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Estate Freeze Techniques

From tax expert Gerry Vittoratos
July 27, 2020
 

In the first instalment, we saw the basics of estate freezes. In this instalment, we will see how to perform an estate freeze through various techniques.


Estate Freeze Techniques

There are two general approaches to implementing an estate freeze: internal techniques and external techniques. The main distinction between these two techniques is the creation of separate entities in order to perform the freeze with the external technique, which is not required to perform the internal techniques. We will now break down the various ways we can perform either.

Sale To a Holding Company (External Technique)

The author of the freeze sells the shares of his/her operating company to a family holding company whose common shares belong to the beneficiaries of the freeze, directly or through an inter-vivos trust.

The sale of the shares will usually be done through a section 85(1) rollover and can be done without immediate tax consequences if the elected amount chosen is the ACB of the shares exchanged. The author of the freeze can also trigger the capital gains deduction (crystallize) by inflating the elected amount in order to use up his/her lifetime exemption.  

This type of exchange will inevitably trigger the deemed dividend rules of section 84.1 if the transaction is done amongst related persons. If section 84.1 is triggered, then a portion or the entire capital gain could be converted into a taxable dividend.
This approach does add some complexity to the estate freeze due to the use of another corporation to execute.

Here’s a layout of how the procedure of using a holding company would work.

 




Donation (Internal Technique)


The author of the freeze simply donates the shares he/she holds to the successors. Considering that in most of these cases the donation will be made between “related persons”, the transaction will be deemed at arm’s length. Due to this, the author of the estate freeze will be deemed to have disposed of his/her shares at fair market value (FMV) [ITA 69(1)(b)], and the successor will be deemed to have acquired the shares at fair market value (FMV) [ITA 69(1)(c)].

This approach is by far the simplest of the ones we will discuss in this article. However, it does come with immediate tax consequences, which is a taxable capital gain as of the moment of the donation. This gain can be mitigated by the capital gains deduction should the company’s shares be considered qualified small business corporation shares [ITA 110.6(1)]. No capital gains reserves can be claimed since the donor is deemed to have received fair market value (FMV) for the shares [ITA 69(1)(b)], and is not expected to receive any additional funds in future years [ITA 40(1)(a)(iii)].

Another consideration if choosing this approach is the fact that the author of the freeze loses control of the shares and might consequently lose control of the company. This is different from other techniques we will see below.


Direct Sale of Shares (Internal Technique)

The author of the freeze sells the shares he/she holds to the successors in a bona fide transaction. Since the transaction will likely be amongst related persons, the sale price of the shares will be set at fair market value (FMV) [ITA 69(1)(b)], and the cost of the shares acquired by the successors will be set at fair market value (FMV) [ITA 69(1)(c)].

This approach is also very simple but would require legal documents to make the transaction official. Just like the donation technique, it comes with immediate tax consequences with a taxable capital gains transaction to declare. However, the tax effects can again be mitigated by the capital gains deduction should the shares be considered qualified small business corporation shares at the time of sale (see donations section above).

An important consideration using this technique is financing the transaction. Since this is a bona fide transaction between the author of the freeze and the successors, the latter must find the funds to finance the transaction. The successors could take out personal loans, which would be difficult to obtain considering the funds involved.

Another way of financing the transaction is by creating a holding company (external technique discussed above) and having that company buy the shares instead of the individual successor. It will be easier for the holding company to obtain a loan for the funding of the transaction. However, if the holding company is owned by related persons, the deemed dividend rules under section 84.1 would be applicable, and convert a portion of the taxable capital gain of the author of the freeze to dividend income. Consequently, no capital gains deduction can be claimed if section 84.1 becomes applicable.


Exchange of Shares (Internal Technique)

The author of the freeze exchanges his/her common shares for preferred shares in the same corporation. In this case, the exchange of shares will be done with little to no additional taxation using specific sections of the ITA.


The tables below summarize the various sections available for this exchange:


Section 85(1) rollover

Mechanism

The common shares are rolled over to the corporation in exchange for preferred shares

Conditions

1 - The transferor is either an individual, corporation or a trust [ITA 85(1)]
2 - The transferee is a taxable Canadian corporation [ITA 89(1)]
3 - The asset rolled over is an eligible property [ITA 85(1.1)]
4 - The consideration received from the transferee must include at least one share of capital stock
5 - A joint election (T2057) must be filed by the prescribed deadline [ITA 85(6)]

Administrative requirements

T2057 form must be completed by joint election

Tax Implications

Depends on the elected amount chosen, can be tax-free if elected amount=ACB

 

Section 86 reorganization

Mechanism

All common shares held are disposed of and replaced by preferred shares

Conditions

1 - The transferor is either an individual or a corporation
2 - Transferor disposes of all the shares of one class (“old shares”)
3 - Transferor receives in exchange a new class of shares (“new shares”) or other assets

Administrative requirements

No form required, automatic application

Tax Implications

No capital gains to declare since the disposition amount = ACB

 

Section 51 – Convertible property

Mechanism

Exchange a “convertible property” (common shares) for other shares (preferred)

Conditions

1 - The property exchanged is a stock, bond or note from a company (“convertible property”).
2 - A share of the capital stock of a company is acquired following the exchange of a "convertible property". The exchange is therefore carried out with the same company.
3 - The exchanged convertible property qualifies as an asset (not in inventory).
4 - No non-share consideration (boot) is received in exchange for the convertible property.

Administrative requirements

No form required, automatic application

Tax Implications

No capital gains to declare since the disposition amount = ACB

 

Here are some important facts to consider when choosing any one of these sections for the exchange of shares:

  • Section 85(1) takes precedence over section 86 [ITA 86(3)], and in turn section 86 takes precedence over section 51 [ITA 51(4)].
  • If the author of the freeze wants to trigger the capital gains deduction (crystallize), he/she can only do so with an ITA 85(1) rollover since they can choose the disposition amount through the elected amount mechanism. This choice is not available for sections 86 and 51.
  • If the author of the freeze wants to receive assets other than shares in the exchange, he/she cannot use the section 51 mechanism.

 

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