When a loved one passes away, taxes can take an unexpected toll on their estate. In Canada, deemed dispositions at death often trigger significant capital gains, and in many cases, the same assets may be taxed more than once. The loss carryback strategy under subsection 164(6) of the Income Tax Act (the “ITA”) provides executors and families with a way to reduce this burden. For high-net-worth individuals, understanding this option can help preserve more wealth for future generations.
What causes this problem?
Pursuant to paragraph 70(5)(a) of the ITA, a deceased individual is deemed to have disposed of all capital property immediately before death for proceeds equal to the property’s fair market value. Although the property is not actually sold, the individual in subject to the tax consequences of the deemed disposition in their terminal year, typically triggering a capital gain. For taxpayers who own shares of private corporations, this can lead to double taxation.
For example, consider Mrs. Smith, who owns a private corporation holding an investment portfolio. Upon her death, she is deemed to have disposed of her shares for proceeds equal to their fair market value. The resulting capital gain is reported on her terminal return (“Tax Event 1”). Her estate is deemed to acquire the private corporation shares at an adjusted cost base equal to that fair market value. Later, the executor liquidates the investments. With the investments having grown in value, a second capital gain is triggered, and the private corporation pays tax on it. A wind-up dividend is then paid to the estate and taxed at the dividend tax rate (“Tax Event 2”). In this scenario, tax has been paid twice on the same economic gain in the value of the investments: once at the shareholder level and again at the corporate level.
How does the loss carryback strategy work?
Subsection 164(6) of the ITA allows capital losses realized by an estate to be carried back to offset capital gains reported on the deceased’s terminal return.
Once the investments held by Mrs. Smith’s corporation are liquidated and the wind-up dividend is paid, the shares become worth $0. However, they still have an adjusted cost base equal to their terminal fair market value. The disposition of the shares on the dissolution of the corporation therefore results in a capital loss in the estate. On an elective basis, subsection 164(6) permits this capital loss to be carried back to Mrs. Smith’s terminal year return and applied against the capital gain that arose on her death. In this way, full or at least partial relief is provided for Tax Event 1, thereby avoiding double taxation. The executor must make the election in the estate’s T3 return of income, pursuant to subsection 164(6), so that the relevant capital losses of the estate are deemed to be capital losses of the deceased for the terminal year.
Like the Mrs. Smith example, the executors of the estate of Mr. Jones can elect to carry back the capital loss eventually realized on the sale of the cottage to Mr. Jones’s terminal return, to offset the capital gain that arose on his death based on the appraised value. This provides relief where the estate did not realize the full fair market value reported at the time of death. The same principle applies to any reductions in the fair market value of marketable securities between the time of death and the time of eventual liquidation by executors of an estate.
What additional considerations must be taken into account?
To take advantage of the loss carryback strategy, the estate must designate itself as a graduated rate estate (“GRE”) in its T3 return for its first taxation year. Certain conditions must be met for an estate to maintain GRE status, which are outside of the scope of this article. For example, the GRE must maintain testamentary trust status, which can be jeopardized in several ways, including having a beneficiary pay estate expenses.
Previously, for subsection 164(6) to apply, the property had to be disposed of by the estate within the first year of the GRE. This tight deadline often caused difficulties, given the frequent delays in estate administration due to administrative wait times or will challenges. As of August 2024, the Department of Finance released draft legislation extending this period to the first three years of the estate for individuals who die on or after August 12, 2024. This amendment provides welcome relief, although complex estates may still face challenges meeting the deadlines.
How can corporate tax attributes enhance this strategy?
When private corporations hold life insurance, refundable tax balances, or a capital dividend account (“CDA”), these tax attributes can be combined with the loss carryback strategy to maximize tax savings.
Let’s return to Mrs. Smith and assume that she founded a second private corporation operating an active business. Several years ago, she implemented an estate freeze, and her children will be continuing to operate the business. The operating corporation owned a life insurance policy on Mrs. Smith and had also accumulated a refundable tax balance over its years of operation.
As described above, the deemed disposition of the preferred shares Mrs. Smith received on the estate freeze results in a capital gain that must be reported. In this case, however, the corporation also has a CDA and a refundable tax balance. The estate can redeem some of the shares using the capital dividend account, thereby combining the capital loss on the disposition of the shares with a tax-free dividend.
Subject to the stop loss rule in subsection 112(3.2) of the ITA, partial relief from the equivalent of Tax Event 1 can be achieved through the subsection 164(6) carryback. The impact of the stop loss rule can be mitigated by implementing steps known as the 1/2 solution, which is beyond the scope of this article. Redeeming shares to trigger a full refund of refundable tax balances facilitates partial relief from Tax Event 1 by combining a tax refund for the corporation with an equivalent tax cost to the estate (resulting in no net tax), while also triggering a capital loss that can be used by the estate in the loss carryback strategy.
What should executors and business owners do now?
Executors should seek legal and tax advice early in the estate administration process to ensure that losses are utilized efficiently. Business owners and their families can also benefit from advance planning, such as implementing estate freezes or structuring corporate holdings to effectively leverage CDA balances.
Our Private Client Services Group helps business owners, families, and executors navigate complex tax and estate planning. From loss carryback elections to succession strategies, we provide tailored solutions to preserve wealth across generations. Contact us today or subscribe to our newsletters for ongoing legal updates that matter to you and your organization.
