Careful planning may mitigate the effects of the 21-year deemed disposition.
By Sean Rheubottom
Suppose that a number of years ago you implemented a “freeze” in which you exchanged your corporation’s common or “growth” shares for fixed-value freeze shares, and your family trust subscribed for new growth shares. One of the more exciting benefits was splitting dividend income with lower-taxed family members.
These days it’s difficult – though not impossible – to split dividend income because of the new tax on split income (TOSI) rules.
But your freeze may still be working for you in other ways. Another main benefit is the deferral, and possibly splitting, of taxable capital gains. After you froze, further growth in the value of your business accrued to the trust rather than to you. If you sell the business (or in the event of your death), inherent capital gains in the trust’s shares will not land on your personal tax return.
If a share sale happens, capital gains distributed by the trust may qualify for the $883,384 capital gains exemption (CGE) that applies to qualified small business corporation (QSBC) shares. The CGE is indexed annually until it reaches $1,000,000. Complex tax rules must be satisfied.
The TOSI rules do not apply to taxable gains from QSBC shares. Splitting such taxable gains with family may be possible, even where the CGE is not used. Proper consideration of trust tax reporting and attribution rules is critical. Note that each beneficiary of your trust has their own $883,384 CGE.
Deemed disposition every 21 years
Tax rules state that on every 21st anniversary (“D-day”) of your family trust, the trust is deemed to realize the inherent capital gains in its shares, preventing indefinite deferral. However, there are some things you can do to side-step D-day and defer the tax, or mitigate any tax that does occur.
Planning for D-day
Start planning at least a few years in advance of D-day. Some tax strategies (for example, qualifying for the CGE) may take at least two years to work.
You must review your trust agreement from tax and legal perspectives. For example, some plans may involve transferring shares to a corporation. Does your trust authorize such reorganizations or perhaps even provide that a newly created corporation is a beneficiary? Does it allow a beneficiary to be added? Would the operation of trust law or a court application allow a variation of the trust? Would such changes result in a taxable disposition? Adding a beneficiary may result in certain beneficiaries being deemed to have sold a part of their interests in the trust at fair market value, resulting in capital gains.
You must also ensure that your proposed plan is consistent with the trustees’ obligations to the beneficiaries.
Trust-to-trust transfers don’t work
Tax rules provide that if a trust transfers its assets to another trust, the second trust has to use the first trust’s 21-year clock. There is no reset.
Reduce value and let D-day pass
You could simply let D-day pass, allowing the trust to realize the capital gains. Before that, you could try to reduce the shares’ value by paying dividends, accessing any refundable or capital dividend accounts.
Your trust terms might allow deemed, CGE-sheltered taxable gains to be allocated to beneficiaries, although practically speaking, this might be difficult. Something similar may be possible under the “rollout” described below.
Finally, tax rules allow a trust to pay any “21-year tax” in instalments over 10 years, with security and interest.
Rollout prior to D-Day
The main idea with most 21-year planning is to move shares out of the trust before D-day. Tax rules allow shares to “roll out” to Canadian resident beneficiaries without triggering gains, unless desired. The gains may be deferred until the shares are actually sold.
However, if a certain attribution rule applies because of, among other things, a potential reversion of trust property to someone the trust received it from, the rollout will generally not be allowed.
If you’re a beneficiary, the trust can give shares back to you, but to the extent that this is done, your freeze is undone.
Children’s planning issues
Before any transfer of shares to your children,
- Have them plan their own structures, including possible use of holding corporations and trusts;
- Have them sign a shareholder agreement restricting transfers of their shares; and
- Encourage them to enter into family property agreements with spouses.
Buy some time with a second freeze
Let’s say you’re 10 years out from the date you froze. The value of your business has since grown considerably. That growth is contained in the shares held by your trust. Now, think about giving that value outright to your children some time in advance of your D-day. Are you feeling nervous? Concerned about maintaining some control?
It should be possible to freeze the shares held in your family trust (FT1), even if its D-day is several years away, by exchanging them for fixed-value preferred shares. Next, you could issue new common shares to a new family trust (FT2). The inherent gain in FT1 is capped, limiting the amount you have to distribute before D-day arrives. Future growth accrues to FT2, whose D-day is 21 years from now. This is not a trust-to-trust transfer because the corporation issues new shares to FT2.
Rollout with control
There are variations of “rollout” plans that seek to maintain control.
For example, it should be possible to ensure that beneficiaries receive non-voting shares so that they get the value, but no control. You or the trust may be able to retain voting shares with low value.
Distribute non-retractable shares
You could consider freezing the value of the trust’s shares shortly before distributing them to beneficiaries, just like a second freeze. A problem is that for technical reasons freeze shares must be “retractable,” meaning the beneficiaries would have the right to demand payment in full from the corporation to completely liquidate the shares.
A possible solution is to transfer the preferred shares to a holding corporation in exchange for non-voting common shares of the holding corporation, and then distribute the non-voting common shares to the beneficiaries. The beneficiaries would get the value but no right to require a repurchase of their shares.
Be cautious about any plan under which the value rolled out to beneficiaries can be shifted back to you using share attributes. The CRA recently imposed a punitive reassessment on such a plan.
What doesn’t work
It may seem possible to distribute the trust’s shares to a beneficiary corporation, the shares of which are owned by a new trust with a fresh 21-year clock. However, the CRA says that while this is technically not a trust-to-trust transfer, the CRA will seek to disallow it under general anti-avoidance rules.
Finally, understand that 21-year planning requires specialized advice as well as teamwork among your tax, legal and financial advisors.
First published in the December 2020 edition of The Business Advisor.