The use of post-mortem “pipeline” planning is a popular technique aimed at avoiding double taxation in situations where there is a capital gain recognized on the death of a taxpayer who held a significant interest in the shares of a Canadian private corporation at the time of death. It can also apply in situations where the shares were in a “spousal” or “alter-ego” trust and subject to a deemed disposition on the death of the life-tenant.
In essence, this technique involves a transfer of shares with a “stepped-up” cost base to another corporation in return for either debt or high paid-up capital (”PUC”) shares. The objective is to covert the high cost base shares into an instrument that will allow corporate retained earnings to flow tax-free to the holder. My co-authors David Louis and Brian Nichols, and I, wrote about such planning in depth in a series of articles that ran from 2002-2004 in CCH’s Tax Topics that was entitled “Estate Planning in The 21st Century”. I believe that we collectively were responsible for making the term “pipeline” much more popular than it previously had been, as well as increasing awareness of the benefits of this technique.
Although, in recent years, there has been some concern about the potential application of subsection 84(2) of the Income Tax Act (“the Act”) to result in deemed dividend treatment, it seems, based in part on a number of recent CRA rulings, that the technique is still alive and well, but, in certain situations, may have to be implemented in a more careful and gradual manner.
More and more, I see situations involving non-resident beneficiaries. I find that most professional advisors are not sufficiently attuned to the complications that this can create in the context of “pipeline” planning.
As a general rule, such planning can either be implemented while the relevant shares are still in an estate or trust, or it can be implemented after such shares have been transferred to the beneficiaries.
Why might it be implemented after the shares are transferred to beneficiaries? There are several possible reasons:
- The shares were in a testamentary trust that did not provide for continuance after the death of the life-tenant, and, as a matter of law, the trust ceases to exist after that time,
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- The shares were subject to a deemed disposition on the death of the life tenant (most commonly applicable to a testamentary spousal trust) and it was necessary to transfer the shares to the beneficiaries in order to have an acquisition of control “as a consequence of death” (see paragraphs 88(1)(d.2)/88(1)(d.3) of the Act) , or
- The trustees did not receive high-level tax advice, and they were not aware of the potential benefits of “pipeline” planning until after the shares were transferred to the beneficiaries.
Whatever the reason, there is a little-known pitfall that can rear its ugly head in situations where the shares have already been transferred to the beneficiaries and one or more of them are non-residents for tax purposes.
Namely, for the non-resident(s), section 212.1 of the Act will generally apply on the transfer of shares to the other corporation to create the “pipeline”. Section 212.1 of the Act is the cross-border counterpart of section 84.1 of the Act, which is a much more familiar provision for most accountants.
Both provisions are essentially aimed at preventing “surplus stripping” and limit the extent to which “boot” (i.e. non-share consideration) or “paid-up capital” (“PUC”) may be received tax-free on non-arm’s length transfer of shares of a “connected” corporation to another corporation.
However, here is the big difference between the two provisions: whereas section 84.1 generally limits the amount that can be extracted to the adjusted cost base of the transferred shares, section 212.1 limits it to the PUC. Normally, in Canadian private corporations, the PUC of shares is just a nominal amount. More significantly, it does not get “stepped-up” on death like the adjusted cost base does. The result is that what would otherwise be a tax-free pipeline will get taxed as a dividend subject to Part XIII withholding tax, either immediately, if debt is received, or as funds are withdrawn, if shares are received.
So, be wary of such situations.
If fact, it is also important to consider whether the relevant estate or trust itself might be a non-resident, based on its “central management and control”. If so, section 212.1 may even apply to the establishment of a “pipeline” at the estate or trust level, although one would also have to consider the application of the “deemed resident trust” rules in subsection 94(3) in certain cases.
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
