In times of crisis, people can be opportunistic, and this economic turmoil can allow for certain tax planning opportunities. The current economic downturn caused by the COVID-19 pandemic has negatively affected the valuation of many Canadian businesses. Accordingly, it is wise to revisit any estate freeze transactions that may have been implemented at a time in a prior year when the economy was booming.
What is an estate freeze?
An estate freeze is an estate planning technique by which the current value of shares in the capital stock of a private corporation is frozen and locked-in for one individual (commonly a parent) with any future increase in value of a private corporation accruing to another (e.g., the parent’s children or a trust settled for the benefit of their children).
An estate freeze is typically structured such that the parent retains control of the private corporation by exchanging, on a tax-deferred basis, their common shares of the corporation for voting, fixed value, redeemable and retractable preference shares, with the newly-issued common shares going to the children or a trust settled for the benefit of the children. The redemption value of the preference shares will be equal to the value of the old common shares at the time of the exchange.
The parent effectively divests themselves of the future growth in the value of the private corporation on a tax-deferred basis. In doing this, the parent is able to limit their potential capital gain upon death to the value at the time the freeze was executed.
Why a “refreeze” transaction?
In some cases, an estate freeze is undertaken at a time when the economy is booming, and the value of a private corporation is high. However, in times of an economic downturn, it may turn out that the value of the frozen corporation has since declined. This could result in situations where the redemption value of the preference shares that were issued on the initial estate freeze are higher than the company’s current market value. Under these circumstances, a “refreeze” transaction could be considered.
Types of “refreeze” transactions
There are a few different methods of implementing a “refreeze” transaction, but the most common method is having the holder of the high value preference shares exchange such shares for new preference shares, which would have a fixed redemption value equal to the currently declined value of the company. This exchange may be done on a tax-deferred basis.
Benefits of a “refreeze” transaction
The following are some of the benefits of implementing a “refreeze” transaction:
- A lower locked-in value will reduce the shareholders’ tax resulting from the deemed disposition that will occur upon their death in the event the company’s value rebounds.
- A lower locked-in value may allow dividends to be paid on other preference or common shares that could be restricted under the circumstances. Most preference shares issued in an estate freeze transaction have what is commonly referred to as a “non-impairment” clause. This clause prevents the payment of dividends on other shares of a corporation if the payment of such a dividend would impair the ability to redeem the “estate freeze” preference shares. The lower value of the new re-freeze preference shares may now allow for the payment of dividends and thus potentially improve income splitting opportunities. Any income splitting through corporate structures would be subject to the tax on split income (TOSI) rules.
- A lower locked-in value prior to the holder’s death may avoid issues with the Canada Revenue Agency (CRA) challenging the fair market value of the company upon an audit of the deceased’s terminal income tax return. The “refreezing” effectively resets the redemption value of the preference shares. This lower redemption amount will be set by a directors’ resolution confirming the value and new redemption amount.
Providing the CRA with a copy of a bona fide directors’ resolution is more advantageous than trying to argue with them that the market value at time of death is below the documented redemption value of the preference shares. The CRA will likely presume that the original redemption amount is equal to the current value of such shares and assess a higher tax balance. Undertaking a refreeze transaction may allow the deceased estate’s executors and advisors to avoid such conflicts with the CRA.
- Similar to avoiding conflicts with the CRA, refreezing to a lower value prior to a marital breakdown may reduce any net equalization payments and avoid the additional aggravation in trying to refute that the original redemption amount is higher than the shares’ value at the time of the breakdown.
The CRA’s view on refreeze transactions
In the past, the CRA’s view was that if a refreeze transaction was implemented, a benefit to the common or preferred shareholders may result. However, recently in document 2010-0362321C6 dated June 8, 2010, the CRA clarified its administrative policy on whether a shareholder benefit is conferred as a result of an estate refreeze transaction.
In that document, the CRA stated that a benefit is not conferred on the common or preferred shareholders of a corporation that implement an estate refreeze transaction provided that the decrease in value of the corporation is not the result of stripping the company of corporate assets and the value of the new preferred shares is equal to the value of the old preferred shares at the time of the refreeze.
The CRA provided examples of what it views as “corporate asset stripping” and it listed the following two examples:
- Dividends that would be paid by the corporation on the common shares of its capital stock and that would impair the value of the original freeze’s preferred shares (i.e., contravening the non-impairment clause typically found in the attributes of most preferred shares issued in an estate freeze transaction); and
- The payment by the corporation of a bonus or salary to the beneficiary of the freeze in connection with a post-freeze asset sale by the corporation, and such a bonus or salary is not commensurate with the value of the services performed and the responsibilities assumed by the beneficiary of the freeze.
Therefore, no benefit should arise where a corporation pays dividends if the dividends paid out do not impair the value of the original freeze preference shares and the corporation has sufficient retained earnings. However, the risk that the CRA assumes the decline in value occurred because of the dividends is higher if the refreeze is carried out shortly after dividends are paid.
The payment of bonuses and salaries should not negatively impact a refreeze transaction undertaken shortly after the payment, provided that such a bonus or salary is commensurate with the value of the services performed by the recipient.
Finally, it is highly recommended that any holder of preference shares that have declined in value should engage a Chartered Business Valuator to support such an impairment in the event that the CRA scrutinizes the valuation and attempts to assert that there has been no such decline in value.
The COVID-19 pandemic has resulted in a significant economic downturn that has led to devaluations of many private corporations. However, this may prove to be an opportunity for some to modify a previously implemented estate freeze and possibly reduce future taxes.