Estates May Need to Take Steps to Trigger Losses During First Year28-Jul-17
Proposed tax amendments have significantly limited options available for dealing with shares of private corporations in estates. Executors may now need to take active steps to trigger losses to avoid significant tax consequences.
On July 18th, 2017, the Department of Finance released proposed changes to the Income Tax Act (the “Act”). These changes have the stated aim of eliminating many of the tax advantages of private corporations.
While the proposed legislation is not directly aimed at estates (which are granted special tax treatment as graduated rate estates (“GREs”) during the three years after death) one of the proposed changes could have significant negative tax consequences for GREs and their beneficiaries.
Effective July 18th, 2017 (so immediately!) the Department of Finance has expanded and added to the anti-avoidance provisions preventing surplus stripping by individuals.
Only 50% of capital gains are subject to tax, meaning they are taxed at a significantly lower effective rate than dividends. Therefore, there are substantial advantages in taking profits out of a corporation as capital gains instead of as dividends – i.e. surplus stripping. The Canada Revenue Agency and the Department of Finance have long had issues with surplus stripping and there were already provisions in the Act which aimed to prevent it in certain circumstances, most notably when the lifetime capital gains exemption (“LCGE”) had been claimed on shares in the past by a related party in order to increase the adjusted cost base (“ACB”) of the shares.
The proposed changes would dramatically expand the scope of provisions which prevent surplus stripping such that no capital gain ever previously reported by a non-arm’s length party will contribute to the “hard” ACB of shares for the purposes of surplus stripping.
This causes a problem for estates and their beneficiaries because they will usually be related to the deceased. Therefore, despite the fact that the deceased was required to pay taxes on a deemed disposition at fair market value on his or her death, unless the estate or beneficiary can find an arm’s length purchaser to buy the shares, any amounts taken out of the corporation will be taxed a second time as dividends.
Luckily, there is one potential solution to this problem – use the loss carry back available to GREs in their first year. If all the value in the shares is paid out in the form of dividends and the shares are then disposed of (either by winding up the corporation or redeeming the shares) this will trigger a capital loss in the estate equal to the value of the shares high ACB. The estate may elect to carry this loss back to the deceased’s terminal return, thereby eliminating the capital gain the deceased was required to report.
This will still result in the amount being taxed at the higher dividend tax rates, as opposed to the lower capital gains tax rates, but at least the double taxation is avoided. Steps which previously allowed for the capital gains tax treatment instead of the dividend tax treatment will no longer be effective.
It is critical to note that the loss carry back is only available in the first year. Therefore, it is crucial that executors take steps in the first year of the estate to trigger the losses or they will lose the opportunity.
What Executors Should Do
The above described changes potentially require executors to take active steps during the first year of the estate to avoid significant negative tax consequences. As a result, we recommend that executors of estates with corporate shares should consult with a tax advisor as soon as possible regarding what, if any, steps should be taken in light of the changes.
Click here to read our alert on how the proposed changes to the Income Tax Act will affect small business owners and professionals.