Commercial Law News: The Pipeline
By John Loukidelis
The “pipeline” is a planning technique that can reduce the taxes payable by a deceased taxpayer and her estate where she is a shareholder of a Canadian-controlled private corporation (a “CCPC”, as defined in the Income Tax Act (Canada) (the “Act”)). This article outlines why a pipeline might help a taxpayer to reduce taxes, the mechanics of a pipeline reorganization, and the CRA administrative positions that make the pipeline possible. This article also discusses why pipeline planning might not always be a useful tool and why it might not be available to taxpayers forever. (Spoiler: The Department of Finance appears not to like them very much.)
Taxes on Death
“Jane Smith” dies when she is the sole shareholder of a CCPC that is a corporation (“Holdco”) under the Business Corporations Act (Ontario) (the “OBCA”). Holdco holds a portfolio of publicly-traded securities. At the time of Jane’s death, her Holdco shares have a fair market value of $1 million and a tax paid-up capital (“PUC”) and tax cost that are nominal. Jane is deemed to have disposed of the shares immediately before her death. The resulting gain is not eligible for a rollover or the capital gain exemption. As a result, her executor must report a deemed capital gain in her terminal return of about $1 million.
The executor might consider causing Holdco to redeem the shares that Jane held. If the executor did that, Jane’s estate would receive a deemed dividend because her deemed disposition of the Holdco shares immediately before death increased their tax cost but not their PUC. The estate would also realize a capital loss on the redemption of the shares equal to the deemed capital gain reported in Jane’s terminal return. If the estate realizes the capital loss in the year following Jane’s death, it can elect to carry the loss back to her terminal return to offset the gain that was reported in it.
If Jane and her estate were subject to income tax in Ontario at the highest marginal rate, then the estate would likely have paid tax of about $267,000 on the deemed gain reported in her terminal return. That tax will be refunded as a result of the loss carryback, but the estate will pay tax of about $477,000 on the deemed dividend (assuming that the entire amount is non-eligible).
The “pipeline” might provide a better tax result.
The Pipeline Reorganization
Instead of causing Holdco to redeem its shares, the estate could undertake the following reorganization.
The estate would incorporate Newco under the OBCA. Newco would also be a CCPC. Newco’s authorized share capital would entitle it to issue ordinary voting Common Shares and Preferred Shares. The Preferred Shares would be non-voting, entitled to non-cumulative annual dividends of 5% and be redeemable and retractable at a price equal to $1.00 per share. The estate, when it organizes Newco, would subscribe for 100 Common Shares in its capital for $100 in total.
The estate would transfer all of its shares in the capital of Holdco to Newco, and in exchange Newco would issue to the estate :
- a demand note (the “Note”) with a principal amount and fair market value equal to the tax cost of the shares less $100; plus
- some Preferred Shares with a total redemption amount and a fair market value equal to $100 plus the amount, if any, by which the fair market value of the Holdco shares at the time of the transfer exceeds $100 plus the principal amount of the Note.
The foregoing assumes that the Holdco shares have not declined in value since Jane’s death.
The estate and Newco would elect under section 85 of the Act so that the transfer of the Holdco shares to Newco would occur on a tax-deferred basis under the Act (in case the value of the shares has increased since Jane’s death).
Holdco would continue to carry on its “investment business” for at least twelve months following the transfer of the Holdco shares to Newco.
Twelve months after the transfer of the Holdco shares to Newco, Holdco and Newco would amalgamate to form Amalco. As a result, all of the property and all of the liabilities of Newco and Holdco immediately before the amalgamation, including the Note, would become property and liabilities of Amalco.
After the amalgamation, Amalco could begin to repay the Note. In general, to comply with the CRA requirements for a pipeline, the amount paid in any quarter after the amalgamation should not exceed something like 15% of the principal amount of the note when it was first issued.1
Amalco would continue to carry on the Holdco investment business for the foreseeable future.
As a result of the foregoing planning, the estate would pay tax only in respect of the deemed disposition of Jane’s shares in the capital of Holdco. The Note (the “pipeline”) would permit the estate to receive the assets formerly held by Holdco without additional tax at the shareholder to the extent of the principal amount of the Note.2 The estate might save as much as $210,000 of taxes as a result of undertaking a pipeline.
Some tax issues
Why must Amalco continue to carry on the Holdco “business”? Why must Amalco wait twelve months before beginning to repay the Note? Why must the note be repaid over time and not all at once? Subsection 84(2) of the Act provides in part that
"[w]here funds or property of a corporation resident in Canada have … been distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders of any class of shares in its capital stock, on the winding-up, discontinuance or reorganization of its business the corporation is deemed to pay a dividend equal to the amount distributed or appropriated less the PUC of the issued shares of the corporation."
Recall that, in Holdco’s case, Jane’s deemed disposition of her shares increased their tax cost but not their PUC. If subsection 84(2) applies to the reorganization undertaken with Newco, then the estate will be deemed to receive a dividend from Holdco in respect of the shares transferred to Newco, which would negate any benefits from the reorganization. Subsection 84(2) could apply to Jane’s estate to deem it to have received a dividend, if the estate transfers Holdco shares to Newco for the Note, and Holdco (through Newco) winds-up its business and immediately distributes its net assets to the estate.
The CRA, however, has issued numerous advance tax rulings for pipelines that confirm subsection 84(2) will not apply, if CRA guidelines are followed. The CRA will generally “bless” a pipeline where the note is paid off gradually and the Holdco “business” continues for the foreseeable future. In fact, the CRA recently issued a ruling that approved an earlier repayment of the pipeline note, if the money were to be used for paying taxes.3
What constitutes a “business” for the purposes of a pipeline is beyond the scope of this article, but the CRA has taken the position that a corporation that holds only cash cannot take advantage of pipeline planning. It is possible, however, for investment holding companies to undertake pipelines.
Pipelines Always and Forever?
A pipeline might save hundreds of thousands of dollars of taxes, but it does not always do so. For example, in Jane’s case, Holdco might have large amounts of refundable taxes on hand, in which case a redemption of shares might trigger relatively little additional tax and the loss carryback method could be preferable. Moreover, implementing a pipeline means living with the restraints imposed by the CRA guidelines, which is not always possible. Every situation must be analyzed in detail to determine the costs and benefits (tax and non-tax) of the pipeline compared to other planning techniques.
Interestingly, the CRA has continued to issue pipeline rulings although it appears the Department of Finance thinks they embody bad tax policy. When it introduced the new split income rules in 2017, Finance also took aim at pipelines: proposed section 246.1 of the Act, among other things, would have ended them. Finance stated at the time that it believed estates should be taxed on surpluses received from corporations at (the higher) dividend rates and not at the capital gain rate.4 It withdrew the proposal after a storm of protest from small business owners and their advisers who were concerned about its effect on small business transition planning.
Perhaps, however, Finance will use another tool, if not to kill pipelines, then to make them less attractive. The pipeline saves tax because of the difference in rates applicable to dividends and the rate applicable to capital gains. The federal government has now incurred enormous additional debt in its fight against the health and economic effects of COVID-19. Some are speculating that the government, to collect more revenue, might increase the portion of a capital gain that must be included in income from 50% to 75%.5
If the government had implemented this change immediately before Jane died, then the tax her estate would have paid in respect of the gain would be about $401,000 instead of only $267,000. The pipeline savings would be reduced from $210,000 to only $76,000. The pipeline might still be worth implementing, but its savings would be greatly reduced.
Advice to Clients
Smart clients and their advisers create estate plans that take into account post-mortem tax planning. The pipeline is a key tool for that kind of planning that clients should know about and consider. A lawyer should not advise a client to die sooner so that he or she can take advantage of pipeline planning. The lawyer should outline pipeline planning, its savings and its limitations. The lawyer should also mention that its utility could be reduced or eliminated by government action in the near future.
John Loukidelis provides tax advice to business owners, accountants and other lawyers. John’s Tax Court experience includes dealing with complex tax litigation on behalf of public and private corporations. He can be reached at:
Loukidelis Professional Corporation
20 Hughson Street South, Suite 707
Hamilton ON L8N2A1
1 In fact, the appropriate percentage is a bit of a mystery because recently the CRA has taken to redacting this percentage in the rulings it has issued. In the author’s experience, 15% seems typical, but the CRA has not chosen to provide firm public guidance on this point.
2 Of course, transfers of assets from Amalco in satisfaction of the note could give rise to capital gains in Amalco on which it might be required to pay tax. It might be possible to combine the pipeline with a “bump” for income tax purposes that would increase the tax cost of Amalco’s assets. Bump transactions are quite complex, however, and well beyond the scope of this article.
3 CRA ruling 2018-0789911R3.
4 Manu Kakkar “The Pipeline Comes Back to Life (But for How Long?)” 18:1 Tax for the Owner-Manager(January 2018).
5 The capital gain inclusion rate in early 2000 was 75% before it was lowered by the Chretien Liberals.