estate planning and trusts 4 2017...estate planning and trusts to freeze or not to freeze name:...
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Estate Planning and Trusts
To Freeze or not to Freeze
Name: Francine Nelson Wiseman, BCL, LLB
Company: GWBR
Tuesday, April 4, 2017
Name: Steven Moses, CPA, CA, TEP
Company: PSB Boisjoli LLP
Tuesday, April 4, 2017
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To Freeze or not to Freeze
Estate Freeze:
• Review a typical estate freeze including where one or
more children reside in the United States
Post Mortem Tax Planning:
• Review some of the Canadian and US tax
consequences that may arise in the context of the
current tax rate landscape where the parent owns
shares of a Canadian company.
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To Freeze or not to Freeze
Reasons to “Freeze”
There are many reasons why a freeze could be contemplated, some of which
include the following:
• Minimize capital gains tax payable as a consequence of death
• Allow future growth to accrue to the next generation
• Allow next generation to partake in shareholders’ meetings and decisions
• Opportunity to reduce taxes to an Estate by redeeming preferred shares owned
by the parent during his/her lifetime
• Provide income splitting opportunities
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To Freeze or not to Freeze
“Basic Freeze”
• Parent would incorporate a new company (“Holdco”) presumably under the same jurisdiction
as Operating Company (“Opco”);
Note – This could also be completed at the level of Opco, but we often find both tax
and commercial advantages for establishing a Holdco
• A discretionary family trust (“Trust”) is created with the following attributes:
- The Settlor is a family friend or a non beneficiary/Trustee relative;
- The trustees would include Parent and at least one other person who is neither a
beneficiary nor a settlor;
- The beneficiaries include Parent, spouse, children, grandchildren and other corporate
beneficiaries;
- The Trust is fully discretionary during the lifetime of Parent.
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To Freeze or not to Freeze
“Basic Freeze”
• Parent transfers his/her shares of Opco to Holdco on a tax deferred
basis pursuant to section 85 of the Income Tax Act (“ITA”) and the
Quebec equivalent. In exchange, Parent receives voting preferred
shares having a fair market value equal to that of the shares
transferred;
Note – Consider issuing a separate class of “skinny” voting preferred shares if
parents’ desire is to separate vote from value
• Trust borrows $100 from an arm’s length person and subscribes for
100 non-voting common shares of Holdco (this loan must be repaid by
the Trust, with interest typically from the receipt by the Trust of a
dividend from Holdco)
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To Freeze or not to Freeze
Trust
Holdco
Opco
Parent
Non-voting
common shares
100% of all shares
Voting preferred shares
(control)
Non-voting preferred shares
(freeze shares)
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To Freeze or not to Freeze
Why Use a Discretionary Family Trust
• Minor children might not have the legal capacity to subscribe for the non-voting common
shares;
• Protects the shares from future creditors;
• Perhaps protects the shares in case a child suffers a marital breakdown in the future;
• Reduces the risk of the acceleration of gains upon the premature death of someone in the
next generation;
• Multiplies access to the capital gains exemption if freezing at the Opco or Holdco, level
provided shares qualify for this exemption;
• Creates the opportunity to income split without beneficiaries having legal ownership of
shares;
• Flexibility to pay tax free dividends to corporate beneficiaries of the Trust
• Provides discretion to Trustees and thus provides a “crystal ball” for 21 years
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To Freeze or not to Freeze
• Over the years, the difference between capital gains
rates and dividend rates has changed.
• Tax practitioners would readily recommend an estate
freeze for all the previously mentioned reasons.
• As of today, the gap between capital gains rates and
dividend rates has increased, especially in the
situation of non-eligible dividends
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To Freeze or not to Freeze
Quebec Ontario Alberta
Dividends Dividends Dividends
Other
incomeEligible
Non-
Eligible
Capital
GainsOrdinary Eligible
Non-
Eligible
Capital
GainsOrdinary Eligible
Non-
Eligible
Capital
Gains
2016 0.5331 0.3983 0.4384 0.2665 0.5353 0.3934 0.453 0.2676 0.48 0.3171 0.4025 0.24
2011 0.4822 0.3185 0.3635 0.2411 0.4641 0.2819 0.3257 0.232 0.39 0.1772 0.2771 0.195
2006 0.4822 0.3635 0.2411 0.4641 0.3134 0.232 0.39 0.2458 0.195
2001 0.4872 0.3344 0.2436 0.4641 0.3134 0.232 0.39 0.2408 0.195
1996 0.5294 0.3872 0.397 0.5292 0.3574 0.3969 0.4607 0.314 0.3455
Table on Tax Rates
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To Freeze or not to Freeze
Post-Mortem Tax Planning
• Typical tax planning includes the following:
i. Loss carryback strategy (Subsection 164(6) ITA)
ii. Pipeline strategy
iii. Hybrid approach
• Given the change in tax rates between capital gains and dividends,
different family needs, etc., the chosen approach has evolved over time
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To Freeze or not to Freeze
Post-Mortem Tax Planning
Other factors that must be considered in deciding on the approach include the
following:
• The existence of “grandfathered shares” which would not result in the
application of Subsection 112(3.2) ITA
• Balance in the refundable dividend tax on hand account
• Any balance in the capital dividend account
• Were the shares owned on V-day or acquired in a non-arm’s length transaction
where capital gains exemption was claimed
• Whether or not there are unrealized capital gains within the corporation
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To Freeze or not to Freeze
Example 1:
Consider the simplest of examples where Shareholder X
owns all of the shares of a company (“Holdco”) that has
$10,000,000 of value, all in liquid assets
Shareholder X
Cash
Note – Technical matters to be discussed in the following examples
Holdco
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To Freeze or not to Freeze
Comparison of Capital Gains Tax and Dividend Tax $ Rounded
FMV at time of death 10,000,000
Adjusted cost base/Paid up capital 0
2016 2011 2006 2001 1996
Quebec
Tax on capital gain 2,665,000 2,411,000 2,411,000 2,436,000 3,970,000
Tax on deemed dividend on share redemption 4,384,000 3,635,000 3,635,000 3,344,000 3,872,000
Advantage of capital gains rate 1,719,000 1,224,000 1,224,000 908,000 -98,000
Ontario
Tax on capital gain 2,676,000 2,320,000 2,320,000 2,320,000 3,969,000
Tax on deemed dividend on share redemption 4,530,000 3,257,000 3,134,000 3,134,000 3,574,000
Advantage of capital gains rate 1,854,000 937,000 814,000 814,000 -395,000
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To Freeze or not to Freeze
As illustrated, the tax advantage of using a pipeline (capital gain) strategy as opposed to the loss
carryback (deemed dividend) strategy has increased over the years as follows (all rounded)
Other non-tax factors that must be considered include the following:
• Different beneficiary needs and objectives
• Timing of cash requirements of the beneficiaries
• Costs, complexities and compliance of the approach
• Staying current with CRA pronouncements on technical matters
Quebec Ontario
2016 1,719,000 1,854,000
2011 1,224,000 937,000
2006 1,224,000 814,000
2001 908,000 814,000
1996 (98,000) (395,000)
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To Freeze or not to Freeze
Example 2:
Consider the following set of facts:
• Mr. X is 60 years old and divorced;
• Mr. X has 3 major children ranging from ages 18 to
22 who live in Canada. No one in the family is a U.S.
citizen or green card holder;
• Mr. X owns shares of a holding company (“Holdco”)
having a current fair market value of $10,000,000
which he believes will grow in value over time.
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To Freeze or not to Freeze
Assume the following facts upon the death of Mr. X:
• Value of Holdco has grown to $20,000,000. Mr. X
still owns his preferred shares worth $10,000,000;
• CDA = $1,000,000 (the shares are not
grandfathered);
• RDTOH = $300,000.
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To Freeze or not to Freeze
Mr. X. had previously completed an Estate Freeze in favor of a
discretionary family trust, such that the structure is as follows:
Mr. X
Holdco
Discretionary
Family Trust
Control and preferred shares
worth $10,000,000 with a
nominal ACB
Non-voting common
FMV shares
$10,000,000
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To Freeze or not to Freeze
Tax Consequences Upon Death:
1.Subsection 70(5) ITA• On death, the shares of Holdco owned by Mr. X are deemed to be disposed
of for proceeds of disposition equal to $10,000,000.
2.Subsection 164(6) ITA• Permits a capital loss generated upon a redemption of Mr. X’s preferred
shares in Holdco during the first year of the estate to be carried back and
applied against the capital gain resulting from the deemed disposition upon
Mr. X’s death.
3.Pipeline• Permits the Estate to receive the liquid assets from Holdco without
additional taxes.
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To Freeze or not to Freeze
Analysis of subsection 164(6) ITA
The benefit of this approach is twofold:
i.Entitles the corporation to an RDTOH refund
ii.The use of the CDA to pay a tax free dividend to the Estate
resulting in a reduction of the taxes paid on Mr. X’s death.
Note: Need to consider whether it is worthwhile triggering gains in Holdco
to increase the CDA and RDTOH
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To Freeze or not to Freeze
Technical Problem
Subparagraph 112(3.2)(a)(iii) will cause a reduction dollar for dollar
in the resulting capital loss to the extent that the capital dividends
paid exceed 50% of the lesser of:
a)the capital loss due to the 164(6) ITA election, or
b)the deemed capital gain resulting from the death of Mr. X.
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To Freeze or not to Freeze
Proposed solution
• To overcome the stop loss rules, Estate will need to convert
shares into classes of shares having a value equal to $2,000,000
(“Class R Shares”) and $8,000,000, respectively.
Technical matter:
• Holdco will increase the paid up capital on the Class R Shares
by $1,000,000 and elect that the resulting dividend be deemed to
be a capital dividend (this will increase the adjusted cost base of
the Class R shares pursuant to ss 53(1)(b) of the ITA).
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To Freeze or not to Freeze
Technical matter
• Pursuant to Subsection 83(2) ITA, the corporation must elect on
the full amount of the dividend;
• CRA document 2009-031060117 confirms that a two step share
redemption, one elected pursuant to subsection 83(2) ITA and
one a taxable dividend are viewed as separate transactions for
the purpose of applying the stop-loss rule in subsection 112(3.2)
ITA;
• Redeem the Class R shares worth $2,000,000 thus resulting in
an RDTOH refund to Holdco and a taxable dividend of
$1,000,000.
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To Freeze or not to Freeze
Technical matter:
Make sure there are no capital gains in the estate in its first
taxation year or the benefits of the loss carryback will be
eliminated – CRA documents 2012-0449801C6 and 2012-
1457541C6
Note: Subsection 112(7) ITA must be considered since if its shares
are exchanged post demise pursuant to section 85 of
the ITA, the stop loss rules could apply to reduce the
capital loss otherwise realized. Therefore, the mechanism
of the share exchange must be such as permitted pursuant
to that subsection.
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To Freeze or not to Freeze
Example 2 $ Rounded
Quebec Ontario
Capital gain upon death 10,000,000 10,000,000
Tax on capital gain 2,665,000 2,676,000
Use of loss carryback
Conversion of shares (ss 51) 2,000,000 2,000,000
Increase in paid up capital 1,000,000 1,000,000
Revised adjusted cost base 3,000,000 3,000,000
Redemption of shares : CDA 1,000,000 1,000,000
Taxable dividend 1,000,000 1,000,000
Capital loss 3,000,000 3,000,000
Less : ss 112(3.2) loss restriction 1,000,000 1,000,000
Capital loss 2,000,000 2,000,000
Tax savings from capital loss carryback 533,000 535,200
less Income tax on taxable dividend 438,400 453,000
Tax savings to estate 94,600 82,200
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To Freeze or not to Freeze
Analysis - Pipeline
After this planning, the Estate owns shares in Holdco worth
$8,000,000 with an adjusted cost base of $8,000,000. To complete
the pipeline, the following steps are required.
• Incorporate a holding company (“Newco”).
• Transfer the remaining shares to Newco with a FMV of
$8,000,000 for a promissory note worth $8,000,000 or preferred
shares with a PUC, ACB and FMV equal to $8,000,000 and
eventually draw out the remaining funds tax free by redeeming
the shares over an extended period, pursuant to CRA’s
published rulings.
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To Freeze or not to Freeze
Estate
Newco
Trust
Holdco
Shares - FMV $8,000,000
ACB $8,000,000
PUC $8,000,000
Common shares
FMV - $10,000,000
(low ACB)
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To Freeze or not to Freeze
Cash Flow Summary $ Rounded
Quebec Ontario
Estate- Fair market value of shares 10,000,000 10,000,000
Less capital gains tax 2,665,000 2,676,000
add tax savings from loss carryback 94,600 82,200
Net cash flow to Estate 7,429,600 7,406,200
Trust - Fair market value before death 10,000,000 10,000,000
Add dividend refund 300,000 300,000
Fair market value after planning 10,300,000 10,300,000
Total fair market value with planning 17,729,600 17,706,200
Total fair market value without planning 17,335,000 17,324,000
Net tax cash flow benefit 394,600 382,200
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To Freeze or not to Freeze
What does the CRA currently say about Pipelines?
i.Subsection 84(2) – will have a deemed dividend where:
“funds or property of a corporation resident in Canada have …
been distributed or otherwise appropriated in any manner
whatever to or for the benefit of the shareholders of any class
of shares … on the winding-up, discontinuance or
reorganization of its business ….”
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To Freeze or not to Freeze
What does the CRA currently say about Pipelines?
ii. CRA will give a ruling if:
a) The corporation in question remains a distinct entity for a
year or longer, and
b) The corporation continues to carry on its “business”
during that year and thereafter the repayment of the
promissory note or the share redemption occurs over
time.
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To Freeze or not to Freeze
Example 3 - Facts:
− Mr. X is 70 years old and his holding company is worth $5,000,000;
− Mr. X has 3 major children who live in Canada and are not U.S. citizens
or green card holders;
− The expectation is that the company will only grow by $5,000,000 upon
Mr. X’s death;
− Mr. X extracts dividends on an annual basis such that there is not a
material increase in RDTOH;
− Assume that a freeze was done and upon death, the holding company
has a CDA balance of $1,000,000 and RDTOH of $300,000.
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To Freeze or not to FreezeExample 3 - with estate freeze $ Rounded
Quebec Ontario
Capital gain upon death 5,000,000 5,000,000
Tax on capital gain 1,332,500 1,338,000
Use of loss carryback
Conversion of shares (ss 51) 2,000,000 2,000,000
Increase in paid up capital 1,000,000 1,000,000
Revised adjusted cost base 3,000,000 3,000,000
Redemption of shares : CDA 1,000,000 1,000,000
Taxable dividend 1,000,000 1,000,000
Capital loss 3,000,000 3,000,000
Less : ss 112(3.2) loss restriction 1,000,000 1,000,000
Capital loss 2,000,000 2,000,000
Tax savings from capital loss carryback 533,000 535,200
less Income tax on taxable dividend 438,400 453,000
Tax savings to estate 94,600 82,200
Cash to children 3,762,100 3,744,200
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To Freeze or not to Freeze
Example 3 - with estate freeze $ Rounded
Quebec Ontario
If the children require (or want) the cash, the following would result
Fair market value of shareholdings before planning 5,000,000 5,000,000
add dividend refund 300,000 300,000
Fair market value available for distribution 5,300,000 5,300,000
less : tax on distribution 2,323,520 2,400,900
Net cash to children 2,976,480 2,899,100
Total net cash 6,738,580 6,643,300
Amount per child 2,246,193 2,214,433
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To Freeze or not to Freeze
If there was no freeze:
• $10,000,000 gain on death
• CDA $1,000,000
• RDTOH $300,000
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To Freeze or not to Freeze
Example 3 - no freeze $ Rounded
Quebec Ontario
Capital gain upon death 10,000,000 10,000,000
Tax on capital gain 2,665,000 2,676,000
Use of loss carryback
Conversion of shares (ss 51) 2,000,000 2,000,000
Increase in paid up capital 1,000,000 1,000,000
Revised adjusted cost base 3,000,000 3,000,000
Redemption of shares : CDA 1,000,000 1,000,000
Taxable dividend 1,000,000 1,000,000
Capital loss 3,000,000 3,000,000
Less : ss 112(3.2) loss restriction 1,000,000 1,000,000
Capital loss 2,000,000 2,000,000
Tax savings form capital loss carryback 533,000 535,200
less Income tax on taxable dividend 438,400 453,000
Tax savings to estate 94,600 82,200
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To Freeze or not to FreezeExample 3 - no freeze $ Rounded
Quebec Ontario
Taxable dividend on liquidation
Fair market value of shares 10,000,000 10,000,000
Add : dividend refund 300,000 300,000
Less : redemption 2,000,000 2,000,000
Less: pipeline 8,000,000 8,000,000
Taxable dividend 300,000 300,000
Income tax 131,520 135,900
Cash flow summary
Estate - Fair market value of shares 10,000,000 10,000,000
Add dividend refund 300,000 300,000
Total fair market value 10,300,000 10,300,000
Less tax upon death 2,665,000 2,676,000
loss carryback savings 94,600 82,200
tax on liquidation 131,520 135,900
Net cash to children 7,598,080 7,570,300
Amount per child 2,532,693 2,523,433
Tax savings per child 286,500 309,000
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To Freeze or not to Freeze
Example 4 - Child living in the U.S. - Facts:
(a) Mr. X. is 60 years old and divorced;
(b) Mr. X has 2 major children who live in Canada and
are not U.S. citizens or green card holders but 1
major child who lives in the U.S.;
(c) Mr. X owns a holding company (“Holdco”) that is
worth $10,000,000 which he believes will grow in
value over time.
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To Freeze or not to Freeze
Planning changes:
Why?
• Passive Foreign Investment Company (“PFIC”) Test
• At least 75% of its gross income for the year is
passive income, or
• On average for the year, at least 50% of the fair
market value of its total assets are passive assets.
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To Freeze or not to Freeze
Planning changes:
Issue:
No issue until you have “Excess Distributions” – a
distribution in excess of 125% of the distributions over
the last three years.
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To Freeze or not to Freeze
Planning changes:
Issue - Excess distribution:
• Is taxed at the highest marginal rate plus interest, i.e. the test
looks at when you acquired the shares, divides the income over
that period and then taxes the amount as income plus interest.
• Any gain on the shares is treated as an excess distribution and
that distribution is taxed as income instead of a capital gain.
• Generally no tax free reorganization of one’s shares.
• Shares of a PFIC acquired by inheritance from a U.S. decedent
do not get a step up in U.S. tax basis.
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To Freeze or not to Freeze
Common planning for this situation was as follows:
− Only freeze in favor of the 2 Canadian children
Note: Before effecting the freeze, be sure that Mr. X has
other assets to allow for a future equalization or
U.S. child may receive less than his Canadian siblings.
− This will avoid PFIC issues until Mr. X’s death.
− On Mr. X’s death, he owns shares worth $10,000,000 and
his 2 Canadian children own shares worth $10,000,000.
− To simplify, assume that there is no CDA or RDTOH upon
Mr. X’s death.
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To Freeze or not to FreezeExample 4 - Freeze with U.S. child $ Rounded
Quebec Ontario
Capital gain upon death 10,000,000 10,000,000
Tax on capital gain 2,665,000 2,676,000
Net before planning 7,335,000 7,324,000
Use of loss carryback
Redemption of shares equal to 1/3 of all shares 6,666,667 6,666,667
Withholding tax 1,000,000 1,000,000
Tax savings from loss carryback 1,776,667 1,784,000
Net tax to Estate on remaining shares 888,333 892,000
Value of U.S. beneficiary 5,666,667 5,666,667
Value of Estate available for Canadians
Fair market value of shares before redemption 10,000,000 10,000,000
Less : redemption 6,666,667 6,666,667
Less : tax on deemed disposition 888,333 892,000
Net Estate value for Canadians 2,445,000 2,441,333
Total after tax Estate value 8,111,667 8,108,000
Increase in after tax Estate value 776,667 784,000
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To Freeze or not to Freeze
Example 4 - Freeze with U.S. child $ Rounded
Quebec Ontario
Total value attributable to Canadians
Net Estate value for Canadians 2,445,000 2,441,333
Add : value of shareholdings 10,000,000 10,000,000
Total pre distribution value 12,445,000 12,441,333
Value per child 6,222,500 6,220,667
Excess of Canadian beneficiary value over U.S. beneficiary value 555,833 554,000
What if Canadians want cash
Value of shareholdings - per individual 5,000,000 5,000,000
Less : dividend tax on distribution 2,192,000 2,265,000
Net after tax share value 2,808,000 2,735,000
Add net Estate value 1,222,500 1,220,667
Total Canadian after tax value - freeze 4,030,500 3,955,667
43
To Freeze or not to FreezeExample 4 - no freeze with U.S. child $ Rounded
Quebec Ontario
Capital gain upon death 20,000,000 20,000,000
Tax on capital gain 5,330,000 5,352,000
Net before planning 14,670,000 14,648,000
Use of loss carryback
Redemption of 1/3 shares 6,666,667 6,666,667
Withholding tax 1,000,000 1,000,000
Tax savings from loss carryback 1,776,667 1,784,000
Net retention by U.S. Child
Cash from share redemption 6,666,667 6,666,667
Less : withholding tax 1,000,000 1,000,000
Net retention 5,666,667 5,666,667
44
To Freeze or not to FreezeExample 4 - no freeze with U.S. child $ Rounded
Net retention by Canadian Children Quebec Ontario
Pipeline of remaining shares 13,333,333 13,333,333
Less taxes from death 3,553,333 3,568,000
Net to Canadian children 9,780,000 9,765,333
Net per child 4,890,000 4,882,667
Total net 15,446,667 15,432,000
Tax reduction 776,667 784,000
Comparison of freeze and no freeze
Total Canadian after tax value - no freeze 4,890,000 4,882,667
Total Canadian after tax value - freeze 4,030,500 3,955,667
Increase in after tax value for Canadians 859,500 927,000
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To Freeze or not to Freeze
Query:
• Should the savings in Canada be shared?
• Should the Canadian siblings be fully compensated for the
future tax?
• If there are other assets in the estate, consider giving the
U.S. resident child even more shares and equalize with
other assets for his or her Canadian siblings.
• What does the CRA say about this type of planning?
46
To Freeze or not to Freeze
CONCLUSION
Factors that may mitigate against a “freeze”:
• Low value of company currently or only a moderate growth in projected
value;
• What is the asset mix and what type of income does the company
generate?
• What are the financial needs of the children?
• Will it be easy to liquidate the company in the future?
• Where do the children live and where will they likely live in the future?
• Are there any children who are U.S. citizens?