Introduction - Deemed Disposition Upon Death and Double Taxation

One of the major considerations in estate planning for Canadian taxpayer is the deemed disposition upon death. Under paragraph 70(5)(a) of the Income Tax Act, when an individual dies, all owned capital property is deemed to have been sold immediately prior to death for proceeds equal to the fair market value of the property.

However, since no property is actually sold when the Income Tax Act deems there to be a disposition upon death, double taxation can occur since the fair market value of the properties are taxed once with deemed disposition upon death, and again when the estate actually disposes the property. This double taxation can be occur when the estate realizes a capital loss after the property of the deceased is deemed to be transferred to the estate upon death. The estate, as a separate person under the law, cannot offset any previously incurred capital gains of the deceased with the capital loss. A tax planning method to avoid this problem is for the testator to have already vested his or her capital properties in a corporation via estate freeze. These properties will not be subject to deemed disposition upon death, and any capital losses incurred by the holding corporation can be used to offset previous incurred capital gains.

Subsection 164(6) of the Income Tax Act is aimed to provide relief against potential double taxation.

This article will explain the subsection 164(6) loss carryback rule and how it interacts with other rules under the Income Tax Act.

Subsection 164(6) - General Outline

A graduated rate estate is the estate that arose on and as a consequence of the individual's death.

Subsection 164(6) of the Income Tax Act provides for a mechanism where a graduated rate estate has the option to elect under subsection 164(6) to carry a capital loss from the first year after death of the testator back against the capital gains incurred in the terminal year of the death of the testator. This loss carryback provision can only be applied for the capital gains in the terminal year of the deceased and cannot be applied for capital incurred in any prior years to the terminal year.

For the subsection 164(6) election to apply, the estate of the deceased must dispose of the capital property of the estate or all of the depreciable property of a prescribed class of the estate within the first taxation year of the estate. We will further discuss the timing issue at the section below.

Subsection 164(6) - Timing Issue

A tax year-end may or may not coincide with a calendar year end of December 31 depending on the type of taxpayer and the elections made by the taxpayer. Under the Income Tax Act, individuals always have a tax year between January 1 to December 31.

However, a gradual rate estate can designate its tax year end flexibly outside of the December 31 year end. This means a graduated estate maybe enjoy the opportunity to "lock-in" their loss carrybacks before the December 31 year end. Consult our experienced Toronto tax lawyers to make sure this is done correctly so as to minimize the overall estate taxes.

Subsection 164(6) - Graduated Rate Estate Status

The estate of the deceased must qualify for the graduated rate estate status in order to make the subsection 164(6) election. There are four requirements it must meet to be considered a graduated rate estate:

  1. must be a testamentary trust resident in Canada,
  2. it must designate itself as such in the T3 return of its first taxation year,
  3. it must be the only graduated rate estate for that testator, and
  4. graduated rate estate can only exist no longer than 36 months after its formation.

Subsection 164(6) - Shares in an Affiliated Corporation

When the capital property disposed under a subsection 164(6) election are shares in a corporation, it is important to pay attention to the stop-loss rules in subsection 40(3.6) and the relief rule in subsection 40(3.61)

Subsections 40(3.6) prevents taxpayers from deducting losses arising from disposition of shares in an affiliated corporation that is affiliated with the taxpayer immediately after the disposition. It does so by deeming the loss to be nil when the taxpayer and the corporation are affiliated persons immediately following the disposition. This rule is designed to prevent taxpayers from artificially generating losses for tax purposes through disposing a property to an affiliated person while effectively still controlling the property.

Subsection 40(3.61) was specifically introduced to restrict the application of 40(3.6) in estate context. When a graduated rate estate elects to use subsection 164(6) loss carryback rule, any application of the subsection 40(3.6) stop loss rule will only be restricted to loss only to the extent that the amount of the loss exceeds the portion of the loss to which the election applies. This makes subsection 40(3.61) a relief provision to override the operation of the stop-loss rule where capital loss is carried back by a graduated rate estate under subsection 164(6).

This means even when the estate and the corporation remain affiliated persons after the estate made its disposition for a capital loss under its subsection 164(6) election, the estate can nevertheless carryback that capital loss against the terminal year capital gain of the deceased without having subsection 40(3.6) deeming such loss to be nil.

Pro Tax Tip - Plan for Your Estate Before Post-Mortem Tax Planning

While a graduated rate estate structure can enable the estate to avoid double taxation as well as enjoy flexible tax year-end elections, capital gain upon death can be more effectively deferred and mitigated with estate planning when making a will. With the advice of experienced Canadian tax lawyers, estate planning structures such as section 85 or section 86 estate freeze, pipeline structure with related corporations and family trust can all be effectively used to achieve your tax planning goals. Whatever your tax planning goals, our experienced Toronto tax planning lawyers are always available to help.

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.