Background Tax Pipeline Planning
A "pipeline plan" or "pipeline planning" are terms expert Canadian tax planning lawyers use to identify a post-mortem tax planning technique. The idea behind the pipeline is to reduce taxes payable on death by having the accrued gains on shares taxed as a capital gain in the Estate, rather than a deemed dividend on redemption. Generally, capital gains have preferred tax consequences because of the ˝ inclusion rate. That means that only half of the capital gain is considered taxable capital gains. Hence, the non-taxable portion of the capital gain is completely tax free. On the other hand, dividends, including deemed dividends, are fully taxable.
The 50% tax inclusion rate creates a taxpayer preference for capital gains. The goal of tax planning, of course, is to reduce overall tax payable and if tax planning to create capital gains instead of dividends would reduce taxes, then it may be advisable to employ a pipeline plan technique.
The Base Case: Share Redemption Without a Pipeline Tax Plan
To understand the benefit of a pipeline plan, it is important to present the alternate - the base case. In the base case, the Testator ("T") passes away while owning shares of a business ("Opco"). Assume that the fair market value (FMV) of the shares is
To take an example, if A pays to
Using the same example, assume A is the sole shareholder of
At this step, the Estate has a significant problem. In order to distribute funds, it will need to either sell or redeem the shares. If the shares are sold to a third party, then no issue arises. However, because
Before proceeding to intricacies and benefits of a pipeline plan, it is important to note that there is a caveat to the double taxation problem. Section 164(6) (see our article on the topic) allows the Estate to use the proceeds of redemption to offset taxpayer's (A) capital gains. In our example, there is a deemed dividend on the amount the redemption proceeds (
Unfortunately, while there is a reduction in tax resulting from capital gains, the result is paying tax on dividends when there is the potential to pay capital gains instead. A pipeline plan is a tool used to avoid paying tax on dividends and pay tax on capital gains instead.
Using the Pipeline: A Case Study
At its core, the pipeline contains a simple strategy: pay taxes on capital gains rather than on dividends. After the 70(5) deemed disposition due to A's death, the shares are held by the Estate. Because A has paid taxes on the accrued gains, the Estate acquires the shares with an increase to the cost-base up to the amount of tax paid. In our example, A would have
At this stage, the base-case, the share redemption method would redeem the shares and thereby incur a dividend. The pipeline plan, however, works as follows:
- A new corporation,
Holdco , is incorporated. UsuallyHoldco has nominal value, such as$1 . This means both the PUC and ACB of the shares ofHoldco are nominal as well. Assume that there is 1 share for a FMV, ACB, and PUC of$1 . - Shares of
Yesco are sold toHoldco in exchange for a promissory note. It is important to value the promissory note equal to the value of the shares. Otherwise, there may be tax consequences such as a shareholder benefit, which is taxable. Yesco declares a dividend and distributes the dividend toHoldco . Because inter-corporate dividends (a dividend between corporations) are generally tax free, no tax is paid on the dividend flowing fromYesco toHoldco .Holdco uses the dividend to repay the promissory note back to the Estate.
The result is that the monies have been extracted from
The result is that the value of the operating business
Pro Tax Tip: Pipeline planning can be an incredibly effective means of reducing your tax bill when you own shares of an operating corporation. However, a pipeline must be done correctly, and in the past, the CRA has reassessed incorrectly planned pipelines. Because of the complexity of pipeline planning, our specialized Canadian tax lawyers can assist you in carefully crafting and implementing a pipeline estate tax reduction plan.
FAQ:
1. What is a pipeline plan?
A pipeline plan is a type of post-mortem (after death) tax planning that is used to minimize taxes when removing value from an operating business. It involves creating a holding corporation in order to extract surplus without creating deemed dividends or needing to redeem the shares, thereby causing a deemed dividend.
2. What is a dividend redemption?
A dividend redemption occurs when a shareholder sells a portion of their shares back to the company. For tax purposes, a share redemption gives rise to a deemed dividend when the value of the redemption exceeds the PUC (paid-up capital) of the shares. Often, the PUC of shares are low relative to FMV (fair market value) of the shares, which leads to a large deemed dividend.
3. When is it right to use a pipeline tax plan?
Using a pipeline tax plan is only beneficial under certain circumstances. In other circumstances, such as when the operating company has significant PUC, a pipeline plan may be sub-optimal for tax purposes. It is critical to have a tax specialist advise and evaluate your circumstances to best advise you. Contact our Canadian tax lawyer experts at
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a Canadian tax lawyer."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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