Incorporated clients will have greater flexibility to avoid double or triple taxation at death under a government proposal that would extend how long an estate can carry back a loss to the deceased’s final tax return.
In draft legislation released Aug. 12, the Department of Finance proposed giving executors up to three tax years, versus one, to use a provision in the Income Tax Act (ITA) that allows a capital loss in a graduated rate estate (GRE) to be carried back to the terminal return.
Without this strategy or another “post-mortem” tax strategy, the value of the business could face up to 83.43% in taxes in Ontario, for example, after the owner dies. That compares with up to 74.50% before Ottawa hiked the capital gains inclusion rate (CGIR) to two-thirds from half, effective June 25.
“This becomes a very, very punitive result,” particularly for clients who leave retained earnings trapped in a private corporation at death, said Hemal Balsara, head of tax, retirement and estate planning, individual insurance, with Manulife Financial Corp.in Toronto.
Restricting the use of the loss carryback strategy to an estate’s first tax year meant many executors ran out of time to implement it.
“Twelve months evaporates quite quickly,” said Brian Ernewein, senior advisor with KPMG LLP in Ottawa. “The additional 24 months are really quite helpful in trying to take the steps necessary to eliminate double tax in this way.”
When the owner of a private corporation dies, the value of their business can be taxed both as a capital gain and as a dividend, leaving little money for heirs.
First, there is a deemed disposition of the owner’s shares on death at fair market value (FMV), which triggers a capital gain included in the final tax return. In Ontario, for top earners, the effective capital gain tax rate is 26.76% on the first $250,000 in gains and 35.69% on gains above. The estate’s beneficiaries then receive the shares with a cost base equal to the FMV at the date of death.
If the corporation redeems the estate’s shares, the proceeds the estate receives from the corporation are treated as dividends. If those dividends are received as non-eligible dividends, they’re taxed at 47.74%.
A third layer of taxation may be imposed if the corporation has taxable assets, which it would need to sell when the business is wound up.
The ITA recognizes the potential inequity of taxing the proceeds of a corporation’s windup as both a dividend and a capital gain. To mitigate that problem, the ITA allows for the proceeds to be reduced by the amount of the dividend, resulting in a capital loss to the estate.
Subsection 164(6) in the ITA then allows an executor to reduce or eliminate double taxation by having the loss associated with the windup be treated as the deceased’s capital loss in their final return, offsetting the capital gain from the deemed disposition at death. The estate is left with just the tax on the dividends and the corporate tax on the sale of assets.
“That’s obviously an advantage,” Ernewein said.
There are other strategies to address the double taxation issue. These include the pipeline strategy, which seeks to eliminate the dividend tax to the estate in favour of capital gains realized in the final return; the bump strategy, which seeks to increase the cost base of certain assets in the corporation to reduce taxes on disposition; and hybrid strategies, which combine the loss carryback, pipeline and/or bump strategies.
With a longer timeline available to employ the loss carryback, the pipeline strategy may become less favoured, said Henry Korenblum, president of Korenblum Wealth Inc.in Toronto.
“You might now see people doing fewer pipeline due to the higher [CGIR],” Korenblum said.
While a bump/pipeline hybrid can be effective for reducing or eliminating the dividend tax and tax on the disposition of corporate assets, both strategies have their drawbacks, Balsara said.
The bump strategy is complex and doesn’t apply to certain asset classes, while the pipeline strategy can be expensive to implement and expose the taxpayer to compliance issues, he said.
In recent years, the Department of Finance has signalled its displeasure with strategies that seek to recharacterize dividends as capital gains. Recent rulings by the Canada Revenue Agency (CRA) intended to provide guidance on which types of testamentary pipeline planning have the agency’s blessing are “all over the map,” Balsara said.
“The CRA’s position has been like the Hokey Pokey: sometimes they’re in, sometimes they’re out and sometimes they have to shake it all about,” he said.
The loss carryback strategy offers compliance certainty and allows the incorporated client to maximize the tax-preferential pools in the corporation — the capital dividend account, refundable dividend tax on hand and the general rate income pool.
If a business owner puts in place a corporately owned life insurance policy, the proceeds of that policy and the capital dividends created by the policy’s death benefit can be used to fund the redemption of shares, further decreasing the tax hit to the business owner’s family.
“Instead of being taxed at 47.74% on a regular dividend, you’re being taxed at zero on the capital dividend,” Balsara said.
Balsara added that clients using the loss carryback strategy should consult with their tax advisor to determine if stop-loss rules, which may prevent the estate from carrying back part of the loss to the deceased’s return, would apply. Clients may also want to consider if there would be any benefit to preserving some of the capital dividends for the next generation.
Loss carryback proposed changes
In draft legislation released Aug. 12, the federal government proposed extending the period, to three tax years from one, during which an executor can elect under Subsection 164(6) of the Income Tax Act to carry back losses from a graduated rate estate (GRE).An estate can be a GRE, benefiting from the same graduated rates of taxation available to an individual taxpayer, for up to 36 months following death. The government said the extension to three tax years would align the tax treatment for losses realized by a GRE with losses realized by other taxpayers.
In a Sept. 4 release, STEP Canada praised the proposal, saying it would give GREs “sufficient time to assess alternatives and undertake post-mortem planning to avoid double taxation.” The organization had asked the Department of Finance for the change in June, arguing that executors need more than one tax year to administer an estate and obtain professional tax advice before implementing a post-mortem tax plan.
The government also indicated that executors would no longer need to file an amended final tax return for the deceased when using the loss carryback provision, and instead would need to file only “a prescribed form” to amend the final return.
The government made the change “to simplify the election process while still ensuring that the Minister of National Revenue obtains the information required to give effect to the election,” it said.
If the draft legislation passes, the changes will be effective for individuals who die on or after Aug. 12, 2024, and for the GREs of individuals who die on or after that date.
This article appears in the September issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.