Canada: Post-Mortem Planning After TOSI

The Tax on Split Income (TOSI) regime has had significant impact on tax planning strategies for owner-managed businesses. (See our previous Tax Alerts for more on these new rules.) Although the focus has been on inter vivos planning, post-mortem planning strategies have also been affected. The right post-mortem planning strategy must now be considered alongside the application of TOSI, as the rules provide specific exceptions for inherited property.

Income paid to an individual under age 25 is not subject to TOSI where property is inherited from a parent. Similarly, for property inherited from someone other than a parent, TOSI will not apply if the individual is under age 25 and enrolled as a full-time student in a post-secondary educational institution.

The TOSI rules also provide for “continuity” provisions, which allow beneficiaries to inherit contributions of the deceased person in determining whether TOSI applies. The continuity provisions are:

  • For purposes of applying the reasonable return exception, the factors that were relevant to the deceased will be relevant to the beneficiary (e.g. the work performed by the deceased, the property contributed by the deceased, the risk assumed by the deceased).
  • For purposes of the excluded business exception, where the deceased was actively engaged on a regular, substantial and continuous basis in the activities of a business throughout five previous taxation years, the beneficiary is deemed to have been actively engaged on a regular, substantial and continuous basis.
  • For the purposes of the excluded share exception, which requires the shareholder to be over age 24, the beneficiary is deemed to have attained age 25 if the deceased was 25 years or older prior to death.

These continuity provisions, along with property inherited by someone under age 25, apply only where property has been inherited as a consequence of the death of another person. Thus, problems with applying these provisions arise where shares are inherited through a life interest trust, such as spousal or alter ego trusts. The issue becomes whether a distribution from the life interest trust to the beneficiaries is considered to be received as a consequence of death. Consider, for example, a parent who dies leaving private company shares to a surviving spouse through a testamentary spousal trust. On the death of the surviving spouse, if the terms of the spousal trust do not provide a clear requirement for the shares to be distributed, it may not be the case that the beneficiaries receive the shares as a consequence of death. If the shares have not been received as a consequence of death, the beneficiaries cannot rely on the continuity provisions to avoid the application of TOSI.

The continuity rules also pose problems when considering various post-mortem planning strategies. When an individual dies holding private company shares, planning is typically undertaken after death to minimize the potential for double taxation. Double taxation can arise as a result of the deceased being taxed on the deemed capital gain and the estate/beneficiaries being taxed when funds are withdrawn from that corporation. In order to minimize double taxation, there are two common post-mortem planning strategies available to advisors and executors.

The first strategy, referred to as the loss carryback strategy, requires that the shares held by a graduated rate estate (GRE) be redeemed, or that the corporation be wound up, within one year from the death of the deceased. The results of the redemption/wind-up are a dividend to the GRE and a capital loss, which can be carried back to the deceased’s final tax return and offset against the capital gain.

The second strategy, referred to as the pipeline strategy, requires the estate to incorporate a new company. The estate then sells the shares previously owned by the deceased to the new company in exchange for a promissory note. Since the shares have an adjusted cost base equal to the fair market value, there are no additional tax implications from the sale of the shares. Eventually, the new company and the existing company are amalgamated. The result is that the deceased reports and pays tax on the capital gain and the estate now owns shares of an amalgamated company, with all the value contained in a promissory note owing from the amalgamated company that can be received tax-free (subject to subsection 84(2) of the Income Tax Act).

Although these two strategies are useful in eliminating the two layers of tax that can arise, the right strategy must now be considered within the context of TOSI. Often, the common shares of a private company are held through a discretionary family trust with the founding shareholder owning a special class of shares with fixed value. If the executors choose to undertake a loss carryback strategy by way of share redemption on the special shares, these shares effectively disappear upon redemption and are no longer available to the beneficiaries. The beneficiaries will continue to benefit from the common shares held through the family trust, but the common shares will not be considered property inherited as a consequence of death. Consequently, future dividend payments on the common shares to the family trust will not benefit from the continuity exceptions. This result could leave the beneficiaries in a position where future dividend payments from the family trust are subject to TOSI if they themselves do not qualify for one of the exceptions. 

A similar issue arises in the context of the pipeline strategy, although it is less clear how the continuity rules would apply under this strategy. As a result of the pipeline steps, the estate holds newly issued shares of a new corporation, and the shares previously owned by the deceased eventually disappear upon amalgamation. Questions arise as to whether the shares of the new company transferred to the beneficiary will constitute property that was acquired as a consequence of death, and whether the continuity rules apply to shares the deceased never owned. Based on the language of the legislation, it appears the continuity rules would not apply.

If the continuity rules do not apply, consideration should be given to retaining the shares in the deceased’s GRE for the first 36 months after death. Dividends received by the GRE are not subject to TOSI and are taxed at graduated tax rates, as the rules do not apply to trusts.

The introduction of the TOSI rules should now, at a minimum, give executors and their advisors pause in determining the right strategy. It may be the case that beneficiaries themselves fit within one of the exceptions. But where they do not, it will be crucial to consider the interaction of TOSI with the objective of minimizing double taxation in order to benefit from the continuity provisions.

As with all things tax, a little forward thinking can go a long way. Clients should consult with their advisors to determine how these rules affect previously developed estate plans. It will be important to consider who owns shares of a private company at the time of death (e.g. a spouse vs. a spousal trust), who is to inherit shares, and whether the language used in documents such as wills and spousal trusts should be amended to avoid any unintended tax consequences. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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