One of the major considerations in post-mortem planning is the deemed disposition on death. Subsection 164(6) of the Income Tax Act ("ITA") provides one method of addressing the deemed disposition. That subsection permits a graduated rate estate to elect to carry a capital loss from the first year after death back to the terminal year of the deceased. The election is available to the extent the capital loss exceeds any capital gains that arise for the estate in that year. The carried back capital loss can then help to offset the capital gain realized from the deemed disposition on death.
Other sections of the ITA can have interesting and unexpected interactions with subsection 164(6). One of those interactions arising from subsections 40(3.6) and (3.61) was discussed at the 2020 STEP CRA roundtable. The CRA's answer is significant because it indicates a change of position from the views the CRA had expressed when asked about the same issue in 2012. By way of background, subsection 40(3.6) generally applies to restrict a loss on the disposition of shares to an issuer when the shareholder and issuer are affiliated immediately after the disposition. The issuer refers to the corporation that issued the shares. A disposition of shares to the issuer is a common method of crystalizing a loss for a subsection 164(6) election and the estate and the corporation will often be affiliated. The application to 40(3.6) to limit 164(6) elections was apparently not intended. Subsection 40(3.61) was added in 2004 to provide relief to estates seeking to make subsection 164(6) elections. Subsection 40(3.61) reads
If, in the course of administering the estate of a deceased taxpayer, the taxpayer's legal representative elects in accordance with subsection 164(6) to treat all or any portion of the estate's capital loss (determined without reference to subsections 40 (3.4) and (3.6)) from the disposition of a share of the capital stock of a corporation as a capital loss of the deceased taxpayer from the disposition of the share, subsections 40 (3.4) and (3.6) apply to the estate in respect of the loss only to the extent that the amount of the loss exceeds the portion of the loss to which the election applies.
Subsection 40(3.61) refers to the loss determined without reference to subsections 40(3.6). There is no equivalent wording in subsection 164(6). Practitioners observed that this leads to an apparent circularity.1 The amount of the loss for subsection 40(3.61) purposes would be determined in accordance with other provisions of the ITA but before 40(3.6). On the other hand, the amount under 164(6) appears to be calculated after 40(3.6) and 40(3.61) are applied.
The problem is primarily relevant when the estate also had a capital gain in its first year. Say the estate had a $100 loss and a separate $20 gain for ease of example. Due to paragraph 164(6)(a) only the portion of the loss exceeding the gain can be carried back. In the example, only $80 could be carried back. The excess loss of $20 not covered by the election is not protected by subsection 40(3.61) and would be deemed to be nil where subsection 40(3.6) applies. The concern was that the loss available for the subsection 164(6) election would then be reduced by the portion of the loss deemed nil by subsection 40(3.6). In the example, this would mean the loss would only be $80, and the amount eligible for the election would still be restricted by the $20 gain. This could then occur in circles until the whole loss was ground down. While this was primarily a concern where the whole loss was not eligible for the election because of a gain, it could also occur where the election was not applicable to the entire loss for some other reason.
The CRA was asked about this circularity in 2012.2 At that time, they confirmed that the technical application of the provisions does appear to result in circularity. The CRA had not actually seen an instance of the circularity occurring and indicated it would review matters on a case-by-case basis. While this was not a definite statement that the subsection 164(6) loss amount would be ground down, it did appear that the CRA was inclined to interpret the provisions that way.
At the 2020 STEP CRA Roundtable the CRA was asked to revisit this issue. The question and response themselves were previously published in Tax Topics issue 2543. The CRA has now changed its guidance. The updated CRA response indicates that grinding down the estate's loss in the way that appears to be possible due to the circularity would be contrary to the purpose of subsection 40(3.61). The CRA also set out its current view of how the provisions should apply. The CRA will apply subsection 164(6) first, without reference to subsections 40(3.4) or (3.6). Then subsections 40(3.4) or (3.6) apply to any loss not subject to the 164(6) election.
The scenario considered in the question and answer involved a scenario relating to Mr. X. Mr. X died owning all of shares in the capital stock of a private corporation ("PrivateCo") as well as a broader investment portfolio. These assets were subject to the deemed disposition on death under subsection 70(5). The estate realized further capital gains from the investment portfolio of $30,000 in its first year. Also, in the first year after death, PrivateCo redeemed a portion of the shares held by the estate which generated a capital loss of $1 million for the estate.
The amount eligible for the subsection 164(6) carryback is the net loss of $970,000 due to paragraph 164(6)(a). The CRA's answer assumes the estate elects to carryback the full $970,000. In the CRA's current view, paragraph 40(3.6) would apply only to the $30,000 that was not eligible to be carried back. In this case Mr. X and then his estate owned all of the shares of PrivateCo. The estate only redeemed a portion of the shares. After the redemption, the estate would continue to hold the remaining shares which are all of the shares outstanding. As such, the estate would appear to control PrivateCo and be affiliated under the definition in subsection 251.1(1) immediately after the disposition. Therefore, subsection 40(3.6) deems the remaining $30,000 loss to be nil. The $30,000 gain is not reduced by the loss and the estate would still pay tax on the $30,000 gain. Since the CRA is now of the view that subsection 164(6) is determined without reference to subsection 40(3.6), the application of subsection 40(3.6) would not impact the subsection 164(6) election. As a result, the estate would be able to carry back the $970,000 net loss against the gain on the terminal period return.
This is a welcome clarification which does appear to be consistent with the intention of subsection 40(3.61). However, this result does appear to require the CRA to read words into subsection 164(6) that are not actually there. It would be preferable to have a legislative amendment to confirm this interpretation.
Footnotes
1 Nick Moraitis and Manu Kakkar, "Potential Circularity Problem with Estate Loss Carryback" (2006) 6:3 Tax for the Owner-Manager 6-7.
https://taxfind.ca/#/document/2006_TOM_6(3)_article_7
2 2012-0462941C6 — 2012 Ontario Canadian Tax Foundation Q14—circularity with 164(6), 2012-0449801C6 — STEP CRA Roundtable Question 5—June 2012
Originally Published by GSNH, February 2021
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