Overview
When an individual dies owning shares in a privately held corporation, there is potential for double taxation, as will be explained below. To avoid this result, there are several strategies available to the estate. The post-mortem tax planning strategy being discussed here is known as a "pipeline".
Tax on Capital Gain
For income tax purposes, an individual is deemed to have disposed of her capital property, including her shares in a private corporation, immediately prior to death and any capital gain accrued on those shares is subject to tax at capital gains rates.
Tax on Dividend
A subsequent redemption of the shares by the corporation in future years will typically result in such redemption being taxed as a dividend at the prevailing rates, without any credit for the taxes paid on death. As a result, the shares would be taxed twice, i.e., double taxation. There are a few techniques which are employed to avoid this unfavourable result, one of which is known as a "pipeline".
The Pipeline
The effect of the pipeline is to create a mechanism to extract corporate funds from the corporation on a tax-free basis, thereby ensuring that tax is paid only once, at capital gains rates on the death of the individual.
Where a taxpayer dies owning shares of a privately held corporation, the shares become property of the taxpayer's estate, and the adjusted cost base to the estate reflects the shares' fair market value immediately before the taxpayer's death.
To implement the pipeline, the estate will transfer the shares to a newly incorporated estate-owned holding company ("Newco"), in consideration for the issuance of a promissory note and shares in the capital of Newco. The amount of the promissory note will be the fair market value of the shares as of the date of death. If there has been an increase in the fair market value of the shares between the date of death and the date of the transfer, the transfer can be undertaken on a tax deferred basis (pursuant to subsection 85(1) of the Income Tax Act).
Distributions can be made to the estate (i.e. the shareholder) as tax-free repayments of the promissory note by Newco. The repayment of the promissory note is the "pipeline" to remove the estate's value in the underlying corporate assets.
Canada Revenue Agency ("CRA") has issued a number of advance income tax rulings on pipeline transactions setting certain conditions which it believes should be met:
- The original corporation's business will continue for at least one year following the implementation of the pipeline structure.
- The original corporation should not be amalgamated or wound-up into the new holding corporation for at least one year.
- The original corporation's assets will not be distributed to the shareholders for at least one year, followed by a progressive distribution of the corporation's assets over an additional period of time.
It is best practice to follow CRA's current position where possible to minimize any chance that the transaction is challenged. For absolute certainty, a taxpayer can obtain an advanced tax ruling from CRA to be assured the transaction will not be offensive to CRA.