Monday, April 5, 2004

Freezing – Even In Victoria and even in August

More and more Canadians are freezing.

No, the above statement is not the latest reverse twist on global warming. Instead, it describes a common response to concerns about death taxes.

While Canada does not have a death tax per se, the Canadian income tax system has a form of death tax. On death, a person is deemed to dispose of all assets for fair market value. If the asset has an accrued capital gain – in other words, the asset has increased in value since acquisition – that capital gain is taxed. It is the opposite of passing Go in Monopoly – instead of getting $200, you have to pay out as you head off into the afterlife. And while the disposition is make-believe, the tax bill is real and has to be paid with real money.

The tax bill can be deferred by leaving assets to a surviving spouse or a qualifying spouse trust. But this only defers the tax until the death of the surviving spouse. The day of reckoning still awaits.

As assets grow in value, so does the amount of the potential tax problem.

One way of starting to deal with the death tax is to conduct an “estate freeze”. An estate freeze means capping the value of your estate at its current value – in other words, “freezing” your estate (so that it no longer grows in value). Once you have capped the value of your estate, you will have also capped the amount of your death tax bill.

Of course, you do not magically stop assets from growing in value. You just cap the value of your interest in the assets. In essence, you transfer future growth to your heirs (but without triggering any immediate income tax liability). While you give away future growth, however, you can still retain control over the asset (so as to ensure that the asset provides you with an income flow until your death). You can even remain in control about how the future growth is to be apportioned among your heirs.

One can accomplish an estate freeze in many different ways. To give a simple example, assume that you are the sole shareholder of a corporation. You paid $100 for your shares of the corporation. Those shares are now worth $1 million, having dipped somewhat in value due to recent declines in the stock market. If the market recovers, however, the shares will increase significantly in value. Since your estate can do without the extra tax liability, you decide to “do a freeze”.

In order to freeze your interest in the corporation, you trade your common shares in for a new type of share with a fixed value equal to the current value of the corporation. VoilĂ  – your interest in the corporation is now frozen at $1 million. Since the fixed-value shares soak up all the current value of the corporation, your heirs (usually through a family trust) can acquire new common shares for a nominal purchase price. Any future growth in the value of the corporate assets will now accrue to those new common shares and not your shares. This means that any capital gains tax on that future growth can be deferred until the death of the next generation. You can (and generally should) retain voting control of the corporation. If you control the corporation, you can ensure that the corporation pays you sufficient cash to meet your needs.

Having capped the amount of your death tax bill, you and your heirs no longer have to deal with a moving target. You can take steps to deal with the (now quantified) future tax liability. These strategies may involve the purchase of life insurance, the creation of a sinking fund or the orderly redemption of your fixed-value shares over time. However, that is a subject for another article.

-- Blair P. Dwyer

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

New REOP - But is it Reasonable?

Second-guessing may be on its way back, starting in 2005.

The federal government has released draft income tax legislation that would have a significant impact on one’s ability to claim tax losses from business ventures or investments.

The proposed rules would be effective for 2005 and later taxation years. Under the proposals, a taxpayer would be able to deduct a business or investment loss only if the taxpayer could show that the business or investment had a “reasonable expectation of profit”. For a long time, income tax authorities attempted to deny the deduction of losses by arguing that the taxpayer could not reasonably have expected to profit from the venture in question. In an earlier decision, the Supreme Court of Canada expressly rejected this approach as a general test for deductibility. The draft legislation would effectively reverse this court decision.

The new statutory “reasonable expectation of profit” test would apply to all business and investment ventures. While the taxpayer would not have to show actual profit in any specific year, the taxpayer would have to be able to show on a year-by-year basis that the taxpayer had a reasonable expectation that the venture would show a cumulative profit over the time that the taxpayer expected to operate the business or hold the investment.

In computing profit for the purpose of applying the reasonability test, capital gains are ignored.

This could have far-reaching implications. For example, take the case of an investor who borrows money to acquire shares of a publicly-traded corporation. The investor may expect to receive dividends but – more likely than not – the investor may well be looking to the eventual sale of the shares for most of his or her “profit”. Under the draft legislation, any capital gain that arises on the sale of the shares would not count when determining whether the investor had a “reasonable expectation of profit”. That expectation would have to be judged by comparing the investor’s interest expense with the dividends expected over the life of the investment.

What if the investor acquires shares of a corporation that has expressly adopted a no-dividend policy for the foreseeable future as the corporation invests its earnings in rebuilding infrastructure?

The draft legislation would also apply to real estate investors. Any expectation of profit from a rental property would have to be based on the anticipated cumulative rental income from the property. Expectation of a capital gain on sale would not justify the deduction of annual operating losses.

Perhaps the biggest concern arising from the draft legislation is its potential chilling effect on risky and innovative ventures. It can take years to turn a profit in some ventures. When does an expectation of profit become unreasonable? If the venture fails (as can happen in even the best-planned ventures), will taxation authorities not use hindsight (as they have in the past) to argue that no reasonable person could have expected profit from such a failure? And what about the successful venture that should have failed but succeeded in spite of all “reasonable” expectations?

The proposed rules have been released for public comment. Subject to changes that may result from the public comment procedure, the rules would come into effect in 2005. It will be interesting to see whether the public views the proposed rules as “reasonable” ones.

-- Blair P. Dwyer

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

The Case for Trusts in Wills

Many wills fail to take advantage of a very powerful estate planning tool – the testamentary trust (also called the will trust).

A will can leave property directly to named heirs. Alternatively, the will can direct that assets be held in trust for those heirs. Many people shy away from using a will trust because the trust seems to imply a distrust of the heirs. However, a carefully-structured will trust can provide the heirs with significant tax and other advantages.

A will trust is treated as a separate individual for income tax purposes. This means that the trust pays income tax at graduated rates – about 22% on the first $30,000 of taxable income, and progressively higher rates on higher levels of income. This can lead to income-splitting advantages.

Assume that you want to give a sizable inheritance to your child, Frank. Assume also that Frank has a good job and earns about $80,000 of taxable income in a given year. As a result, Frank is in a 40% tax bracket. If he invests his inheritance and earns $30,000 in interest income, that extra income would push Frank into a higher tax bracket. As a result, Frank would pay about $12,142 on that income, netting about $17,858 after tax.

You would be doing Frank a favor by leaving his inheritance in a will trust. If the will trust invests the inheritance and earns the same $30,000, that same income would be taxed at 22% (the lowest applicable tax rate, because the will trust would have no other income). As a result, the will trust would pay only $6,600 on that income, netting about $23,400 after tax. The will trust could later distribute that $23,400 to Frank on a tax-free basis.

By having the income earned in a will trust, Frank would save $5,542 in income tax each year that the trust is in existence.

Additional income tax savings are possible if the will trust were to include Frank’s family members as beneficiaries. Depending on the nature of the income, the will trust might be able to distribute income to Frank’s children in order to use up their basic personal exemptions (which means that no income tax would be paid on that portion of the income).

Will trusts can also have significant non-tax advantages.

For example, assume that you leave all your assets to your surviving spouse on the understanding that your spouse will leave the assets to your children. In time, however, your spouse remarries but dies in an accident shortly after the remarriage. In law, marriage automatically invalidates an existing will. Unless your spouse thought to make a new will around the time of the remarriage, your spouse would die intestate. If that occurs, a portion of the property would go to the new spouse rather than to your children. A properly-structured will trust can avoid this unfortunate result and ensure that your children eventually benefit from the property.

To some extent, a property-structured will trust can also offer asset protection advantages. The trust can be structured so that the trust property does not belong to any specific beneficiary. If a specific beneficiary gets into financial difficulty, it would be very difficult for creditors to seize trust assets. Those assets would be held in trust for other family members (possibly including future grandchildren) – not just the family member who has run into financial difficulty.

One cannot say that it is always appropriate to create a will trust. However, I have seen many situations in which the establishment of a will trust could have provided significant advantages to the heirs. When preparing an estate plan, a will trust should at least be considered. Your heirs may actually be very grateful that you did not leave your property to them directly.

-- Blair P. Dwyer

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.