Double taxation is a problem which can arise when an individual dies owning shares of a private corporation.  The Income Tax Act (Canada) (the “ITA”) legislates a deemed disposition of the shares at fair market value immediately before death. In certain circumstances, the pipeline strategy may be a good solution to limit the double taxation problem. The details of the pipeline strategy are further discussed in this article.  

The double taxation problem

As a refresher, double taxation arises when two tax events occur:

Tax Event #1

Tax Event #1 occurs because of the deemed disposition immediately before death. Assuming that the shares of “Priv Co” (a fictional private corporation for the purposes of this example) held by the deceased have increased in value from date of acquisition to date of death, the deceased will generally be deemed to realize a capital gain. It does not matter if Priv Co is an investment holding corporation or an operating business. The capital gain must be reported in the deceased’s terminal income tax return. For income tax purposes, the estate is deemed to acquire the Priv Co shares and therefore has an adjusted cost base equal to their fair market value immediately before the deceased’s death.

Tax Event #2

Tax Event #2 occurs when there is a withdrawal of funds/assets from the private corporation. The distribution is subject to tax in the hands of the Estate.  The distribution is most likely a dividend (capital, eligible, or non-eligible), and it is taxed accordingly to the recipient. The amount of tax paid because of Tax Event #1 cannot be used to offset the tax consequences of Tax Event #2.

What is the pipeline strategy?

The pipeline is a tool in the tax advisor’s toolkit to address the double taxation problem. In simple terms:

  • A new corporation (“Newco”) is incorporated by the estate, and the estate subscribes for shares so that it has voting control.
  • The estate transfers the Priv Co shares (i.e., the shares which were subject to the deemed disposition immediately before death) to Newco in consideration of a promissory note for an amount equal to the estate’s adjusted cost base of the Priv Co shares, i.e., the fair market value immediately before death (and assuming  that there is no increase in value of Priv Co from the date of death to the date of implementation of the pipeline as other steps would be required).
  • There is no capital gain to the estate.
  • The promissory note is paid by Newco, effectively using Priv Co’s assets/funds.

Typically, the repayment of a promissory note is tax-free to the recipient.  If it is tax-free, then the estate has effectively accessed funds of Priv Co by making use of Tax Event #1, or technically, the increased adjusted cost base of the Priv Co shares to the estate arising from Tax Event #1. This means that there is only one incidence of tax: Tax Event #1.

Beyond the basics

The above is overly simplistic. The pipeline is overlaid with a maze of administrative statements from CRA in response to questions at conference roundtables or technical interpretation requests.  Advisors have also tried to discover trends in pipeline steps from published advance income tax rulings, although these are often heavily redacted. 

There is a significant downside if CRA reassesses the pipeline. The issue is subsection 84(2) of the ITA:  If the pipeline is reassessed based on subsection 84(2), the promissory note is taxed to the Estate as a dividend. This means that Tax Event #2, which the Estate had hoped to ameliorate with the pipeline, becomes a reality.

Although this list is not complete, below are some highlights of CRA’s administrative statements in respect of pipelines:

  • CRA does not like a pipeline where the assets of Priv Co are essentially cash.
  • Newco and Priv Co should continue as separate entities for at least one year.
  • The business of Priv Co should continue as before and not reorganize or wind up.
  • The promissory note cannot be immediately repaid but rather, progressively after the above one-year period.  Some published rulings have referred to a maximum of 15% per quarter.  However, there have been more recent rulings with different percentages.

Choosing between the pipeline and the loss carryback

Viewed on an isolated basis, a successful pipeline has a single incidence of tax equal to the capital gains tax on the terminal period capital gain. In contrast, the loss carryback planning (further discussed in our previous article) effectively leads to a single incidence of tax based on a dividend rate (in substitution for the terminal period capital gain). At present, the effective capital gains rate is lower than the dividend rate (eligible or non-eligible). However, it is overly simplistic to merely compare effective tax rates. There are timing rules (loss carryback must be implemented in the first year of the Estate) and CRA administrative practice (pipelines have a considerable delay before funds/assets can be accessed) to be considered.

Further, if Priv Co has tax accounts on hand (capital dividend account, eligible refundable dividend tax on hand, non-eligible refundable dividend tax on hand; general rate income pool), these factor into the effective dividend rate and can only be accessed if the post mortem plan involves a dividend (i.e., the loss carryback plan).  Unless there are other remaining shareholders of Priv Co, the tax accounts could be stranded.

Seek expert advice

The pipeline may be an answer to the double taxation problem, but it should be combined in some form with a partial loss carryback plan. These strategies are complex and carry significant risk if not properly implemented. Miller Thomson’s Private Client Services Group is here to help navigate the tax and estate planning issues that arise upon death.