A pipeline is a common term in the world of Canadian taxation, and refers to a strategy of minimizing income taxes after someone has died, and the deceased owned shares of a company at the time of death.
Let’s walk through an example:
- Ms. W, a widow, owned shares of an investment company (Investco) at the time she died. The value of the company was $500,000, and her tax cost was $1. For this example, I have assumed that the company’s investments were cash, GICs, and T-bills. She left the company equally to her two adult children, X and Y.
- Under our current Canadian tax rules, she is deemed to have disposed of the shares of Investco at fair market value at the time of her death. That would result in capital gains on her terminal return, of $499,999. Assuming she was in the highest tax bracket, and was a resident of BC, her tax on that gain would be $109,250.
- The shares of Investco would be distributed from her estate to her children. Assuming no further tax planning was done, and the company was wound up over time, the children would receive dividends of $499,999. If we assume that they were also in the highest tax bracket, and were residents of BC, their taxes on those dividends would be $168,550.
Between Ms. W and her children, the total taxes paid therefore amount to $277,800, or over 55% of the $500,000 value of Investco. In effect, there is double-tax on the same $500,000 of value. While the taxes may be different depending on the province of residence, the combined taxes would still be significantly more than if no tax planning was undertaken.
This is where the pipeline plan comes in
This plan would involve setting a new company (Newco). The shares of Investco are then transferred to Newco, in exchange for a promissory note for $500,000 (the value at the time of Ms. W’s death), plus preferred or common shares for any value in excess of that. Investco would then be wound up into Newco, thus moving all of the investments from Investco to Newco on a tax-free basis. Newco would now have investment assets worth $500,000, and a promissory note payable of $500,000. The investments are then converted to cash, and the promissory note is paid off without further tax. The overall taxes are therefore limited to $109,250, instead of the $277,800 that would have been paid without any tax planning. This is just a bare-bones outline, and there are usually more planning and implementation issues involved that are not detailed here, so consult with an MNP tax specialist first.
Here’s the kicker
Until a couple of years ago, this type of tax planning was undertaken fairly regularly, and was generally accepted by the Canada Revenue Agency (CRA). However, in 2009, the CRA issued a technical interpretation (2009-0326961C 6) that, in effect, resulted in the same double-tax as outlined above. Their position was that under certain circumstances, subsection 84(2) of the Income Tax Act would apply to treat the promissory note as a deemed dividend received by X & Y, and tax it accordingly. The CRA was relying on their interpretation of subsection 84(2), and their view was that where corporate assets were distributed or otherwise appropriated for the benefit of shareholders on the winding-up, discontinuance or reorganization of the company, a dividend is deemed to be paid to the shareholders immediately before that time. This was a contentious interpretation, since it was contrary to previous interpretations and advanced tax rulings issued by the CRA.
However, in the recent case of MacDonald v. The Queen at the Tax Court of Canada (2012 TCC 123), the judge found that subsection 84(2) could not apply as interpreted by the CRA. Applying the judge’s decision to our example, the judge’s finding was that the deemed dividend could not apply to X and Y, since they were not shareholders at the time Investco was wound up – the shareholder at that time was Newco. As such, X and Y could not be considered to have received any dividends, and therefore would not be subject to any tax. So in effect, the pipeline plan as it applied before the 2009 technical interpretation was issued would seem to apply.
However, there as a post-script to the MacDonald case – on May 16, 2012, the Crown filed a Notice of Appeal, so this matter will now be heard at the Federal Court of Appeal. Watch this space for the results of that appeal.
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