During an economic downturn such as the one in which we currently find ourselves, many taxpayers focus on finding cost-cutting measures, including opportunities to decrease their immediate tax burdens.1 What may not be top of mind, however, are opportunities to minimize future tax burdens by freezing or refreezing an estate.
An estate freeze is a transaction where the current value of an asset is “capped” or “frozen” for the taxpayer so that any future growth in the value of that asset is attributed to a new person(s). Estate freezes can be applied to various capital properties, including real estate, a marketable securities portfolio, or the shares of a corporation. This article explores the goals, the process, and the implications of freezing and/or refreezing the shares of a corporation.
What is the purpose of an estate freeze?
An estate freeze is often carried out to accomplish one or more of the following goals:
- Transferring the future growth of a corporation’s value to new shareholders (for succession planning, for example);
- Reducing the amount of capital gains tax on death and/or probate fees that may become payable on death;
- Multiplying the use of the lifetime capital gains exemption in the event of a future sale; and
- Potentially alleviating concerns relating to the protection of assets from future claims by spouses or other creditors.
A family trust, alter-ego trust, or joint spousal/partner trust is often included as part of an estate freeze to achieve the above objectives.2,3
How is an estate freeze accomplished?
An estate freeze typically involves exchanging a taxpayer’s participating shares for new fixed-value preferred shares. The value of the preferred shares is equal to the fair market value of the corporation on the date of the estate freeze (less the value of the non-share consideration, if any, taken back on the exchange).4 New shares with nominal value that are entitled to the future growth of the corporation’s value are then issued to new shareholders (usually family members, a family trust, key employees, or a holding corporation, and in some cases the original shareholder). The taxpayer may also (either directly or indirectly) retain control of the corporation, with or without participating in the future growth.
Canada’s Income Tax Act includes a number of provisions that allow taxpayers to complete an estate freeze on a tax-deferred basis without triggering immediate tax consequences.5
Timing is key
To minimize the future tax burden of a taxpayer who holds shares of a corporation, it’s best to implement an estate freeze when the corporation’s value is at its lowest. That’s why an economic slowdown that results in depressed values can be an ideal time to implement a freeze. For example, a taxpayer may find an estate freeze advantageous if they hold shares in:
- A corporation that holds investments trading at historically low values;
- A corporation that holds real estate assets at depressed values; or
- A corporation that is experiencing cash flow challenges and revenue losses.
While reducing the future tax burden may be the motivator for an estate freeze, other factors should be considered before undertaking this type of transaction, such as the taxpayer’s current and future financial needs, their comfort level in forgoing future growth, and the ease or difficulty with which the estate freeze can be co-ordinated with the taxpayer’s overall estate plan. Consideration should also be given to the consequences of introducing new shareholders.
Valuation is also critical
The valuation of a corporation is a critical component in carrying out an estate freeze. Taxpayers should be mindful of incorrect assumptions or perceived decreases in value that may not be representative of the corporation’s true value and/or supported by market data. The Canada Revenue Agency (CRA) will have the benefit of hindsight if it later challenges the valuation used in an estate freeze, and incorrect valuations can lead to adverse tax consequences in the form of immediate taxes payable or attribution of future income for tax purposes. A common way to address this concern is a price adjustment clause, which adjusts the value of the preferred shares to minimize the impact of adverse tax consequences.6 Other ways to address this concern may include:
- Allowing the redemption value of the preferred shares to be determined within 180 days of the freeze date (instead of on the freeze date), as this may result in a more accurate valuation; and
- Obtaining a report from a qualified valuation expert, especially for a privately held corporation where value cannot be easily ascertained.
What is an estate refreeze?
If an estate freeze was undertaken in the past and an economic downturn subsequently causes the corporation to decrease further in value, a “refreeze” may be advisable for taxpayers who want to maximize future tax savings.
In a refreeze transaction, the taxpayer exchanges the “old” fixed-value preferred shares for new preferred shares with a fixed value equal to the current (i.e., decreased) value of the underlying corporation. In this way, the refreeze “resets” the previously capped value and reduces the taxpayer’s future tax liability by shifting more future growth to the new shareholders once the corporation recovers from the downturn.
While the same considerations for an estate freeze apply to a refreeze, a refreeze may be subject to additional scrutiny from the CRA. As noted above, taxpayers should never assume that a corporation has declined in value as a result of temporary cash flow challenges and/or revenue reductions. As with an estate freeze, taxpayers who are contemplating a refreeze should pay particular attention to valuation to minimize the possibility of future adjustments in the event of an audit by the CRA.
The CRA has issued favourable comments on refreeze transactions when the post-freeze decline in value has not been caused by an intentional stripping of corporate assets.7 Examples of when corporate assets may be stripped include situations where dividends are paid out of pre-tax earnings and situations where bonuses or salaries are paid to the new shareholders at a level that exceeds the value of services performed.
Refreezes and the corporate attribution rule
The corporate attribution rule deems individual taxpayers to have received “phantom” interest income for tax purposes. It applies in situations where:
- An individual has, directly or indirectly, transferred or loaned property to a corporation;
- One of the purposes of the transfer or loan is to reduce the individual’s income and benefit a spouse or related person who is under 18 years old; and
- The recipient corporation is not a “small business corporation.”8
If the corporate attribution rule applied to the original freeze, a refreeze transaction may result in some unintended tax consequences. For example, the taxpayer may be subject to:
- Deemed interest income calculated by reference to the value of the initial freeze rather than the lower value of the refreeze; and
- Perpetual deemed interest income even after the preferred shares of the refreeze have been fully redeemed as a result of the interest income being calculated by reference to the value of the initial freeze, rather than the lower value of the refreeze.
An estate freeze is a flexible and tax-effective tool to transfer the future growth of an underlying corporation to another person(s) and thereby minimize future income taxes—particularly during a period of economic uncertainty, when values may be at their lowest. With that said, freezes and refreezes are complex transactions. Careful planning is required to avoid inadvertently triggering adverse tax consequences, and careful consideration of the benefits and risks involved is needed to obtain the best result.
Nancy Lum, CPA, CA, TEP, is a senior tax manager at D&H Group LLP Chartered Professional Accountants in Vancouver, where she specializes in income tax and succession planning for Canadian owner-managed businesses. She is also a trust and estate practitioner (TEP) and a member of the Steering Committee of the Vancouver Chapter of the Canadian Tax Foundation’s Young Practitioners Group.
1 For more on tax-planning opportunities to improve a business’s cash flow, see “Making Lemonade Out of Losses: Tax Planning in Troubled Times” by Alexandre Hale, CPA, CA, and Shane Onufrechuk, FCPA, FCA, in the July/August 2020 issue of CPABC in Focus.
2 For more on the benefits of a family trust in succession planning, see “Family Trusts: Recent Changes and Continued Benefits” by Bilal Kathrada, CPA, CA, in the May/June 2020 issue of CPABC in Focus.
3 For more on alter-ego trusts, see “Alter-Ego Trusts – An Effective Estate-Planning Tool” by Kam Nat, CPA, CA, in the January/February 2017 issue of CPABC in Focus.
4 The preferred shares should also have rights and restrictions that comply with the Canada Revenue Agency’s policy. See Technical Interpretation 2008-0285241C6.
5 For a discussion of these provisions, see “Tax-Deferred Rollovers Under the Income Tax Act: A Tax Advisor’s Best Friend” by Richard Wong, CPA, in the January/February 2020 issue of CPABC in Focus.
6 The CRA outlines its policy on price adjustment clauses in Income Tax Folio S4-F3-C1, Price Adjustment Clauses.
7 CRA Technical Interpretation 2010-0362321C6, June 8, 2010.
8 Generally speaking, a “small business corporation” is a Canadian-controlled private corporation where all or substantially all of the assets are used in an active business carried on principally in Canada.