use trust tax reporting rules in a way that made the result less punitive than the effective 70% rate that would have resulted under the government’s assessment.
Executors seeking to implement a post mortem pipeline transaction must take great care to ensure that the planned distribution does not fall within the conditions described in subsection 84(2), taking into account the rule’s interpretation by the CRA. This recent Tax Court of Canada case shows that when it comes to the post mortem pipeline strategy, we need to pay close attention to the CRA’s interpretations.
© Heritage Private Wealth Law
General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.