By Allan Lanthier
A recent report in Canadian Business estimated that Canada’s 25 wealthiest families have a net worth of close to $200 billion — an average of $8 billion per family. Meanwhile, 15 per cent of lower-income Canadian families have a net worth of less than $500. So, to help address this gap, should we be asking Canada’s wealthiest to pay more taxes? In addition to numerous annual taxes and levies, they already face capital gains tax on death. But what if taxation on death can be avoided?
Under Canadian tax rules, there is a deemed disposition of capital properties on death, unless the assets are left to a spouse, or to a trust for the spouse’s benefit. One-half of capital gains — based on the value of the assets on the date of death — are included in the estate’s taxable income. On the death of a taxpayer in the top personal tax bracket (or on the death of the taxpayer’s spouse) income tax therefore generally applies at a rate of more than 25 per cent on accrued capital gains. This means that as assets pass from one generation to the next there is a significant amount of capital gains tax to pay. Or at least there would have been had the “estate freeze” not been invented.
Here’s an example. John is widowed and has three adult children. He owns a Canadian company — Canco — that has a value of $10 million. John expects Canco’s value will increase to at least $100 million by the time of his death. He plans to leave the company to his children when he dies and he doesn’t want to burden them with capital gains tax of more than $25 million. So John consults his tax lawyer and they implement the “freeze.”
John surrenders all of his common shares of Canco in exchange for $10 million of new voting preferred shares. His children then subscribe for new Canco common shares, for which they pay a nominal amount. When the smoke has cleared and the ink is dry, John owns preferred shares of Canco that are frozen in value at an amount of $10 million, while his children own all of Canco’s common shares.
The common shares have no value today (Canco is worth $10 million and John has preferred shares of $10 million), but the shares will grow in value until the time of John’s death. In the meantime, John continues to control the company, and $10 million is enough to ensure he enjoys a comfortable lifestyle.
As the years pass, John redeems his $10 million in preferred shares and pays personal taxes as a result. When he passes away, Canco’s only remaining shares are the common shares the children acquired as part of the freeze. The company has been transferred to John’s children without any capital gains tax on death, and more than $20 million of tax has been avoided. Tax eventually will be due but only when the children dispose of the shares, perhaps on their own deaths 30 or 40 years after their father’s demise.
The Canadian tax authorities must be furious, right? Well, not so much. The Canada Revenue Agency views an estate freeze as garden-variety tax planning and has issued a number of tax rulings that endorse it. In fact, when Canada introduced the general anti-avoidance rule (GAAR) in 1988, the CRA stated that the GAAR would generally not apply to estate freezes, on the grounds that the motivation for them is family planning rather than tax avoidance.
The CRA’s position is baffling. Canada’s tax code is supposed to extract capital gains tax at the time when assets are transferred from one generation to the next. Other countries are not as lenient. For example, the United States imposes gift and estate tax (rather than capital gains tax on death) and even has a special “generation-skipping tax” that applies when assets are transferred to grandchildren or great-grandchildren.
With a Canadian federal election on the horizon, many politicians will be calling for additional taxes to address inequality and to provide funds for spending initiatives of all shapes and sizes. Already, echoing Sen. Elizabeth Warren, the New Democratic Party has proposed an annual tax of one per cent on wealth over $20 million. It would make more sense to plug holes in some of our existing tax rules. A good starting point would be to legislate estate freezes out of existence.
Allan Lanthier is a retired senior partner of a major international accounting firm and a former co-chair of the Joint Taxation Committee of the Canadian Bar Association and CPA Canada.
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