When implementing an estate freeze for a private corporation using one of the rollover provisions of the Act, there can be concern that the corporate attribution rule will apply. One way to avoid this problem is to use a stock dividend freeze, but care must be taken to deal with potential problem areas.
The corporate attribution rule in section 74.4 may apply when one of the rollover provisions (section 51, 85, or 86) is used to implement the exchange of common shares for fixed-value preferred shares on a tax-deferred basis. When a shareholder transfers property (for example, a share) to the corporation, and one of the main purposes of the transfer is to reduce the shareholder's income and to benefit "designated persons" (which for purposes of section 74.4 includes spouses and minor children), the attribution rule may apply to deem the shareholder to have received the income. The rule does not apply in certain circumstances, the most important of which is that the corporation is a small business corporation.
A "stock dividend estate freeze" could be implemented to avoid the corporate attribution rules as described above. This can be done by issuing preferred shares in the form of a stock dividend to the shareholder, provided that the governing corporate statute allows it. The shares would have a low paid-up capital and a high redemption value, with the redemption value being equal to the FMV of the corporation at that time. Family members can then purchase common shares of the company at nominal value. Because no property is transferred to the corporation through this method, corporate attribution will not apply.
Several issues should be considered on a stock dividend estate freeze. One is the potential conferral of a benefit as outlined in subsection 15(1.1). If it is determined that one of the purposes of the stock dividend is to significantly alter the value of the interest of any "specified shareholder" of the corporation, the FMV of the stock dividend (except to the extent of any taxable dividends received under paragraphs 82(1)(a), (a.1), and (c) to (e)) is included in the income of the recipient of the stock dividend. Caution should be taken when dividends are declared on one class of shares to the exclusion of another.
Another issue to consider is subsection 69(1). It can apply where the CRA determines that the value of the corporation is in excess of the redemption value of the preferred shares issued, and non-arm's-length persons (typically family members) have subscribed for shares at nominal value. Because a benefit has been conferred on those shareholders—they paid less than FMV for the shares—subsection 15(1) will deem an income inclusion. Importantly, the CRA's position is that a price adjustment clause is not valid on a stock dividend, whereas under section 51, 85, or 86 a price adjustment clause is generally valid protection against the CRA assessing a different value of the corporation (assuming that a reasonable attempt at valuation is made) (see CRA document no. 2003-0004125(F)).
There can also be accounting consequences. Accounting Standards for Private Enterprises (ASPE) state that fixed-value preferred shares issued by way of a stock dividend are to be shown on the balance sheet as debt at the redemption amount. (The exception for preferred shares issued in a tax-planning arrangement under section 51, 85, 85.1, 86, 87, or 88 of the Act does not apply here.) This can affect items such as debt covenants.
As with any tax-planning transaction, the issue of GAAR may be raised. However, there are no court decisions to support this and the CRA has not made any public statements on this point.
Previously on the Canadian Tax Foundation website
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