Estate Freezes: Should they be legislated out of existence?

Kim G C Moody FCPA, FCA, TEP, is director of Canadian tax advisory at Moodys Gartner Tax Law LLP in Calgary.

There is a lot wrong with the above article and example. More on that later.

But, first, a little history lesson. Prior to 1972, Canada had an estate tax regime similar — but not identical — to the United States. Simplistically, if a person died, that person’s estate would pay a tax based upon the FMV of the person’s assets immediately prior to death. Such a tax is a wealth tax (and not an income tax) since a person’s assets are generally accumulated with after-tax funds but an estate tax will tax such funds regardless of the fact that such assets were accumulated by paying tax during the person’s lifetime. Canada also had a companion gift tax since any good estate tax regime (which many countries around the world have) will have a companion gift tax so as to prevent individuals from simply gifting their assets away to avoid the estate tax. Following up on the recommendations of the Royal Commission on Taxation in 1966 (the last major comprehensive tax review that Canada has had), Canada implemented major tax reform in 1972. It abolished the estate tax (and gift tax) regime. It also introduced taxation on capital gains (with only 50% of capital gains being taxable despite the Royal Commission’s recommendation that capital gains be wholly included in taxable income; prior to 1972, capital gains were not taxable). As part of the introduction of capital gains taxation, new provisions were introduced into the Income Tax Act that enabled limited form tax deferral treatment for certain types of share for share exchanges. Concurrent with the abolishment of the estate tax and the introduction of taxation on capital gains, Canada also introduced a deemed disposition on death regime that requires an individual to include in his or her income any unrealized capital gains on property held immediately prior to death. The “new” rules deemed the recipient beneficiaries of the decedent’s property to acquire such property with an adjusted cost basis equal to the FMV at the date of the death. Such a deemed disposition regime contained limited deferral opportunities (mainly to accommodate transfers to surviving spouses). Subject to some technical amendments, the deemed disposition on death regime exists today — roughly — in its form introduced in 1972.

Comparatively, the United States has had an estate tax – with a companion gift tax and generation — skipping transfer tax — regime with little change in substance since 1917. Overly simplified, if a person is a United States citizen at the time of death or is a non-United States citizen who is domiciled in the United States at the time of death, such a person will pay an estate tax if his or her estate exceeds the applicable exemption amount. The exemption amount and tax rates have changed dramatically over the years. For a quick review of how much the rates and exemptions have changed, have a look at the Wikipedia summary here. For clarity, the United States does not have a deemed disposition on death regime. However, the recipient beneficiaries of the decedent’s property will acquire the property with a cost basis equal to the FMV of the property at the date of the death. Some have argued that this automatic inheritance of the decedent’s property at the FMV at the date of death is inappropriate since any gains that were unrealized at the date of death will permanently escape income tax (or tax in general if no estate tax was exigible on the decedent’s estate). That policy discussion is beyond the scope of this short article. In the 1980s, the United States introduced legislation to explicitly prohibit estate freeze transactions like those that are often utilized in Canada. One can generally understand why if the estate freeze transaction was implicitly designed as a gift — or disguised gift — to the next generation but most Canadian estate freeze transactions are not gifts or disguised gifts. Notwithstanding, if a U.S. citizen shareholder of a private corporation who was also resident of Canada carried out a vanilla estate freeze, such transactions would nonetheless be subject to the negative implications of the US prohibitions. This, in my opinion, is too harsh of a result for many United States citizens who are simply trying to develop a legitimate succession plan for their business.

Prior to the abolishment of the Canadian estate tax regime, many estate freeze type transactions were entered into in order to avoid the application of the estate tax. In 1972, such transactions were obviously not needed since the estate tax was abolished. However, the shift focused to trying to manage the implications of the new deemed disposition on death regime. Shortly after 1972, some of newly introduced share for share exchange provisions of the Income Tax Act were amended. Such amendments made it easier to “freeze” a person’s interest in a private corporation on a tax deferred basis and cause new shareholders to be introduced with minimal financial consequences (although, to be clear, the amendments to the share exchange provisions were not explicitly made to accommodate estate freeze transactions). This opened the door to many succession plans being built around an estate freeze transaction.

The typical estate freeze can best be described by way of a realistic example. Consider the following example facts:

1. Mom and Dad, both age 65, are Canadian residents for income tax purposes (and are not United States citizens or green card holders).
2. Mom and Dad own all of the shares of BakeryCo, a reasonably successful business that they started years ago.
3. Mom and Dad have three adult children none of whom are interested in taking over the business notwithstanding it has provided a very good living for the overall family.
4. Mom and Dad have sought appropriate advice and are told the the business is worth $2M. They would like to realize their value rather than shutting down the business before their retirement.
5. Mom and Dad have approached one of their key bakers (“Baker”) to see if she would be interested in acquiring the business but Baker does not have significant financial resources to immediately pay Mom and Dad the FMV of the business.

At this point, if Mom and Dad would like to retire soon, they have limited options. They could:

1. List the business for sale and hope that an arm’s length purchaser could be found;
2. Work with Baker to see if a solution could be found; or
3. Shut the business down.

Alternative #3 certainly doesn’t fit their overall objective so that alternative is not pursued. In addition, given their loyalty to Baker, they would prefer to not sell to an arm’s length party unless absolutely necessary. Accordingly, after getting appropriate advice, the following transactions were agreed to by all parties:

1. Mom and Dad would exchange all of their common shares of BakeryCo for a class of preferred shares that would have an aggregate redemption value of $2M (the current FMV of all of the common shares of BakeryCo).

   Such a transaction would occur on a tax deferred basis using one of the provisions of the Income Tax Act that explicitly enables such a transaction to occur. However, in order to ensure that the exchange is indeed tax deferred, care would be taken to ensure that the preferred shares have a FMV equal to the FMV of the common shares that Mom and Dad just exchanged.  Voting rights, redemption rights, retraction rights and other attributes would need to be carefully considered to ensure that any specific rights inherent in the newly issued preferred shares do not negatively alter the FMV.  If so, this could cause the tax deferred exchange to have negative tax consequences. (The Canada Revenue Agency has – on many occasions – stated what the attributes of the newly issued preferred shares should contain so as to ensure that the transaction is in fact compliant within the tax deferred exchange provisions of the Income Tax Act).

2. Since all of the FMV of BakeryCo is now “frozen” in the preferred shares owned by Mom and Dad, new common shares would be issued to Baker for nominal consideration. Baker would now own all of the issued common shares thus entitling Baker to any and all growth of BakeryCo should that in fact materialize. Care must be taken, of course, that the newly issued common shares truly have a nominal value at issuance.  It is usually strongly advisable to obtain valuation advice from a Chartered Business Valuator to ensure that the issuance of the newly issued common shares at a nominal value can be supported using generally accepted business valuation principles.

3. Mom, Dad and Baker would enter into a shareholders’ agreement whereby key operational issues would be agreed upon (how key decisions of the business are made, what would happen upon an untimely death of Mom, Dad or Baker, etc.). In addition, a plan would be agreed to whereby the preferred shares of BakeryCo would be redeemed over an acceptable period of time – say 5 years – using the cash resources of the business. Upon redemption of the preferred shares, Mom and Dad would pay income tax at the value of the shares redeemed. Such redemptions would be considered taxable dividends — and not capital gains — thus potentially increasing the overall taxation burden to Mom and Dad as compared to an arm’s length sale where Mom and Dad could have realized capital gains — at lower tax rates — on the disposition of their BakeryCo shares.

While the above plan is not without risk, it is very palatable to all parties and they are willing to make it work. Is there any mischief going on with the above succession plan? No ... this is a legitimate succession plan negotiated amongst them.

But what about possible tax mischief with the above plan?  Critics of the estate freeze seem to centre their complaints around four main issues:

1. The Availability of Tax Deferral
   Upon exchange of the common shares for preferred shares, critics argue that such an exchange should be immediately taxable. The argument here seems to be that any other normal exchange would be taxable. And that’s true. However, the Income Tax Act explicitly enables certain tax deferred share-for-share exchanges with the overall policy being that the exchanger’s economic interest and position has not really changed pre and post exchange. Thus, taxation is deferred until another exchange where no deferral is enabled, an actual monetization event, the holder becoming a non-resident of Canada, or upon death.

   Some critics complement their criticism by stating that the tax deferred exchange should not be allowed for estate freeze transactions with the exception of certain businesses. But, again, I’m not sure why. If the economic interest pre and post exchange is not substantively different, why should the tax deferral be denied when other taxpayers are able to exchange their capital properties on a tax deferred basis using existing legislation? And to allow certain businesses to be exempt and others not seems to be a recipe for complication and unnecessary administration with the overall question arising as to why certain businesses should be exempt and others not.

2. The Avoidance of Taxation on the Growth After the Freeze

   In the National Post article, the author seems offended that the $90M of growth, in his example, was not subject to taxation in Dad’s hands. However, this is easily rebutted. First, the example utilized is not realistic or, at a minimum is exceedingly rare. In all of the hundreds of estate freeze transactions that I have worked on over the years, the main objective is usually estate and succession planning driven like that in the example I’ve illustrated. In my example, why should Mom and Dad have to pay tax on the growth when they have no legitimate or legal entitlement to the growth? In the absence of a freeze, Mom and Dad would have sold their shares of BakeryCo — assuming they could find a buyer — and then pay capital gains tax at that time. Instead, they are able to work with Baker to ensure that the business maintains it value while extracting such value over time and paying tax upon such extraction. To suggest that such value would be maintained until their death and thus they have avoided any tax on the growth is simply not realistic. At worst, the estate freeze transaction in Mom and Dad’s example enables a deferral of the tax liability on the $2M of value.

   The National Post article seems to suggest that estate freeze transactions are disguised attempts to transition valuable and growing businesses to the next generation and inappropriately defer taxation. As mentioned above, that is certainly not my experience. However, even if it was, my experience is that most businesses that are transitioned to or inherited by non-active children upon the death of the active parent, a monetization or liquidation event will soon occur thus triggering the inevitable income tax event.

3. An Estate Freeze Transaction Should be Subject to the General Anti-Avoidance Rule (“GAAR”)

   One could spill a lot ink on both sides of this coin but let’s just say that the application of the GAAR should be carefully considered in any transaction(s) that may have a tax benefit. However, to state that estate freeze transactions in general are subject to the GAAR would be a stretch and simply not true. When the GAAR was introduced in 1988, the Technical Notes released by the Department of Finance stated the following:

“…“estate freezing” transactions whereby a taxpayer transfers future growth in the value of assets to his children or grandchildren will not ordinarily be avoidance transactions to which the proposed rules would apply despite the fact that they may result in a deferral, avoidance or reduction of tax. Apart from the fact that many of these transactions may be considered to be primarily motivated by non-tax considerations, it would be reasonable to consider that such transactions do not ordinarily result in a misuse or abuse given the scheme of the Act and the recent enactment of subsection 74.4(4) to accommodate estate freezes.”

Information Circular IC 88-2 released by the Canada Revenue Agency in 1988 after the introduction of the GAAR contain similar comments at paragraph 10.

Accordingly, it is obvious that the government has carefully considered this issue and landed on reasonable and solid conclusions.

4. Other Countries – Like the United States Have Prohibited Estate Freeze Transactions
   Estate freeze transactions are unique to each country’s relevant laws – including tax laws.  Some have argued that since the United States has explicitly prohibited estate freeze transactions or prohibits assets to be transferred to the next generation (without the incidence of gift or generation – skipping transfer tax) to avoid its estate tax regime, then so should Canada.  However, that criticism is not easily comparable because they are two completely different regimes.  For reasons that I have already stated, I believe the United States prohibition against estate freezes can be overly harsh for many legitimate business succession arrangements.

So, to summarize:

1. Most, if not all, Canadian estate freeze transactions are done with legitimate succession planning in mind. The ability to develop such a succession plan on a tax deferred basis can greatly assist the transition of the business in an orderly fashion;
2. The avoidance of taxation on the post-freeze growth is not mischievous from a tax policy perspective since Mom and Dad, in my example, have given up their entitlement to legally participate in any growth. In addition, as previously stated, if growth was in fact shifted to non-active children, it is our experience that such children will typically seek a monetization event (with resulting tax payable) shortly before or after the passing or retirement of the active parent; and
3. Many estate freeze transactions are utilized to proactively deal with double taxation issues that may arise on the death of the private corporation shareholder. For example, in a worst case scenario, the estate of a shareholder of a private corporation would pay capital gains tax upon death. Another level of taxation would be incurred by the individuals’ heirs upon the extraction of assets from the private corporation (taxable dividends). The is classic double taxation. However, such double taxation is proactively dealt with and avoided in the estate freeze example as illustrated above.

Accordingly, my answer is “no.” Estate freezes should NOT be legislated out of existence. They are a very valuable tool to assist in legitimate succession planning. Unlike the clickbait headline of the National Post article, estate freezes are not reserved for the rich but instead are used by the average business owner. Any attempt to change estate freeze capabilities should only be done under the auspices of a comprehensive review of intergenerational transfers and a comprehensive review of our entire Income Tax Act.

Enough said ...

Kim G C Moody FCPA, FCA, TEP, is director of Canadian tax advisory at Moodys Gartner Tax Law LLP in Calgary.