Articles & Media


Tax Planning Opportunities

19-May-20

By Michelle Fong and MaryAnne Loney

The COVID-19 pandemic has impacted every facet of regular life for Canadians. We see this in the health care authorities issuing safety guidelines, the government implementing economic measures to buoy a suffering economy, and everyday people living surreal lives while practicing social distancing. For many, one of the most stressful results has been financial as businesses have been forced to close, the value of oil has plummeted and no one knows if and when the economy will get back to normal.  

While the last thing many business owners want to think about right now is tax planning, it is important to be aware that there are tax considerations which could have significant impacts right now, both in the form of tax planning opportunities that can make you better off and tax risks that can cause you problems if you don’t properly prepare.

We will discuss several of these tax considerations below.

Depressed Corporate Value: An opportunity for a corporate freeze or refreeze

If you are a business owner who owns a corporation now may be a good time for an estate freeze or a refreeze.

An estate freeze allows you to “freeze” the current value of your business by exchanging your common shares for preferred shares. These preferred shares have a redemption value equal to the fair market value of the business and may be redeemed over time (resulting in deemed dividend income). Your employees, children or a family trust (whoever is to get the future growth in value of the corporation) can then subscribe for new common shares at a nominal value since all of the “value” of the business is already locked in your preferred shares. From that point, any growth in value in the business flows to the new common shareholders.

If you completed an estate freeze in the past and the value of the business has now dipped below the value of the preferred shares, you may want to consider doing a refreeze. From a corporate law perspective, the redemption value of the preferred shares should not exceed the value of the business as this means that the preferred shares will not be fully redeemed.

An estate freeze or refreeze allows the future growth of the corporation to be transferred to someone else, without triggering immediate tax.  Taxes are deferred until the preferred shares are sold or redeemed, which may be done over time, or upon your death.

Benefits

There are two reasons business owners will normally implement an estate free.

First, from an estate planning perspective, if the new common shareholders are also your beneficiaries when you die, you are able to defer the potential capital gains taxes your estate would otherwise incur on your death. Only the preferred shares you still own will be deemed disposed and taxed when you die while any growth since the freeze will instead already belong to your beneficiaries via their common shares.  You may also use the preferred shares to equalize between business-owning children and non-business-owning children. The preferred shares have a redemption value but usually do not carry voting rights, therefore you can leave some or all of the preferred shares in your Will to your non-business-owning children.

Second, from a business transition perspective, if children or key employees are taking over the business as founders retire, it often makes sense for the people who are currently operating the business to benefit from its future growth.  This not only motivates the new owners but also protects the value the original owners have locked in the preferred shares.  Over time, the preferred shares can be redeemed by the corporation or purchased by the new owners.

Both of these objectives are best achieved if the value of the preferred shares is as low as possible.  However, to avoid immediate tax consequences the shares must be frozen at their fair market value.  That means that when the fair market value legitimately drops, it may be a good time to consider doing a corporate freeze.

Losses: An opportunity to offset previous or future income or gains

Each type of loss receives different treatment:

  1. Net Capital losses – Incurred when you sell capital property at a loss, such as shares, investments, equipment, and land (assuming you are not in the business of selling these properties). These can only be netted against taxable capital gains and can be carried back 3 years and carried forward indefinitely.
  2. Non-capital losses – Incurred when there are business losses or other non-personal, non-capital losses. These can be netted against any income and can be carried back 3 years and carried forward 20 years. If you have not applied a non-capital loss by the end of 20 years, then it will convert to a net capital loss.
  3. Allowable Business Investment Loss (ABIL) – Incurred when you sell qualified small business shares at a loss. Generally, these are shares in Canadian-controlled private corporations that use 90% or more of their assets in active Canadian business. These can be netted against any income and can be carried back 3 years and carried forward 10 years. After the 10 years, it will convert to a net capital loss.

There are other losses as well, such as farm losses and restricted farm losses, that can be applied in other situations.

Benefits

Losses can be carried back or carried forward to reduce the tax burden of future gains and income. This can assist, to some extent, with liquidity issues by generating a tax refund. Further, proper planning can make a significant difference in the value of a loss.  Effective tax planning can allow spouses to take advantage of loss rules and for corporate groups to utilize losses most effectively. The order that things are done can also make a significant difference.  For example, for the best tax result, capital dividends (tax-free) should be paid out prior to triggering capital losses.

Note, however, the stop loss rules may apply to some losses.[1]  Further, the CRA likes to audit loss claims, so it is important to ensure you have proper documentation supporting the loss.  You should discuss with your tax advisor what documentation will be required depending on the type of loss.

Forgiving Debts: Risk that it may create taxable income

Having a debt forgiven is often a relief – it eases the financial pressure on a business. However, it is important to be aware there are debt forgiveness rules that can result in some or all of the forgiven commercial debt obligation being treated as taxable income. 

The debt forgiveness rules are highly complex. But, in simplified terms, when a commercial debt obligation is forgiven, the forgiven amount will “eat up” any existing non-capital losses, farm losses, restricted farm losses, ABIL, and net capital losses you have, in that order (and, in each category, the oldest to newest). You can then apply the forgiven amount to other certain tax bases. If there is excess “forgiven” amount after this, then these may be included in your taxable income.

A commercial debt obligation is essentially any amount loaned to a business.[2]  This means that pretty much any amount you borrowed for business purposes will be caught, even if it was a loan from a related party.

It is also not yet clear if these debt forgiveness rules are going to apply to Canada Emergency Business Account loans. Specifically, 25% of Canada Emergency Business Account loans may be forgiven if repaid to a certain date. On the face of it, the debt forgiveness rules would appear to apply since these loans are commercial loans.

Risks

If you have accrued losses, then having a lender forgive debt will have minimal immediate tax impact if the forgiven amount can be applied to accrued losses. From a cash flow perspective, even though there may be undesirable tax impacts since you cannot utilize losses against prior and future profitable years, it will still allow the business to retain some of its cash instead of needing it to service debts.

However, if the forgiven amount becomes taxable income (if insufficient accrued losses to offset) then this will in turn create a tax liability.

Lending to Your Own Business: Risks and opportunities of shareholder loans

Shareholders and business owners (and their relatives) may lend their personal funds to the business to keep it afloat. Inversely, businesses can also loan to their shareholders if the shareholders require funds temporarily.

Benefits

Businesses that need cash may look to three options: Shareholders, new investors, and commercial lenders. Investors are likely reticent to invest in businesses right now, as they may be facing their own struggles. Commercial lenders are offering loans with the support of the government, but these loans are generally at prime rate or higher and it may be difficult for some businesses to get the amount they need within the time they need. Loans from a shareholder can therefore be a good option if the shareholder has the resources. 

Also, loans to shareholders do not trigger any immediate tax consequences.[3] Then, when the corporation is able to, the loaned amount may be repaid by the shareholder tax-free.

Risks

The risk of lending to your corporation is, of course, the risk that the corporation may never be able to pay it back.  The reason a loan can be repaid tax free is because you have used after-tax funds for the loan. If the business then cannot repay your loan, then it means you have paid tax on those funds and yet have been left with nothing.

In the event a loan is not repaid to you, you may be able to claim a loss, depending on the potential circumstances (the loss may even be an ABIL which is quite valuable).  However, the CRA is very critical of loss claims, especially ABIL claims, and tends to audit such claims.  Therefore, it is critically important when making the loan that you take proper steps to ensure the loan will qualify as a deductible loss in the event it is not repaid.

The main consideration is that the loan is for the purpose of earning income to the lender.  That means if the lender is not a shareholder who is eligible for dividends, interest should be charged.  However, the lender should also make a realistic assessment regarding whether they think they will be repaid and can earn income on the loan. The lender should also keep documentation supporting their reasoning. This can get surprisingly complex so it is worth talking to a tax advisor before making a loan to a business, especially if the business is in financial distress.

Prescribed Rate Loans: An opportunity for income splitting

For many years, tax lawyers spent a significant amount of time organizing clients’ affairs in an attempt to allow income splitting between higher income earners (who are taxed at high marginal tax rates) and lower income earners (who are taxed at lower marginal tax rates).  Changes to the Income Tax Act over the last few years have eliminated many of these opportunities.  However, one opportunity that still exists is prescribed rate loans.

Usually, giving loans to certain family members so that they can use such loans to invest will be subject attribution. This means that any income from these investments (bought with the loan) will be taxed in the hands of the lending family member (higher income earner). An exception to the attribution rules is if interest is charged at (at least) the prescribed rate (being the prescribed rate at the time of the loan). This results in the investment income earned with the loaned funds being taxed in the family member’s hands instead of in the lender’s hands.

Benefits

Starting on July 1, 2020, the prescribed rate will be 1%, which means the interest that must be charged to avoid attribution is relatively minimal.

Provided that the income earned on the investments is higher than the prescribed rate, this is an effective income splitting method since the income from the investment (less the interest charged) will be taxed in the hands of the lower-earning family member instead of in the hands of the lender. Also, since the interest rate on the loan may be locked in at the outset of the loan, loans made effective July 1, 2020 may take advantage of the extremely low prescribed rate of 1%.

Transferring assets: Opportunity to minimize capital gains

If you would like to transfer assets to a non-arm’s length party, this may be the perfect time to do so. Since non-arm’s length transfers are considered to occur at fair market value, subject to specific exceptions. [4] when there are substantial unrealized gains the transfer will have significant tax consequences.  However, if the property currently has minimal capital gains, then the transfer will have minimal tax consequences.

Benefits

There are not always exceptions that allow for the specific non-arm’s length transfer that you want to complete to be tax deferred.  Further, even when exceptions are available, they often require additional long-term complications and additional documentation that must be prepared by your lawyer and accountant which increases costs.  Therefore, if you have an asset you want to transfer to a non-arm’s length party, having it lose value may save you significant tax and/or professional fees.

 

[1] Stop loss rules aim to prevent shifting a loss to an affiliated or related person when no real loss has occurred in the group. Where a real loss has occurred, there can be some tax planning appli

[2] The technical test is whether interest was or could have been deducted if charged.

[3] Note if a corporation loans money to a shareholder and the loan is not repaid within one year of the corporation’s tax year-end, then the loan will be included in the shareholder’s personal income. If the shareholder loan is repaid within the one-year timeframe, then interest at the CRA prescribed rate will still be imputed to the income of the shareholder. However, the prescribed rate will be decreased to 1% on July 1, 2020.

[4] For example, a section 85 rollover may be used to transfer investment assets into a corporation. This would defer capital gains in your personal hands until later, when you redeem the share consideration that you receive in return.

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