Canada: Post-Mortem Planning: Reprieve For The Pipeline?

When individuals die, they are deemed to have disposed of all of their assets at fair market value at the time of death. This deemed disposition applies to capital property such as vacation properties, rental properties and shares of public and private corporations. An exception to this rule applies where there is a surviving spouse, in which case the assets may be transferred to the surviving spouse with no tax consequences. If there is no surviving spouse, any income resulting from the deemed dispositions is included in a final tax return filed on behalf of the deceased. 

Double taxation

As a result of the deemed disposition, a deceased person's estate acquires the assets at a cost equal to their value at the time the individual died. When the estate subsequently disposes of the assets, it will pay tax only on any proceeds that are greater than the fair market value when the individual died. Most assets will be sold in due course; public company shares may be sold easily while real estate may take longer. However, it may be difficult or impossible to find a purchaser for the shares of a private corporation, particularly one that holds investment assets such as real estate or stock market portfolios. If the private corporation cannot be sold, the estate's only option for accessing the value in the corporation may be to liquidate the assets and remove the remaining funds from the corporation. The withdrawal of corporate assets will be treated as a dividend paid to the estate, which will result in a second incidence of tax related to the shares of the private corporation: first as a capital gain in the final tax return of the deceased and second as a dividend in a tax return of the estate.

Consider the example of an individual, Donald, who died in June 2017. Donald was a widower and, in addition to his RRIF and savings accounts, he owned all of the shares of Holdco. In prior years, Donald had carried on a business in Holdco, which was eventually sold and the net proceeds invested into stocks and GICs. When Donald died, the value of Holdco was $550,000. The original cost of the shares of Holdco was nominal. In Donald's final tax return, his executors would report a capital gain of $550,000 along with the value of his RRIF and other income he had received in the year. In Alberta (for example) the tax resulting from the capital gain could be as high as $132,000. When Holdco is wound up and its investment assets transferred to the estate, the estate would pay about $193,000 of tax. As a result, Donald's estate would pay almost 60 per cent tax on the value of Holdco.

There are currently two options for the executor to avoid this double taxation.  

The subsection 164(6) election

The first option is to wind-up Holdco and distribute its assets to the estate. In addition to the dividend and resulting income tax consequences described above, this option will result in the estate realizing a capital loss of $550,000. Since a capital loss may only be used against capital gains, this loss would likely have no benefit to the estate. However, if the windup of Holdco occurs in the first year of the estate (i.e. within one year of Donald's death), the estate may use an election under s. 164(6) of the Income Tax Act to carry the loss back to Donald's final return to eliminate the capital gain that was previously reported. 

Using this election avoids the double taxation that would otherwise occur. However, it results in the estate paying tax on the value of Holdco as a dividend, which is currently taxed at a higher rate than a capital gain.

The pipeline transaction

The second option is commonly called a pipeline transaction. In a pipeline transaction the estate transfers its shares of Holdco to another corporation, Newco, and in exchange receives a promissory note from Newco equal to the value of Holdco when the individual died. If properly structured, the transfer should result in no tax. Holdco and Newco are then merged and the assets distributed to the estate. A tax liability will arise only if the assets received exceed Holdco's value when the individual died.

The pipeline transaction avoids the dividend that occurs in the s. 164(6) election. The value of Holdco remains taxed as a capital gain in the final return of the deceased. Since capital gains are currently taxed at a lower rate than dividends, the pipeline transaction results in lower tax to the estate.

The Canada Revenue Agency has issued favorable rulings on the pipeline transaction and, among other things, generally requires a company such as Holdco to carry on its business in the same manner as before for a period of at least one year before it is merged with Newco and its assets distributed. Consequently, though the pipeline transaction will produce lower taxes for the estate, the executor may prefer to use the s. 164(6) election to wind up Holdco and distribute its assets to the beneficiaries on a more timely basis. 

The above is a simplified description of a pipeline transaction. Before implementing such a strategy, a thorough review of the technical provisions of the Income Tax Act is recommended. Executors should consult with their professional advisors.

Recent events

On July 18, 2017, the federal finance minister proposed a number of new tax rules for private corporations, including a provision that would have ended the use of the pipeline transaction by deeming the estate to receive a dividend on the transfer of the Holdco shares in the above pipeline example. Consequently, double taxation would again apply in a pipeline transaction, and it appeared that, after July 18, the only way to avoid the double taxation would be through a s. 164(6) election.

However, on October 19, 2017, the minister announced that the government will not be moving forward with the July 18 proposals related to the conversion of income into capital gains, including those affecting pipeline transactions. In addition, the government will re-examine these specific proposals with a possible reintroduction of some of them. It remains to be seen whether the pipeline transaction will be targeted again in the future.

At present, it appears that the pipeline transaction remains available to estates, but how long this will continue is not certain. The strategy can result in lower taxes for an estate but professional advice is recommended. Contact your Collins Barrow advisor for 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.