Download Report

Buy-sell agreements
Options for funding and
transfer of ownership at death
Revised by:
Ed Rothberg, LL.B.
June 2008
Table of contents
OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
SECTION I – FUNDING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
BUY-OUT AT DEATH: A CASE STUDY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Remaining shareholder borrows (shareholders sell to each other) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Corporation borrows and redeems shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Corporation redeems shares over time out of corporate earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. Liquidate personal or corporate assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. Life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
OTHER CONTINGENCIES: DISABILITY AND CRITICAL ILLNESS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Disability insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Critical illness insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2
2
3
3
4
5
5
6
6
6
SECTION II – STRUCTURING THE FUNDED BUY-SELL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
PARTIES TO THE BUY-SELL AGREEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
OWNERSHIP OF THE INSURANCE POLICIES: CORPORATION OR SHAREHOLDERS?. . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
REVIEW OF BASIC PLANNING CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1. Loss carryback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2. Capital dividend account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3. Stop-loss rules (1995) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
4. Stop-loss “grandfathering” rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
PLANNING STRUCTURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
A. OWNERS OWN OPCO DIRECTLY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Basic scenario assumptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1. Cross-purchase—Personally owned insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2. Cross-purchase—Opco owned insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3. Share redemption (“50% solution”)–Opco owned insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Implementing the 50% solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4. Hybrid of cross-purchase and redemption (“50% solution”)–Opco owned insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Comparing the four strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Buy-sell agreements
Sun Life Financial
Table of contents continued
B. OWNERS EACH OWN A HOLDCO WHICH OWNS SHARES IN OPCO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Holdco scenario assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1. Cross-purchase of Opco shares by Holdcos—Holdco owned insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Additional planning option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2. Cross-purchase of Opco shares by Holdcos—Opco owned insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Additional planning option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3. Redemption of shares by Opco—Opco owned insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Additional planning options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Comparing the three strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
APPENDIX 1: BUY-SELL PLANNING WITH A SURVIVING SPOUSE—PUT-CALL AND CAPITAL GAINS EXEMPTION . . . . 40
APPENDIX 2: THE “STOP-LOSS” RULES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
CALCULATING THE AMOUNT OF LOSS “STOPPED”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
GRANDFATHERING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Grandfathered life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Grandfathered buy-sell agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Last updated: June 2008
This paper is intended to provide general information about buy-sell agreements. It does not necessarily reﬂect the views of Sun Life
Assurance Company of Canada or any related company, their sales representatives, their employees, their ofﬁcers or their directors.
Every reasonable effort has been made to ensure the accuracy and currency of the information provided as of the date indicated above,
but all information and any examples are presented for the purposes of general explanation only and may be subject to subsequent
changes in the law or its application by federal, provincial and territorial taxation agencies. No one should act upon the information
or examples without a thorough examination of their particular legal and tax position with their professional advisors, after full
consideration of the speciﬁc facts of their circumstances.
Buy-sell agreements
Sun Life Financial
Overview
A buy-sell agreement is key to any business plan where there are multiple owners or
interested successors. A well-crafted buy-sell agreement specifies what happens to the
shares of the business when a shareholder retires, becomes disabled or dies. It may
also cover other events such as a dispute, bankruptcy or marital breakdown. A buy-sell
agreement may be part of a more comprehensive shareholders’ agreement. However, given
the planning issues and the level of detail in even a simple buy-sell agreement, it will likely
be a separate document.
At a minimum, in private corporations, a properly funded buy-sell agreement provides the
shareholders with both a market for the seller and a reliable source of funds for the buyer
to pay for the purchase. In addition, a well-thought-out and structured buy-sell agreement
protects the interests of the business owner, his or her family, other shareholders and
the business. The process of identifying those interests and negotiating how the buy-sell
agreement will allocate them will itself provide value for the business and its principals.
While every buy-sell agreement is as unique as the people and businesses it safeguards,
there are essentially four steps required for effective planning and implementation:
1. Negotiation of the circumstances that will trigger a buy-sell, the structure of the buy-out
and the funding, where applicable.
2. Determining how the shares to be bought out will be valued.
3. Creation and signing of the buy-sell agreement.
4. Purchase of the financial instruments, if any, necessary to fund the buy-sell transaction
after a triggering event occurs (e.g., life insurance, disability insurance, or savings and
accumulation products).
Section I examines, at a high level, five of the most common funding options available,
with an emphasis on buy-sells triggered by the death of a shareholder.
There are a variety of methods for funding a buy-sell agreement: borrowing, life insurance
and many others. Each has its own advantages and disadvantages.
There are numerous structures for implementing a buy-sell agreement. Each structure
presents a number of different consequences and opportunities involving taxes, control of
the business and financial compensation.
Section II reviews some of the more common structures that utilize life insurance. To
understand the various methods and their comparative advantages, it is helpful to keep in
mind that there are only two basic methods for the remaining shareholders to buy out the
interest of the departing shareholder:
1. the remaining shareholders buy the shares of the departing shareholder
2. the corporation buys back (“redeems”) the shares of the departing shareholder, so that
the remaining shareholders acquire the economic interest of the departing shareholder
in the business in proportion to their shares.
Each method has different tax consequences. To tailor the tax consequences for all
participants, the two basic methods are sometimes combined in a “hybrid” method.
The application of the concepts presented in this paper may be explored in greater detail
using software provided in the Sun Life Financial buy-sell needs analysis tool, which
creates illustrations under eight funding scenarios. A link to a sample client report prepared
with this detailed and flexible tool appears on www.sunlife.ca/advisor, under Strategies &
concepts — All sales concepts — Buy-Sell agreements. The page also contains links to a
buy-sell check list and fact finder.
Once the funding method and its structure have been agreed upon, the buy-sell agreement
can be implemented.
Buy-sell agreements
Sun Life Financial
1/43
Section I – Funding
Introduction
The cash required to fund a buy-sell agreement can be obtained in a number of ways.
When the buy-out occurs precipitously as a result of a dispute or other non-health related
issue, the transaction generally occurs at an appraised fair market value, an amount
calculated according to a formula agreed upon by the shareholders in advance or as a
result of a “shotgun” price offering. This type of buy-out should be anticipated in the
buy-sell agreement and provision made for the method of financing that will be used.
Often, this requires the seller to take back debt from the buyer because of the desire to
sell the business interest immediately and the difficulty in obtaining the entire purchase
price from traditional lending sources.
Retirement, on the other hand, can be anticipated. A retirement buy-out can be entirely or
partly pre-funded through the allocation of corporate cash flow over time into portfolio
investments (e.g., investment funds or other securities) or the cash value of life insurance
that has been purchased for risk management or to fund a buy-out at death.
Where funding for a buy-out is not in place when it is needed, the remaining owners,
family successors or employee purchasers may be severely challenged to finance the
buy-out of the retiree. The retiring owner may have to take back debt for a portion of the
sale proceeds and depend on the successors to run the business well enough to pay off
that debt over the stipulated time frame.
A buy-out triggered by death or health problems can jeopardize the well-being of the
business and the confidence of its suppliers, customers and financing institutions. That is
the bad news. The good news, in comparison to a buy-out caused by a shareholder dispute,
for example, is the ability most business owners have to purchase insurance that will
provide the funds precisely when they are needed to buy out the shares of the deceased or
disabled owner.
A properly funded buy-sell agreement protects all shareholders. It gives the outside
purchaser or other shareholders the funds to buy out the departing shareholder. It gives
the estate of the deceased shareholder, or the disabled shareholder, a guaranteed market
for their shares and immediate or assured payment of these proceeds.
This section examines a number of methods for funding a buy-sell agreement, each with
its own cash flow and tax consequences. It will focus on the death of a shareholder and
provide examples that illustrate different funding methods. The same numerical fact
pattern is used for each method, making their evaluations comparable.
Buy-out at death: a case study
For the purposes of comparing the alternative funding mechanisms at death, we will
assume two shareholders each directly own 50% of the shares of a company with a total
fair market value of $2,000,000. The company was started from scratch with a nominal
contribution to share capital by each shareholder. Therefore, each shareholder has a
nominal adjusted cost base (ACB) and paid-up capital (PUC) for tax purposes (assume nil
in each case).
Each shareholder needs access to $1,000,000 to buy out the other shareholder’s interest.
Both shareholders receive employment compensation from the business and are in a 45%
marginal tax bracket. Their company’s corporate tax rate is also 45%. Following are five
financing options for the purchaser, the remaining shareholder.
Buy-sell agreements
Sun Life Financial
2/43
1. Remaining shareholder borrows (shareholders sell to each other)
The surviving shareholder borrows the $1,000,000 personally. The following analysis
summarizes the costs and cash flow requirements to fund the purchase with personal debt.
If we assume that the loan is a 10-year term loan, with amortized annual payments, at an
interest rate of 7% the surviving shareholder will have to obtain $1,423,775 over 10 years
(or $142,378 per year) to repay the loan. We assume that the interest portion, $423,775, is
tax deductible as interest on a loan incurred for the purpose of acquiring income-producing
property, i.e., the shares. If the tax saving from deducting the loan interest is applied against
the loan balance, the cash flow required by the buyer to repay the loan after the buyer’s
assumed tax rate of 45% is $123,308 per year.
Purchase price
Cumulative interest over 10 years
Total paid over 10 years
$1,000,000
423,775
$1,423,775
Annual payment
$142,378
Annual personal cash flow requirement if interest is deductible
$123,308
Annual compensation from company required to provide this cash flow
$224,196
Total additional compensation required to be generated over 10 years
$2,241,960
In summary, to provide additional income that will allow the surviving shareholder to
repay the $1,000,000 personal loan, the corporation will need to generate $2,241,960 in
additional revenues over the next 10 years.
Before committing to the agreement, the shareholders should give careful consideration to
the desirability of taking on this kind of debt at some future date when a partner has just
died. Debt financing may be difficult to secure or expensive if it is attainable. Alternatively,
the family of the deceased shareholder may have to give back debt. This will expose them
to the success or failure of the business in the years that follow and to dependence on the
skill and care of its successor owners.
Before committing to the agreement, the selling shareholder receives $1,000,000, and has a
taxable capital gain of $500,000, generating taxes due of $225,000. This tax burden could
be reduced through the use of the $750,000 lifetime capital gains exemption.1
2. Corporation borrows and redeems shares
The corporation borrows $1,000,000 at 7% over a 10-year repayment period. As above, the
interest is assumed to be deductible.2 Assuming the tax rate of the corporation is 45%, the
following amounts are required:
1
2
Income Tax Act, R.S.C. 1985, c. 1 (5th Supplement), as amended (ITA), s. 110.6(2.1), which applies the calculation for the capital gains deduction for qualiﬁed farm property in s.
110.6(2). The lifetime capital gains exemption was increased from $500,000 to $750,000 by the Budget and Economic Statement Implementation Act, 2007, S.C. 2007, c. 35, s.
31(1).
The Canada Revenue Agency (CRA) and its predecessors have challenged the deductibility of interest on money borrowed by a corporation for the purpose of redeeming
its shares. See Interpretation Bulletin IT-533, “Interest deductibility and related Issues,” paragraphs 22, 23 and 29, for the CRA’s current position on loan interest for a share
redemption in light of court decisions that allowed the deduction.
Buy-sell agreements
Sun Life Financial
3/43
Purchase price
Cumulative interest over 10 years
Total paid over 10 years before tax reduction for interest
$1,000,000
423,775
$1,423,775
Annual payment
$142,378
Annual corporate cash flow requirement if interest is deductible
$123,308
Annual additional profit required to cover the loan payments
$224,196
Total additional profit required to be generated over the 10 years
$2,241,960
In summary, the company must generate additional profits of $2,241,960 or $224,196 per
year for 10 years to repay the loan.
Corporate borrowing to fund a buy-sell agreement may be preferred where the corporate
tax rate is less than the personal rate. However, the corporation may not be able to borrow
the required funds following the death of an owner.
The recipient receives $1,000,000 as proceeds of share redemption. The redemption
proceeds in excess of the PUC of the shares (here assumed to be nil) will be treated as a
taxable dividend for tax purposes, generating an estimated tax liability of $330,000.3
3. Corporation redeems shares over time out of corporate earnings
This method is a variation on the preceding method. Rather than borrowing to redeem
all of the shares at once, the company redeems the shares over a specified period of time
out of after-tax earnings. The redemption proceeds in excess of the PUC of the shares
(here assumed to be nil) will generally be treated as a taxable dividend to the estate of the
deceased (selling) shareholder.4 The costs for the company are as follows:
Purchase price
$1,000,000
Annual payment (after tax paid at 45%)
Annual additional pre-tax profit required to cover the redemption proceeds
Total additional pre-tax profit required to be generated over the 10 years
$100,000
$181,818
$1,818,180
It might be necessary to do a freeze of the seller’s interest in the business from common
to preferred shares to accommodate this transaction, since the value of common shares
would grow (or possibly decline) over the 10 years of redemption. Preferred shares would
also permit the payment of dividends that would provide an income to the survivor
shareholder and compensate the shareholder for the delay in receiving full payment.
However, this scenario will be viable only where the parties to the buy-sell agreement are
willing to require their estates to wait out a redemption period of 10 years after they have
departed from the business. In addition, this funding option may leave the estate of a
deceased shareholder without sufficient cash to meet its tax liability when it falls due.5
3
4
5
This estimate assumes that the dividend will not qualify as an “eligible dividend” that is taxable at the lower of two dividend tax rates under amendments to the ITA
enacted in 2006. Generally, non-eligible dividends, taxed at the higher rate, will originate in corporate income taxed at the reduced rate for small business income.
ITA s. 84(3).
The deceased owner will owe tax on the shares, which are deemed to be disposed of immediately before death and acquired by the deceased’s estate: ITA s. 70(5). While
it is possible for the tax liability on the deemed disposition of the shares to be paid in instalments over as much as 10 years, this will require giving the CRA security for
the outstanding balance (such as a lien on the shares) and payment of interest at a prescribed rate (9% in 2007): see ITA ss. 159(5) and (7) and Form T2075. The estate may
carry back certain tax losses to offset the deceased’s tax liability but only by electing to do so in the ﬁrst year of the estate: ITA s. 164(6).
Buy-sell agreements
Sun Life Financial
4/43
4. Liquidate personal or corporate assets
Where the intended purchasers or the corporation possess sufficient liquid capital (e.g.,
cash or near cash), it may be possible to fund the buy-out from those assets. The cost of
funding the redemption will be $1,000,000.
For a new business, however, cash flow generally must be reinvested in the business and
used as working capital. For a growing business, excess cash flow is also generally invested
back into the business because it may generate a return on capital that is often superior
to the return from portfolio investments. As a result, sufficient excess cash will rarely
be available, since the opportunity cost of keeping large amounts of cash on hand will
generally be greater than the cost of corporate borrowing.
However, consider the circumstance where a business has a capital asset that is no longer
needed, such as a building that has appreciated in value and has been partially depreciated
for tax purposes. Assume the asset has an ACB of $1,000,000, fair market value of
$1,300,000 and capital cost allowance previously taken of $370,000.
Based on a tax rate of 45%, the sale of this asset generates the following net cash flow that
can be used to redeem the shares of the shareholder:
Proceeds of sale of property
Less taxes
Recapture $370,000 at 45% tax rate
Capital gains 45% on 50% of $300,000
Less Selling costs (5%)
Net after-tax cash received on disposal of the property
$1,300,000
Required for redemption
$1,000,000
(166,500)
(67,500)
(65,000)
$1,001,000
The total cost to raise the $1,000,000 is close to $1,300,000 in this case.
5. Life insurance
Where the event to be funded is the death of a shareholder, life insurance is usually chosen
as the most cost-efficient and risk-free funding method. Life insurance is a particularly
common choice because it provides funds exactly when they are needed and the range of
products and prices available permits flexible solutions to meet varying needs.
A well-crafted buy-sell agreement will refer not only to the fact that insurance is to be
purchased to fund the buy-out. It will also specifically state the amount and type of coverage
to be maintained and may list the applicable policies as an appendix to the agreement.
Life insurance premiums or payments6 can range in cost from as little as 0.1% to 10% or
more of the coverage required per annum. The exact amount will depend on the type of
policy purchased, the age and health of the insured and the time frame over which the
required premiums or payments are paid.
There are numerous types of life insurance appropriate for funding a buy-sell agreement. For
example, subject to underwriting requirements, a 40-year-old male non-smoker can obtain:
• Ten-year renewable term coverage of $1,000,000 with an annual premium in the $800
range (i.e., less than 0.1% per year of the coverage needed). However, this cost will
roughly double every 10 years when the coverage must be renewed.
− This solution may be appropriate where there are limited funds to pay for the
insurance or the parties to the buy-sell agreement expect to dispose of their interests
in the business during the term of the policy.
6
Some insurance policies, such as “universal” life insurance, a popular type, may direct payments in excess of the cost of the insurance component to a
savings component.
Buy-sell agreements
Sun Life Financial
5/43
• Term-to-100 or universal life coverage of $1,000,000 with a level face amount and a level
annual premium for life in the range of $5,000-$6,0007 (i.e., a little more than 0.5%
per year of the coverage needed). This provides permanent coverage with a roughly
level death benefit throughout life. In this case, there is little cash value available in the
contract to fund an inter-vivos buy-out or for other purposes.
− The level death benefit may be suitable for a buy-sell of shares following an estate
freeze, where share values will not increase.
• Universal life coverage of $1,000,000 plus fund value with an annual payment for 10
years in the range of $33,000. This differs from the previous policies because additional
payments are made, subject to the limits for a tax-exempt life insurance policy, that
create a tax-deferred accumulating fund within the policy. This provides a total benefit
that can be paid out tax-free at death that starts at $1,000,000, with a projected
growth to roughly $2,500,000 at age 80. Prior to death, the company can access the
accumulated cash value or “cash surrender value”at any time by means of a policy loan
or withdrawal. The value in excess of the amount needed for a buy-sell transaction on
death can be used to partially or, if sufficient, fully redeem a departing owner’s interest
at retirement. It may also be available to help fund an unplanned buy-out in the event
of dispute, disability or other contingency. However, some or all of the funds that are
taken from the policy before death may be subject to tax.8 Another way to access the
value of a policy is to do so indirectly, that is, by using it as collateral for a loan from a
third-party lender in a so-called leveraging strategy.9
− The increasing death benefit may be more consistent with a buy-sell of a growing
business. To maximize the benefit of the tax-deferred growth in exempt life
insurance contracts, for example, to make it available for a living buy-out, this
strategy should be implemented a minimum of 10 to 15 years before the
anticipated buy-out date.
Other contingencies: Disability and critical illness
Insurance is often used to fund buy-sell agreements where contingencies other than death
cause an owner to leave the business. The usual funding vehicle will be disability or critical
illness insurance.
Disability insurance
Disability insurance is generally harder to obtain and more costly than life insurance because
the risk of a long-term disability before retirement is actually far greater than the risk of dying.
Disability insurance policies are available to fund lump sum or staged buy-outs and costs vary
by age and degree of insurability.
Critical illness insurance
Critical illness insurance pays a lump sum benefit following the diagnosis of one of a list of
covered life threatening illnesses, such as cancer or stroke; serious medical conditions, such as
loss of limbs or severe burns; and major medical procedures, such as coronary artery bypass
surgery or heart valve replacement. The benefit is payable when the event occurs. There is no
need to verify the loss of the ability to work in an occupation or to claim reimbursement for
specified expenditures. Costs vary by age, insurability and policy features selected.
7
8
9
This example and the next use a SunUniversalLife policy illustrated at 5% interest. See the complete policy illustration for the projected performance of the policy with
alternative rates.
ITA ss. 148(1) and 56(1)(j) set out the rules that require part or all of a policy loan or withdrawal to be included in computing the policy owner’s income as the disposition
of an interest in a life insurance policy.
Where the loan is from a qualifying lender, there is a business or investment purpose for the loan and the lender requires the policy as collateral, the company may be
able to deduct a portion of the premium as an expense: ITA s. 20(1)(e.2).
Buy-sell agreements
Sun Life Financial
6/43
Section II – Structuring the funded buy-sell
Introduction
There are a variety of ways to structure a buy-sell agreement. All are variations on two
basic transactions:
1. The shares can be purchased from the selling shareholder by new or existing
shareholders, or
2. The corporation can buy back or redeem its shares.
The tax consequences vary for each scenario. They may be combined flexibly in a hybrid
arrangement to produce a tax outcome that will reflect the circumstances and bargaining
positions of the parties to the agreement.
This section assumes that life insurance is the chosen funding method and presents an
analysis of alternative strategies, based on a common factual scenario.
Parties to the buy-sell agreement
The examples in this paper introduce the following potential parties to a buy-sell
agreement: an incorporated operating business (Opco) and two shareholders, A and B.
In some scenarios, A and B own Opco directly. In others, A and B own Opco indirectly
through their respective holding companies, Holdco A and Holdco B. Parties to the buysell agreements discussed in this paper will always include the individual or corporate
owners of Opco.
In addition to Opco’s owners, Opco itself will be a party to the agreement where Opco as
a separate legal entity has to perform a corporate act to implement a buy-sell arrangement,
such as purchasing life insurance, redeeming its shares or making an election authorized
under the Income Tax Act. In those cases, as a practical matter, it is the owners of the
business who will direct the required corporate actions and undertake in the agreement
to cause Opco to carry them out. However, where Opco is a participant in the buy-sell
arrangement, it is customary to include Opco as a party to clarify its role and the examples
in this paper do so as well.
Ownership of the insurance policies: corporation or shareholders?
The business owners will have to decide who owns the insurance. There are two
basic choices:
1. The owners of the business own insurance on each other, or
2. The company owns insurance on the owners.
Some of the common funding strategies discussed in this paper require the shareholders
to own the life insurance policies; others require corporate ownership. The following
additional factors may also influence the decision:
• Cost: Insurance premiums are generally not tax-deductible. They are paid for out of
after-tax income. They will therefore be cheaper for a corporation if the corporation’s
tax rate is lower than the tax rates of its shareholder owners.
• Administrative efficiency: If there are more than two shareholders, it will be
more efficient and less expensive for the corporation to hold policies on each of
its shareholders than for each shareholder to hold policies on all of the others. A
shareholder will also have access to corporate information and so be able to ensure that
the corporation has purchased and is paying for the intended policies. Note, however,
if corporate ownership is not desired, the shareholders may achieve the same results by
arranging for a trustee to own and pay for the policies on their behalf.10
10
In Quebec, the framework for trusts created by the Civil Code does not permit a “bare trust” such as the arrangement described here, where a trustee holds and
administers insurance policies as an agent for the parties to a buy-sell agreement. Throughout Canada, careful planning is generally advisable for a trust to avoid
unintended tax costs to the trust or, by attribution, to its settlors. For example, if the trust is set up to pay the insurance premiums out of trust income, possibly from
dividend-paying shares transferred to the trust, the income will be taxed at the highest personal rate: ITA s. 122(1). Also, if the trust is the beneﬁciary of the life insurance
policy instead of the corporation, the proceeds on death will not qualify for a credit to the corporation’s capital dividend account (described later in this paper under
“Review of basic planning concepts”).
Buy-sell agreements
Sun Life Financial
7/43
• Unequal premiums: Where the cost of insuring the shareholders varies greatly because
of their differing ages or health, they may wish the business to pay for insurance as
the cost of continuity of the business for the collective benefit of its owners, rather
than have individual shareholders bear the costs unequally. In that case, their cost of
insurance will be in proportion to their share holdings.
• Creditor protection: Under the Quebec Civil Code, insurance contracts are protected
from seizure by creditors where the beneficiary is a qualifying family member (spouse,
“descendant or ascendant”) in relation to the policy owner.11 To achieve creditor
protection, the policy owner must therefore be an individual and not a corporation.
Outside Quebec, however, provincial insurance statutes protect insurance contracts
from seizure by creditors where the beneficiary is a qualifying family member in
relation to the life insured12 no matter who owns the policy. Therefore, a corporate
beneficiary designation and not corporate ownership would preclude creditor
protection. There may be a concern that, if Opco or individual shareholders are policy
beneficiaries, their creditors may seize the policy proceeds and thereby defeat the buysell agreement. If so, the shareholders may consider using holding companies, which
are less likely to have creditors, to own the policies and be designated as beneficiaries.
Where corporate ownership is chosen and there are only two shareholders, the corporation
may consider purchasing a joint first-to-die policy rather than separate policies on each
shareholder. In most cases, however, separate policies will be preferable if there is a corporate
purpose for life insurance apart from funding a buy-sell agreement because a separate policy
on the life of the surviving shareholder that is underwritten after the first death will be issued
at the rate for the survivor’s attained age and will therefore be more expensive.13
11
12
13
Civil Code (Quebec), art. 2457. Note, however, that an irrevocable beneﬁciary designation will also confer creditor protection without limiting the nature of the
beneﬁciary: Civil Code (Quebec), art. 2458.
For example, Insurance Act (Ontario), R.S.O. 1990, C. I.8., s. 196(2). S. 191(1) provides for creditor protection by means of an irrevocable beneﬁciary designation, regardless of
ownership of the policy or the nature of the beneﬁciary.
Sun Life Financial joint ﬁrst-to-die policies provide that, within 31 days of the death of the ﬁrst insured person, the surviving insured person may buy life insurance to
replace the joint coverage without providing evidence of insurability but at the rate for the survivor’s attained age. The base coverage amount is paid out twice if both
insured persons die together or within 31 days of each other.
Buy-sell agreements
Sun Life Financial
8/43
Review of basic planning concepts
The remainder of this introduction summarizes basic planning concepts that underlie strategies
for funding buy-sell agreements. They are included to assist readers who do not ordinarily
work in estate planning for business owners.
1. Loss carryback
This is a basic technique that may reduce or eliminate the tax payable on capital gains on the
shares of a deceased shareholder in a private corporation and transfer the tax liability to the
remaining shareholders.
There are several steps in the process. Some occur automatically under the tax rules. Others
require the corporation or the estate administrator to “elect” or choose to take it. The steps
are, highly simplified:
• According to the Income Tax Act, the shareholder is deemed to dispose of the shares
immediately before death to the shareholder’s estate at their fair market value14 (FMV, e.g., $100).
• The shareholder realizes a capital gain that is equal to the proceeds of disposition ($100)
less their cost, adjusted for tax purposes (“adjusted cost base” or ACB, e.g. $0). The capital
gain is $100, 50% of which or $50 is reported on the taxpayer’s final return as a taxable
capital gain.
• The shareholder’s estate acquires the shares at their FMV, $100, which becomes the ACB of
the shares to the estate.15
• The corporation redeems the shares for $100.
• According to the Income Tax Act, the shareholder’s estate receives the redemption amount,
$100, (less any paid-up capital, here assumed to be nil) as a dividend (“deemed dividend”).16
• To avoid exposing the estate to tax twice on the $100, once as a dividend and a second
time as proceeds of disposition of the shares, the proceeds of disposition ($100) are
reduced by the amount of the dividend ($100). This results automatically from the
definition of “proceeds of disposition” in s. 54, paragraph (j). The proceeds of disposition
of the shares by the estate therefore become $0.
• The estate realizes a capital loss on the disposition of the shares: its adjusted proceeds of
disposition ($0) minus ACB of the shares to the estate ($100). The capital loss of the estate
in this example is therefore $100.
• The Income Tax Act permits the estate to carry back the capital loss of $100 to the tax return
of the deceased shareholder provided it does so in the estate’s first taxation year.17 When the
estate does so, the estate’s capital loss of $100 cancels the shareholder’s capital gain of $100
(described in the second bullet), resulting in a taxable capital gain of $0 and $0 tax.
• Result:
− The deceased shareholder pays no tax on the deemed disposition of the shares.
− The remaining shareholders acquire a proportional value of the deceased shareholder’s
interest in the company at no cost. When the shareholders dispose of their shares, the
acquired value will be exposed to taxation as a capital gain (provided, of course, that
subsequent business losses do not erode the gain so acquired).
− The estate receives a $100 dividend (which may or may not be taxable:
see the following items).
14
15
16
17
ITA s. 70(5)(a)
ITA s. 70(5)(b)
ITA s. 84(3)
ITA s. 164(6)
Buy-sell agreements
Sun Life Financial
9/43
2. Capital dividend account
A private corporation is able to use a capital dividend account (CDA) to record various
amounts that it receives on a tax-free basis so it can pass them on to its shareholders on the
same tax-free basis.18 Examples include the tax-free 50% of a capital gain and the death benefit
paid under a life insurance policy.
The CDA is calculated for tax purposes only. It is a running balance of the amounts that a
private corporation can pay to its shareholders tax-free. It does so by electing to pay a capital
dividend following a required procedure.19 Therefore, a third example of a tax-free receipt that
may be credited to a private corporation’s CDA is a capital dividend received from another
private corporation.
The CDA is only a bookkeeping record. It is in no way a separate corporate asset. Provided
there is a sufficient balance in its CDA, a private corporation can elect to designate a payment
to its shareholders as a tax-free capital dividend when it has the cash from any source. When
it makes the payment, its CDA is reduced by a corresponding amount.
3. Stop-loss rules (1995)
If the corporation described above under “Loss carryback” has $100 in its CDA (for example,
from insurance it received tax-free on the life of the deceased shareholder), it may elect to
treat the deemed dividend paid to the estate as a tax-free capital dividend. Before April 27,
1995, it was common practice to do so.
The result would be: the estate was not liable for tax on the redemption of the shares by
the corporation and, using the loss carryback described above, neither was the deceased
shareholder liable for tax on the deemed disposition of the shares immediately before death.
Tax on any gain in the value of the shares while they were owned by the deceased shareholder
would be deferred until the remaining owners of the company disposed of them, assuming
that the shares retained their value.
Following April 26, 1995, changes to the Income Tax Act known as the “stop-loss” rules greatly
reduced the tax efficiency of the redemption method when life insurance proceeds fund
a share redemption after the death of a shareholder and provide a largely or fully tax-free
payment to the estate of the deceased shareholder. The stop-loss rules restricted the loss
amount that could also be carried back to reduce or eliminate the gain of the deceased
shareholder on the deemed disposition of the shares at death.20
The 1995 stop-loss rules and subsequent changes to the capital gains inclusion rate mean that it
is now ordinarily possible to eliminate only up to 50% of the capital gain of the deceased from
taxation. (See Appendix 2: “The ‘stop-loss’ rules” for more details.)
The stop-loss rules, in their simplest formulation, require that:
• the loss realized by the estate under a share redemption is reduced
• by the amount that the tax-free capital dividend exceeds 50% (the tax-free portion) of the
deceased’s capital gain from the disposition of the shares.
In the preceding example, the $100 loss realized by the estate is reduced by $50—the amount
that the tax-free capital dividend ($100) exceeds 50% of the deceased’s capital gain ($50).
The result is potential double taxation: the deceased shareholder has a capital gain of $50
but the remaining shareholders, who do not receive a corresponding increase in the ACB of
their shares, face a potential capital gain of $100 if the value of the business received from the
deceased shareholder is retained in the shares until their disposition.
18
19
20
“Capital dividend account” is deﬁned in ITA s. 89(1).
ITA s. 83(2), Income Tax Reg. 2101 and Form T2054.
ITA s. 112(3) (loss on share) and ITA s. 112(3.2) (loss on share held by trust).
Buy-sell agreements
Sun Life Financial
10/43
There may also be a waste of the CDA created by the corporation’s receipt of life insurance
proceeds. If the redeeming corporation pays the entire redemption amount as a capital
dividend, it will deplete its CDA by that amount. But a recipient shareholder will receive only
half the amount as a capital dividend. If the recipient is a corporation, it acquires only half the
CDA that was possible before the application of the stop-loss rules.
This paper later discusses a strategy to minimize the effect of the stop-loss rules, commonly
known as the “50% solution”.
4. Stop-loss “grandfathering” rules
Under the so-called stop-loss “grandfathering” rules, it remains possible to eliminate the tax
liability on 100% of the capital gain following the death of a shareholder and redemption of
shares from the deceased’s estate.21 To do so, among other conditions, life insurance had to be
in force on April 26, 1995 where a documented main purpose of the insurance was to fund the
redemption, acquisition or cancellation of a share or an agreement in writing for the disposition
of the shares had to be in effect before April 27, 1995. Further details appear in Appendix 2.
Grandfathering clearly provides highly valuable tax benefits. Where grandfathering is based on
an agreement made before April 27, 1995, it will be lost if the agreement is cancelled, nullified
or replaced. That could occur by altering a provision of the agreement or by changing the
parties to the agreement.
Even when the circumstances of a business and its shareholders have changed and it may be
desirable to alter or replace a shareholders’ agreement that was made before April 27, 1995,
careful thought should be given to weigh the benefit of the proposed change against the
possible loss of grandfathering.
The redemption strategies examined below assume that they do not qualify for grandfathering
under the stop-loss rules. Therefore, the examples under the redemption strategies illustrate
the so-called “50% solution”, which carries back losses that are less than an amount that will be
ground down by the stop-loss rules. (Essentially, these are losses created by the redemption only
to the extent of the non-taxable portion of the capital gain on the disposition of the shares.)
21
The share redemptions that are “grandfathered” or exempt from the application of the stop-loss rules in ITA ss. 112(3) and (3.2) are described in the coming-into-force
provisions in the amending legislation that introduced the rules, Bill C-28, enacted as S.C. 1998, c. 19, ss. 131(11) and (12). For CRA’s interpretation, see also “Stop-Loss
Provisions—Grandfathering” in CRA Technical News No.12, February 11, 1998.
Buy-sell agreements
Sun Life Financial
11/43
Planning structures
A. Owners own Opco directly
Basic scenario assumptions
• A and B are 50% shareholders of Opco, their operating business
• Opco has a fair market value of $2,000,000
• Shareholder A dies
• A’s holdings consist of:
− FMV of shares of Opco
= $1,000,000
− ACB and PUC of shares of Opco
= nil
• $1,000,000 of life insurance on each shareholder
is used to fund the buy-sell
• In the structures where an insurance policy is corporate
owned, its remaining adjusted cost basis for tax purposes
is nil at the time of death so that the entire insurance
proceeds may be credited to the corporation’s CDA
• Personal marginal tax rate on regular income = 45%
• Personal marginal tax rate on dividends
= 33%22
• Capital gains inclusion rate
= 50%
• The stop-loss rules apply
Lifetime capital gains exemption
In each example, it is generally assumed without further comment that the deceased
shareholder may reduce any tax arising on the deemed disposition of shares immediately
before death by utilizing the $750,000 lifetime capital gains exemption.
Spousal rollover
The examples will assume that a buy-sell agreement that requires the remaining shareholders
to purchase (or Opco to redeem) shares of the deceased shareholder preclude a deferred–tax
rollover of the shares to a surviving spouse or spouse trust under Income Tax Act s. 70(6). That
is because, to qualify for the rollover, the shares must “become vested indefeasibly” in that
recipient. The buy-sell agreement will disqualify the rollover if it requires the shares to be
transferred ultimately to someone else. However, see Appendix 1: “Buy-sell planning with a
surviving spouse—Put-call and capital gains exemption” for alternative planning options.
1. Cross-purchase—Personally owned insurance
In this structure:23
1. The buy-sell agreement is between the two owners.
2. Each shareholder owns and is the beneficiary of a life insurance policy on the life of the
other shareholder and pays the premiums. Alternatively:
• Each shareholder can own and pay for the policy on his or her own life with the
other shareholder as beneficiary. An irrevocable beneficiary designation will reduce
the risk that the policy owner or a creditor will remove policy values intended to fund
a buy-sell agreement24 but will not ensure that premiums are paid and the policy
remains in force.
• A trustee can hold the policies on behalf of each shareholder and monitor the
shareholders’ obligations to ensure that premiums are paid according to an agreed
formula and the policies remain in force.
22
23
24
This rate assumes that the dividend will be a “non-eligible” dividend rather than an “eligible dividend” that is taxable at a lower rate under amendments to the Income Tax
Act enacted in 2006 that created two levels of dividend taxation. Generally, non-eligible dividends, taxed at the higher rate, will originate in corporate income taxed at
the reduced rate for small business income.
The cross-purchase structure is sometimes called a “criss-cross”.
See, for example, Insurance Act (Ontario), s. 191(1). Similar provisions appear in the insurance legislation of the other common law provinces and the Civil Code (Quebec),
art. 2458.
Buy-sell agreements
Sun Life Financial
12/43
When A dies:
3. B, the surviving shareholder, receives the life insurance proceeds.
4. The estate of A sells the shares of A to B.
5. B uses the insurance proceeds to pay for the shares.
B now owns 100% of Opco and the estate of A has received fair market value in cash for
the shares.
Cross-purchase—Personally owned insurance
Today
A
B
Opco
50%
50%
(The business)
Insurance
company
1. Premiums
1. Premiums
2. Tax free $
At death
3. Cash
A’s estate
4. A’s Opco shares
B
100%
Opco
(The business)
1.
2.
3.
4.
A and B pay premiums for insurance on each other.
Insurance company pays B insurance proceeds on A’s life.
B pays A’s estate for Opco shares.
A’s estate transfers Opco shares to B.
Tax consequences
Deceased shareholder (A)
A is deemed to have disposed of the shares to his or her estate for their fair market value
immediately before death.
Proceeds of disposition for tax purposes
ACB
Capital gain
Buy-sell agreements
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Tax payable (45% rate)
225,000
Sun Life Financial
13/43
Estate of deceased shareholder (A)
A’s estate is deemed to acquire the shares at an ACB that is equal to the amount of their
deemed disposition by A, $1,000,000. B purchases the shares from the estate for the same
amount, resulting in a capital gain, taxable capital gain (50% inclusion) and tax payable of
$0 in each case.
Proceeds of disposition for tax purposes
ACB
Capital gain
1,000,000
1,000,000
0
Taxable capital gain (50% inclusion)
0
Tax payable (45% rate)
0
Surviving shareholder (B)
B acquires the shares at fair market value using the life insurance proceeds. Since B pays
$1,000,000 for the shares, for tax purposes, the ACB of all Opco shares owned by B, both
previously owned and newly acquired, increases by the same amount.
ACB of B’s Opco shares after the transaction
ACB of B’s Opco shares before the transaction
Increase in ACB of shares owned by B
1,000,000
0
1,000,000
Value of B’s business interest after the transaction
Value of B’s business interest before transaction
Value purchased from A’s estate
2,000,000
1,000,000
1,000,000
Summary
This structure is most advantageous to the surviving purchaser, from a tax standpoint, because
he or she obtains the shares at an ACB equal to market value with no out-of-pocket expense at
the time of the purchase because the insurance proceeds are used to buy the shares.
The deceased shareholder will pay the tax in this structure, subject to A’s remaining lifetime
capital gain exemption and any other offsetting deductions.
2. Cross-purchase—Opco owned insurance
In this structure:
1. The parties to the buy-sell agreement are the two owners and Opco.
2. Opco owns and pays the premiums for life insurance policies on each shareholder.
3. Opco is the beneficiary of each policy.
When A dies:
4. Opco receives the life insurance proceeds and credits the proceeds to its capital
dividend account.
5. The estate of A sells the shares of A to B.
6. B gives the estate of A a demand promissory note in exchange for the shares.
7. Now that 100% of the shares are owned by B, B causes Opco to pay a dividend. To the
extent of the capital dividend account, Opco can file an election in prescribed form
with the CRA to cause this to be a tax-free capital dividend. The remainder of the
dividend will be taxable.25
25
The capital dividend election must apply to the whole dividend: ITA s. 84(2). If there is not enough in the CDA to support the capital dividend election, the corporation
will be subject to a penalty tax on the excess (ITA s. 184(2)) unless it elects to treat the excess as a separate and taxable dividend (ITA. s. 184(3)).
Buy-sell agreements
Sun Life Financial
14/43
8. B uses the proceeds of the dividend to redeem the promissory note.
9. The estate of A returns the promissory note to B.
B now owns 100% of Opco and the estate of A has received fair market value in cash for
the shares of A.
Cross-purchase—Opco owned insurance
Today
A
B
Opco
50%
50%
(The business)
1. Premiums
At death
Opco
(The business)
2. Tax free $
5. Cap
ital d
Insurance
company
ividen
d
3. Note
A’s estate
4. Opco shares
6. Cash
7. Note cancelled
B
100%
Opco
(The business)
1.
2.
3.
4.
5.
6.
7.
Opco pays premiums to insure A and B.
Insurance company pays Opco insurance proceeds on A’s life.
B pays A’s estate for Opco shares, with a demand promissory note.
A’s estate transfers Opco shares to B.
B, the 100% shareholder of Opco, causes Opco to pay B a tax-free capital dividend.
B pays A’s estate to redeem the note.
A’s estate cancels and returns the note to B.
Tax consequences
The tax consequences of the corporately owned cross-purchase will generally be almost
identical to those of the personally owned cross-purchase.
Deceased shareholder (A)
A is deemed to have disposed of the shares for their fair market value.
Proceeds of disposition for tax purposes
ACB
Capital gain
Buy-sell agreements
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Tax payable (45% rate)
225,000
Sun Life Financial
15/43
Estate of deceased shareholder (A)
A’s estate is deemed to acquire the shares at an ACB that is equal to the amount of their
deemed disposition by A, $1,000,000. B purchases the shares from the estate, paying a
demand promissory note in the same amount, resulting in a capital gain, taxable capital
gain (50% inclusion) and tax payable of $0 in each case.
Proceeds of disposition for tax purposes
ACB
Capital gain
1,000,000
1,000,000
0
Taxable capital gain (50% inclusion)
0
Tax payable (45% rate)
0
Surviving shareholder (B)
On the sale of the shares by the estate, B acquires the shares at the purchase price of
$1,000,000. Since B pays $1,000,000 for the shares, for tax purposes, the ACB of all Opco
shares, both previously owned and newly acquired, increases by the same amount.
In order to redeem the promissory note paid as consideration for the shares, B causes Opco
to pay a $1,000,000 dividend to B. To the extent of the available capital dividend account
in Opco created by the life insurance proceeds, Opco can file an election with the CRA to
make this a tax-free capital dividend. Any excess over the available capital dividend account
would be a taxable dividend.
ACB of B’s Opco shares after the transaction
ACB of B’s Opco shares before the transaction
Increase in ACB of Opco shares owned by B
1,000,000
0
1,000,000
Value of B’s interest in Opco after the transaction
Value of B’s interest in Opco before transaction
Value purchased from A’s estate
2,000,000
1,000,000
1,000,000
CDA credit remaining after capital dividend election
0
Summary
This structure, like the personally owned cross-purchase, is most advantageous to the
surviving purchaser, from a tax standpoint, because he or she obtains shares with an
ACB equal to the purchase price. Again, the deceased shareholder will pay the tax in this
structure, subject to any remaining lifetime capital gain exemption or other offsetting
deductions.
3. Share redemption (“50% solution”)—Opco owned insurance
The redemption strategies which follow assume that they are subject to the 1995 “stoploss” rules, which limit the ability to use a loss created by operation of the tax rules to defer
tax that would otherwise arise. See Appendix 2 for further details. Generally, the stop-loss
rules allow only 50% of the loss created by a share redemption. Therefore, where tax-free
insurance money is used to acquire the survivor’s shares, the assumed structure utilizes the
proceeds as a tax-free capital dividend only to the extent of the non-taxable portion of the
capital gain on the disposition of the shares, i.e., the so-called “50% solution”.26
26
Technically, the structures propose funding the redemption of the deceased’s shares with life insurance money by using two dividends: a tax-free capital dividend to
the extent of the non-taxable portion of the capital gain on the disposition of the shares (using the capital dividend account, that credits the receipt of tax-free life
insurance beneﬁts) and a taxable dividend that provides the balance of the acquisition cost.
Buy-sell agreements
Sun Life Financial
16/43
In this structure:
1. The parties to the buy-sell agreement include Opco as well as the two owners.
2. Opco owns and pays the premiums for life insurance policies on each shareholder.
3. Opco is also the beneficiary.
When A dies:
4. Opco receives the life insurance proceeds and credits the proceeds to its capital
dividend account.
5. Opco redeems the shares of A from the estate.
6. Opco uses the life insurance proceeds to fund the redemption.
7. B now owns all outstanding Opco shares and therefore 100% of Opco.
In this scenario, the surviving shareholder acquires the other 50% of Opco without directly
paying for it.
Note: If Opco elects to pay a capital dividend that is 100% of the deceased shareholder’s
deemed capital gain, i.e., without the 50% solution, the stop-loss rules will prevent half
the capital loss claimed by the estate from being carried back to the final return of the
deceased taxpayer and the taxpayer will pay tax on half the capital gain. With the 50%
solution, the estate will instead pay tax on a dividend in the same amount.
In other words, if the “50% solution” is not used and Opco elects to declare a tax-free
capital dividend to the full extent of its CDA created by the life insurance proceeds, the
overall tax consequences to the deceased taxpayer and the estate will be similar.
However, without the 50% solution, 50% of Opco’s CDA will be lost for any future use.
With the 50% solution, 50% of Opco’s CDA will be carried back to reduce the taxpayer’s
taxable capital gain and 50% will remain to enable a tax-free capital dividend in future
when cash is available.
Buy-sell agreements
Sun Life Financial
17/43
Implementing the 50% solution
Technically, the structures propose funding the redemption of the deceased’s shares with life
insurance money by using two dividends:
1. a tax-free capital dividend to the extent of the non-taxable portion (i.e., 50%) of the
capital gain on the disposition of the shares, hence the “50% solution,” and
2. a taxable dividend that provides the balance of the acquisition cost.
However, the conditions for a corporation to elect a capital dividend under subsection 83(2)
of the Income Tax Act include a requirement that the corporation must make the election “in
respect of the full amount of the dividend.”27 This precludes the ability to split a dividend that
arises by operation of the share redemption rules in subsection 84(3) into a tax-exempt capital
dividend and a taxable dividend. That result has to be achieved by other, indirect means.
Simply redeeming the shares in two equal groups, with distinct dividends, and declaring each
to be a taxable and a capital dividend, respectively, will not circumvent the “entire dividend”
requirement for a capital dividend election and thereby enable the 50% solution. That is because
the stop-loss reduction in Income Tax Act subsection 112(3.2) (“loss on share held by a trust,”
which includes the estate of A, a testamentary trust) is computed on a share-by-share basis.
Each share that is the subject of the 50% capital dividend will be subject to the stop-loss
rule. The result is that subsection 112(3.2) will reduce the loss to the estate on the 50% capital
dividend, share by share, so that the “50% solution” becomes a “25% solution”. This is still
better than reducing the loss on a 100% capital dividend election by 50% but possibly not at
the tax cost to the estate of the 50% taxable dividend and the waste of 25% of a CDA.
One method to plan around the “entire dividend” requirement for a capital dividend
election is to create a deemed dividend using rules that apply to the paid-up capital (PUC)
of a corporation (“PUC bump”).28 To simplify, the PUC of a single share, class of shares or all
the shares of a corporation originates in the stated capital accounts of a corporation that
are required under corporate law.29 This will ordinarily be the initial consideration that the
shareholders pay or contribute to the corporation when it issues new shares. This is assumed
to be nominal in the examples presented in this paper and is valued as “nil”.
However, where corporate law permits, the corporation may increase the PUC of a class
of shares, for example, by adding to the PUC an amount it has credited to its accounts for
retained earnings or other surplus of the corporation.30 When the corporation does so, two tax
consequences follow:
1.
the corporation is deemed to have paid a dividend in the amount of the addition to the
PUC to the shareholders of that class of shares31 and
2. to avoid double taxation, the deemed dividend that arises from any redemption of
shares of that class does not include its PUC and therefore does not include the
addition to its PUC.32
The corporation will be able to elect to treat the dividend that arises from the addition to
PUC as a tax-free capital dividend to the extent of its CDA. The result will be two dividends,
a tax-free capital dividend created by the increase in PUC and capital dividend election, and
a taxable dividend created by redeeming shares.
27
28
29
30
31
32
ITA Form T2054 “Election for a Capital Dividend” reinforces the restriction by requiring the authorized signing ofﬁcer of the corporation to certify that the election is for
“the full amount of the dividend.”
ITA s. 84(1). “Paid-up capital” is deﬁned in ITA s. 89(1).
For example, Business Corporations Act (Ontario), R.S.O. 1990, c. B.16, s. 24.
Ibid., s. 24(5).
ITA s. 84(1).
ITA s. 84(3). The PUC reduces the s. 84(3) deemed dividend to avoid taxation on the return of capital that created PUC on the original issue of the shares and on any
corporate surplus subsequently credited to the PUC that is also taxable as a s. 84(1) deemed dividend.
Buy-sell agreements
Sun Life Financial
18/43
This strategy will require additional refinements and post-mortem planning. First, as a critical
prerequisite, the corporation will need retained earnings or other eligible surplus in its
accounts before it can increase PUC. Further choices and increasing complexity will depend
on the facts of the case. For example, while it is possible to redeem the shares of a single
shareholder, a change of PUC will apply to all shares of the same class and it will be necessary
to convert A’s shares into a separate class if it is desired to restrict the PUC addition and
capital dividend election to A’s shares. These planning issues, among others, exceed the scope
of this paper.
In the present example:
• Opco will increase the PUC of the shares owned by A’s estate by $500,000.
• This will result in a deemed dividend to the estate of $500,000, which Opco will elect to
make a tax-free capital dividend.
• Opco will redeem A’s shares using the life insurance proceeds of $1,000,000.
• This will result in a taxable deemed dividend to the estate of $500,000 (i.e., $1,000,000
proceeds minus $500,000 of PUC).
• Redemption constitutes a disposition of capital property, resulting in a $1,000,000 capital
loss which is subject to the stop-loss rules. However, the amount of the reduction in this
scenario is nil.
• A’s estate carries back the $1,000,000 capital loss to offset capital gain in A’s
terminal return.
• $500,000 remains in Opco’s CDA for the surviving shareholder, A.
Buy-sell agreements
Sun Life Financial
19/43
Share redemption (“50% solution”)—Opco owned insurance
Today
A
B
50%
Opco
(The business)
50%
1. Premiums
At death
Opco
(The business)
3. Redemption
proceeds
(50% capital dividend/
50% taxable dividend)
ree
2. Tax f
$
Insurance
company
5. B owns 100%
4. A’s shares cancelled
B
A’s estate
100%
Opco
(The business)
1.
2.
3.
4.
5.
Opco pays premiums to insure A and B.
Insurance company pays Opco insurance proceeds on A’s life.
Opco redeems Opco shares from A’s estate, paying a deemed dividend, and elects 50% to be a tax-free
capital dividend.
A’s estate transfers Opco shares to Opco for cancellation.
B owns 100% of Opco shares.
Tax consequences
Deceased shareholder (A)
A is deemed to have disposed of his or her shares for fair market value. Subject to the
limitations imposed by the stop-loss rules, the loss incurred by the estate when the shares
are redeemed by Opco can be carried back to reduce or eliminate the capital gain (and
resulting tax) on the final tax return of the deceased shareholder. Provided Opco limits its
use of the CDA to file a capital dividend election to the tax-free 50% of A’s deemed capital
gain on the shares, then the stop-loss reduction will not apply and A’s estate can elect to
carry back the entire redemption proceeds (less PUC of the shares redeemed) as a capital
loss and offset the capital gain of the deceased taxpayer.
Proceeds of disposition for tax purposes
ACB
Capital gain
Loss carried back from the estate of A
Adjusted gain
Buy-sell agreements
1,000,000
0
1,000,000
(1,000,000)
0
Taxable capital gain (50% inclusion)
0
Tax payable (45% rate)
0
Sun Life Financial
20/43
Estate of deceased shareholder
The difference between the redemption proceeds and the PUC of the shares redeemed is
deemed to be a dividend.33 In this case, with a nil PUC, all of the redemption proceeds
will therefore be a deemed dividend. As discussed above, provided the insurance proceeds
created a CDA of $1,000,000 or more in Opco, a capital dividend election could be filed,
allowing the deemed dividend to be tax-free to the estate. However, planning around the
stop-loss rules (i.e., the 50% solution) dictates that Opco files a CDA election to declare
only $500,000 of the deemed dividend as a tax-free capital dividend.
The estate of A simultaneously receives two amounts for tax purposes when Opco redeems
its shares:
• It receives a deemed dividend of $1,000,000, half of which is caused to be tax-free
through the use of the CDA created by the life insurance. (Note again that only half of
the CDA created by the life insurance is used because anything in excess of this would
create an equal stop-loss reduction in the loss carry-back of $1,000,000.)
• It also is deemed to receive proceeds of disposition of $1,000,000 for the redemption
of the shares. But its tax liability is offset by the deemed dividend, resulting in proceeds
of disposition of $0, less an ACB of $1,000,000, for capital gains purposes. It thereby
incurs a capital loss of $1,000,000 on the disposition of the shares.
The capital loss can be carried back and claimed against any capital gains on the final tax
return of A. The half of the deemed dividend that is taxable attracts tax of $165,000, at the
assumed dividend tax rate of 33%.
Proceeds from share redemption by Opco
Portion deemed to be a dividend
Adjusted proceeds for purposes of calculating capital gain for estate34
1,000,000
(1,000,000)
0
ACB to the estate of the shares
Capital loss for the estate
Loss “stopped” by the stop-loss rules
Revised loss for the estate
(1,000,000)
(1,000,000)
0
(1,000,000)
Portion of proceeds deemed to be a dividend
Capital dividend election
Taxable dividend to the estate
Tax payable by the estate on taxable dividend (at 33%)
1,000,000
(500,000)
500,000
165,000
Surviving shareholder (B)
In this scenario, the surviving shareholder (B) acquires the potential taxable gain of A. This
occurs because the surviving shareholder’s interest in the business has increased from 50%
to 100% when B became the owner of all of Opco’s outstanding shares without actually
paying anything for the increase. There are no immediate tax consequences to B on the
redemption of shares. However, since B paid nothing for this increase in share value, B’s
investment in Opco shares receives no increase in its ACB.
33
34
ITA s. 84(3).
Deemed to equal the deemed proceeds of disposition for the deceased shareholder (ITA s. 70(5)).
Buy-sell agreements
Sun Life Financial
21/43
ACB of shares after the redemption
ACB of shares before the redemption
Increase in ACB of shares caused by redemption
0
0
0
Value of shares owned after the redemption
Value of shares owned before the redemption
Additional value acquired through the redemption
2,000,000
1,000,000
1,000,000
Potential gain on sale or death after the redemption
Potential gain on sale or death before the redemption
Increase in potential gain acquired through the redemption
2,000,000
1,000,000
1,000,000
CDA credit remaining after capital dividend election
500,000
Summary
In this structure, the surviving shareholder has acquired the latent gain that existed in the
shares of the deceased shareholder. On the other hand, the surviving shareholder has
acquired the other 50% of Opco formerly owned by the deceased shareholder without any
out-of-pocket payment.
By utilizing the “50% solution” and limiting its election of a tax-free capital dividend to
the 50% tax-free portion of the capital gain on the deemed disposition of the deceased
shareholder’s shares, Opco retains $500,000 credit in its CDA that it can use for future
elections of a tax-free capital dividend when cash is available. That is the key benefit of the
50% solution.
4. Hybrid of cross-purchase and redemption (“50% solution”)—Opco owned insurance
In this structure, it is assumed that A has $500,000 remaining in the lifetime capital gains
exemption that may be used to offset the capital gain on the deemed disposition of A’s
Opco shares immediately before death:
1. The parties to the buy-sell agreement are the owners and Opco.
2. Opco owns and pays the premiums for life insurance policies on each shareholder.
3. Opco is also the beneficiary.
When A dies:
4. Opco receives the life insurance proceeds ($1,000,000).
5. The estate of A sells some of A’s shares to B. The amount sold is sufficient to exactly
use up the remaining capital gains exemption of A, $500,000. (In this example, it is
assumed that one half of the shares may be sold directly to do so.)
6. B pays for the shares with a demand promissory note.
7. Opco redeems the remaining shares of A from the estate of A.
8. Opco uses the life insurance proceeds to fund the redemption.
9. Opco files an election to deem the dividend to be in part a tax-free capital dividend.
The amount of the tax-free dividend depends on two limiting factors: (i) an amount
permitted to the extent of Opco’s CDA (here created by the life insurance proceeds) and
(ii) an amount that will not cause the stop-loss rules to reduce the capital loss claimed
by A’s estate on the share redemption.35 The remainder of the dividend will be taxable.
10. Now that B owns 100% of the shares, B causes Opco to pay a dividend to B. B uses the
proceeds of the dividend to redeem the promissory note.
11. Opco returns the promissory note to B.
35
See the note on “Implementing the 50% solution” under “3. Share redemption (‘50% solution’)–Opco owned insurance” for a discussion of technical issues.
Buy-sell agreements
Sun Life Financial
22/43
B now owns 100% of Opco and the estate of A has received fair market value in cash for the
shares of A.
The benefit of this structure is the ability to sell shares directly to the extent of the capital
gains exemption or other deductions of the deceased shareholder, while deferring the
remainder of the capital gains tax until the death of the surviving shareholder via the share
redemption strategy. This is illustrated in the following diagram.
Hybrid of cross-purchase and redemption (“50% solution”)—Opco owned insurance
Today
A
B
Opco
50%
50%
(The business)
1. Premiums
Insurance
company
At death
Opco
(The business)
6. Rest of A’s
shares cancelled
2. Tax free $
5. Redemption proceeds
7. Capital dividend
(50% capital dividend/
50% taxable dividend)
3. Note
A’s estate
4. Part of Opco
shares (=A’s LCGE)
8. Cash
9. Note cancelled
B
100%
Opco
(The business)
1.
2.
3.
Opco pays premiums to insure A and B.
Insurance company pays Opco insurance proceeds on A’s life.
B pays A’s estate for enough Opco shares to use the remainder of A’s lifetime capital gains exemption, with
a demand promissory note.
4. A’s estate transfers those Opco shares to B.
5. Opco redeems the remaining Opco shares from A’s estate, paying a deemed dividend, and elects 50% to
be a tax-free capital dividend.
6. A’s estate transfers those Opco shares to Opco for cancellation.
7. B, the 100% shareholder of Opco, causes Opco to pay B a tax-free capital dividend sufficient to redeem B’s
promissory note.
8. B pays A’s estate to redeem the note.
9. A’s estate cancels and returns the note to B.
Tax consequences
Deceased shareholder (A)
A is deemed to have disposed of the Opco shares for fair market value, $1,000,000. The
example assumes that A had $500,000 of the lifetime capital gains exemption remaining
at the time of death, so that the tax payable on $500,000 of the capital gain will be $0. As
discussed below, subject to the limitations imposed by the stop-loss rules, the loss incurred
by the estate when Opco redeems a portion of the shares (in this case, half) can be carried
back to eliminate the remaining half of the capital gain (and resulting tax) on the final tax
return of the deceased shareholder.
Buy-sell agreements
Sun Life Financial
23/43
Proceeds of disposition for tax purposes for all shares
ACB
Capital gain
Loss carried back from the estate of A
Capital gain subject to tax
1,000,000
0
1,000,000
(500,000)
500,000
Taxable capital gain (50% inclusion)
Capital gains deduction36 (50% of available capital gains exemption)
Taxable income amount
250,000
(250,000)
0
Tax payable (45% rate, utilizing the capital gains exemption)
Tax payable (45% rate, without the capital gains exemption)
0
112,500
Estate of deceased shareholder
In this example, the estate of A will sell half of the shares to B. Opco will redeem the other
half. The estate of A receives total proceeds of $1,000,000. For tax purposes, these proceeds
are reduced by the portion that is the redemption amount, which is also deemed to be a
dividend ($500,000). The net proceeds, when compared to the estate’s cost of the shares
(the same $1,000,000 at which A was deemed to have disposed them at death), create a
loss of $500,000. This loss can be carried back, as shown above, to reduce the gain on A’s
final tax return.
The difference between the redemption proceeds and the PUC of the $500,000 of shares
that are redeemed, rather than sold, is deemed to be a dividend. In this case, with a nil
PUC, all of the redemption proceeds will therefore be a deemed dividend.
As discussed above, provided the insurance proceeds created a CDA of $500,000 or more
in Opco, then a capital dividend election could be filed, allowing the deemed dividend to
be tax-free to the estate. However, the stop-loss rules cause Opco to elect that only 50%
($250,000) of the redemption proceeds are a tax-free capital dividend.37 Consequently,
the remaining proceeds are a taxable dividend and attract a tax on dividends of 33% or
$82,500. Opco retains $750,000 in its CDA.
Proceeds received by estate of A on sale and redemption of all shares
Portion deemed to be a dividend
Adjusted proceeds for purposes of calculating capital gain for estate
ACB to the estate of the shares38
Capital loss for the estate
Loss “stopped” by the stop-loss rules
Revised loss for the estate
Proceeds of $500,000 of shares redeemed (deemed dividend)
Capital dividend election
Taxable dividend to estate
Tax payable by estate on taxable dividend (33% rate)
36
37
38
1,000,000
(500,000)
500,000
(1,000,000)
(500,000)
0
(500,000)
500,000
(250,000)
250,000
82,500
The lifetime capital gains exemption is utilized by claiming a capital gains deduction at a 50% rate that offsets the 50% inclusion rate for taxable capital gains: ITA s.
110.6(2.1).
See the note on “Implementing the 50% solution” under “3. Share redemption (‘50% solution’)–Opco owned insurance” for a discussion of technical issues.
Deemed to equal the deemed proceeds of disposition for the deceased shareholder, ITA s 70(5).
Buy-sell agreements
Sun Life Financial
24/43
The estate therefore has a tax-free dividend and a capital loss of $500,000. The capital
loss can be carried back and claimed against any capital gains on the final tax return of
the deceased shareholder. But it also has to pay $82,500 tax on the taxable portion of the
deemed dividend.
Surviving shareholder (B)
In this scenario, the surviving shareholder’s interest in the business has increased by
$1,000,000 with B actually paying for only half of the increase ($500,000 share purchase)
but without paying for the other half ($500,000 share redemption). There are no
immediate tax consequences to the surviving shareholder on the redemption of shares.
However, since B paid for only half of this increase in share value, B obtains an increase
in the ACB of B’s overall investment in Opco shares that is limited to the purchase price,
$500,000, or half of the gain in value. B therefore acquires half of the potential taxable
gain of A. At the same time, B acquires access to the remaining CDA in Opco, $750,000,
which Opco may use in future to declare a tax-free capital dividend when there is a
qualifying corporate surplus.
ACB of shares before transaction
Increase in ACB from direct purchase from estate
Increase in ACB of shares caused by redemption
ACB of shares after transaction
0
500,000
0
500,000
Value of shares owned by survivor before the redemption
Additional value purchased directly from estate of deceased
Additional value acquired after redemption
Total value of shares owned after transaction
1,000,000
500,000
500,000
2,000,000
Potential gain on sale or death before transaction
Potential gain on sale or death after transaction
Increase in potential gain acquired from deceased
1,000,000
1,500,000
500,000
CDA credit remaining after capital dividend election
750,000
Summary
In this structure, the purchaser and the deceased share in the tax cost, if any. However, the
tax payable by the purchaser (B) is deferred until death or sale of the shares. The deceased
shareholder incurs liability for tax on the shares sold directly, which is reduced by the
availability of the capital gains exemption that underlies this structure.
The surviving shareholder has acquired some of the latent gain that existed in the shares of
the deceased shareholder through the share redemption portion of the transaction. On the
other hand, the surviving shareholder has acquired the value of the shares of the deceased
that were redeemed without any out-of-pocket payment together with the CDA remaining
in the corporation, which can be used to pay a tax-free capital dividend when qualifying
corporate surplus becomes available.
Buy-sell agreements
Sun Life Financial
25/43
Comparing the four strategies
The following table compares the results from the four strategies for each of the
relevant parties:
Personally
owned
Corporate owned
Hybrid
Crosspurchase
A (deceased shareholder)
Deemed proceeds for tax purposes
ACB
Capital gain
Loss carryback from the estate
Adjusted capital gain
Crosspurchase
Redemption
(50% crosspurchase/50%
redemption)
(50% solution)
1,000,000
0
1,000,000
0
1,000,000
1,000,000
0
1,000,000
0
1,000,000
1,000,000
0
1,000,000
(1,000,000)
0
1,000,000
0
1,000,000
(500,000)
500,000
500,000
n/a
500,000
500,000
n/a
500,000
0
n/a
0
250,000
(250,000)
0
225,000
225,000
0
112,500
n/a
n/a
n/a
n/a
1,000,000
0
1,000,000
(1,000,000)
0
n/a
0
1,000,000
0
1,000,000
(1,000,000)
0
n/a
0
1,000,000
(1,000,000)
0
(1,000,000)
(1,000,000)
0
(1,000,000)
1,000,000
(500,000)
500,000
(1,000,000)
(500,000)
0
(500,000)
n/a
n/a
0
0
1,000,000
(500,000)
500,000
500,000
(250,000)
250,000
0
0
165,000
82,500
ACB of B’s shares after
ACB of B’s shares before
ACB of new shares/value acquired
1,000,000
0
1,000,000
1,000,000
0
1,000,000
0
0
0
500,000
0
500,000
Value of B’s shares after
Value of B’s shares before
Value acquired in the transaction
2,000,000
1,000,000
1,000,000
2,000,000
1,000,000
1,000,000
2,000,000
1,000,000
1,000,000
2,000,000
1,000,000
1,000,000
Potential gain after transaction
Potential gain before transaction
Increase in potential gain acquired
1,000,000
1,000,000
0
0
0
0
2,000,000
1,000,000
1,000,000
1,500,000
1,000,000
500,000
Taxable capital gain (50%)
Capital gains exemption (50%)
Taxable income amount
Tax payable (45% rate, before using any
capital gains exemption)
Tax payable (45% rate, after using any
capital gains exemption)
Estate of A
Proceeds received
Less: portion deemed to be dividend
Adjusted proceeds
Less: ACB of shares to estate
Capital loss for the estate
Loss “stopped” by stop-loss rules
Revised loss for the estate
Proceeds of redemption less PUC
Capital dividend election
Taxable dividend to estate
Tax payable (33% rate)
B
Buy-sell agreements
Sun Life Financial
26/43
Personally
owned
Corporate owned
Hybrid
Crosspurchase
Combined taxes
Tax payable by A and A’s estate
Tax payable by B
Total tax payable at time of death
Remaining capital dividend
Crosspurchase
Redemption
(50% solution)
(50% crosspurchase/50%
redemption)
225,000
0
225,000
225,000
0
225,000
165,000
0
165,000
82,50039
0
82,500
n/a
0
500,000
750,000
Summary
The redemption method potentially creates a lower overall immediate tax burden than
a cross-purchase if no capital gains exemption is available. However, this advantage has
been eroded by the stop-loss rules. In this example, the stop-loss rules have effectively
created $165,000 in tax that otherwise would not have been payable by a full redemption.
As a result of this and the fact that dividend tax rates are now higher than the tax rate on
capital gains,40 the bias may shift slightly towards cross-purchases and away from share
redemptions in insured buy-sells at death. This will particularly be the case where the
shareholders have remaining capital gains exemption.
It is important to note, however, that with the redemption method, B acquires control
of $500,000 of Opco’s remaining capital dividend account that can be used to pay
future tax-free dividends, once corporate cash flow becomes available. If this benefit
were expected to be realized soon after A’s death, it would likely tilt the bias heavily
in the direction of share redemption.
Note that, as would be expected, the hybrid method produces a total immediate tax cost
($195,000, before using A’s lifetime capital gains exemption) that falls between the results
of its two components: less than under a cross-purchase ($225,000) but more than under
a share redemption ($165,000).
Again, a hybrid would most likely be considered where the shareholder had sufficient
remaining capital gains exemption to eliminate the tax on the deemed disposition at death.
In the present example, A’s remaining capital gains exemption of $500,000 was exactly
enough to cancel the $112,500 tax liability on the disposition of A’s shares (deemed
disposition of $1,000,000 less $0 ACB less $500,000 loss carryback from A’s estate).
The hybrid method resulted in only $82,500 in tax payable by A’s estate.
B. Owners each own a Holdco which owns shares in Opco
As their business interests mature, Opco’s shareholders may incorporate personal holding
companies (Holdcos) to hold their shares in the business. One common reason is to
transfer retained earnings of the business to the Holdcos, beyond the direct reach of
Opco’s creditors. The Holdcos will often hold other personal assets or may be used for
estate planning purposes.
Where the owners use Holdcos to hold their shares in the business, they will rarely sell
their Holdcos to each other. Usually, the Holdco of the deceased shareholder will either
sell its shares in the Opco to the other Holdcos or have its shares redeemed by the Opco.
In the latter case, the remaining Holdcos will acquire the economic interest of the Holdco
of the deceased shareholder in the business in proportion to their shares in the Opco.
39
40
Using A’s lifetime capital gains exemption. Without the capital gains exemption, combined tax for A and A’s estate is $195,000.
However, under measures enacted in 2006 to establish dual tax rates on “eligible” and “non-eligible” dividends, the top combined federal-provincial marginal tax rates
proposed for “eligible” dividends in that year will be lower than the rate for capital gains in British Columbia, Alberta, Saskatchewan and Newfoundland, by a differential
that varies between 0.4% and 3.5%. Generally, non-eligible dividends, taxed at the higher rate, will originate in corporate income taxed at the reduced rate for small
business income.
Buy-sell agreements
Sun Life Financial
27/43
The additional layer of ownership at the Holdco level greatly increases the number and
complexity of planning options. This paper will outline some of the common choices and
suggest additional planning options for further consideration.
Holdco scenario assumptions
• Shareholders A and B own 100% of Holdco A and Holdco B, respectively
• Holdco A and Holdco B each own 50% of Opco
• Opco has a fair market value of $2,000,000 and ACB & PUC of nil
• Holdco A’s holdings consist solely of Opco shares which have:
- FMV
= 1,000,000
- ACB and PUC
= nil
• A has
- a personal marginal tax rate on regular income = 45%
- a personal marginal tax rate on dividends
= 33%
• Holdco and Opco tax rate
= 45%
• $1,000,000 of life insurance on each shareholder is used to fund the buy-sell
• Each policy is corporate owned, either by a Holdco or Opco, with a Holdco or Opco
designated as beneficiary
• The remaining adjusted cost basis of each policy for tax purposes is nil at the time
of death so that the entire insurance proceeds may be credited to the corporate
beneficiary’s CDA
1. Cross-purchase of Opco shares by Holdco—Holdco owned insurance
In this structure:
1. The buy-sell agreement is between the Holdcos.
2. Each holding company is the owner and beneficiary of a life insurance policy on the
life of the other shareholder and pays the premiums. As discussed earlier under “Crosspurchase—personally owned insurance,” alternative arrangements are possible. For
example, a trustee can hold the policies on behalf of each Holdco and monitor the
Holdcos’ obligations to ensure that the policies remain in force and premiums are paid
according to an agreed formula.
When A dies:
3. Holdco B receives the life insurance proceeds.
4. Holdco A sells its Opco shares to Holdco B.
5. Holdco B uses the insurance proceeds to pay for the shares.
Holdco B now owns 100% of Opco and Holdco A has received fair market value in cash for
the shares.
Buy-sell agreements
Sun Life Financial
28/43
The buy-out takes place at fair market value so that Holdco B acquires additional Opco
shares with an ACB that is equal to the purchase price. Holdco A has a capital gain that is
equal to the excess of the sale proceeds over the ACB (nil) of its Opco shares.
Cross-purchase of Opco shares by Holdco—Holdco owned insurance
Today
A
B
100%
100%
Holdco A
Holdco B
50%
Opco
50%
(The business)
1. Premiums
Insurance
company
1. Premiums
2. Tax free $
At death
A’s estate
B
100%
100%
3. Cash
Holdco A
Holdco B
4. Opco shares
100%
Opco
(The business)
1.
2.
3.
4.
Holdco A and Holdco B pay premiums to insure B and A, respectively.
Insurance company pays Holdco B insurance proceeds on A’s life.
Holdco B pays Holdco A for Opco shares.
Holdco A transfers Opco shares to Holdco B.
Tax consequences
The deceased shareholder
A is taxable at death on the deemed disposition of A’s shares in Holdco A.
Deemed disposition of Holdco A shares
ACB
Capital gain
Buy-sell agreements
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Tax payable (45% rate)
225,000
Sun Life Financial
29/43
Holdco A
Holdco A sells its Opco shares to Holdco B, resulting in a capital gain since proceeds
exceed Holdco’s ACB in the Opco shares.
Proceeds on sale of 50% of Opco shares
ACB
Capital gain
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Tax payable (45% rate)
Capital dividend account available (from 50% non-taxable capital gain)
225,000
500,000
Holdco B
Following is the summary of tax consequences to Holdco B.
ACB of Holdco B’s Opco shares after purchase from Holdco A
ACB of Holdco B’s Opco shares before purchasing new shares
Increase in ACB from direct purchase from Holdco A
1,000,000
0
1,000,000
Total value of Opco shares owned by Holdco B after purchase
Value of Opco shares owned before purchase
Additional value of shares purchased directly from Holdco A
2,000,000
(1,000,000)
1,000,000
Potential gain on sale or death after purchase
Potential gain on sale or death before purchase
Increase in potential gain on shares purchased from Holdco A
1,000,000
(1,000,000)
0
Capital dividend account available (from insurance proceeds)
1,000,000
Holdco B has a tax cost equal to what it paid for the new shares. No new potential gain has
been created.
Summary
A sale of the Opco shares between the Holdcos generally favors the Holdco of the survivor.
There are at least two reasons for this:
1. The ACB of the shares acquired by Holdco B is equal to the purchase price since the
shares were purchased directly for full consideration.
2. Upon receipt of the life insurance proceeds, Holdco B credits its capital dividend
account for the amount by which the death proceeds exceed the adjusted cost basis
of the policy. On the direct purchase of shares by Holdco B for cash, Holdco B does
not need to issue a dividend. No capital dividend election is required and the capital
dividend account retains the increase in its value. Therefore, Holdco B can retain the
capital dividend account to elect to pay future tax-free capital dividends, when the cash
becomes available to do so.
Buy-sell agreements
Sun Life Financial
30/43
Additional planning option
It may be possible to eliminate the capital gain of the deceased shareholder if Holdco A uses
the money it receives from Holdco B for the Opco shares to redeem its own shares from A’s
estate. The steps would be:
1.
Holdco A redeems its shares from A’s estate for $1,000,000.
2. The estate receives this money as a dividend for income tax purposes.
3. The deemed dividend reduces the estate’s proceeds of distribution for the shares by
$1,000,000, to $0.
4. The estate therefore recognizes a loss of $1,000,000 on the redemption of the shares
($0 less the $1,000,000 ACB of the shares created by the deemed transfer of the shares
from A at $1,000,000 fair market value).
5. The executor of the estate elects to carry back the loss to A’s amended final return,
thereby offsetting A’s capital gain on the deemed disposition of the shares.
Two considerations will determine the effectiveness of this strategy:
1.
No capital dividend account will be available for Holdco A since it did not receive the life
insurance proceeds. Consequently, the dividend would be fully taxable (and the stop-loss
rules would not apply). Therefore, this additional redemption strategy would be desirable
only where the tax rate on dividends is less than the rate on capital gains.41
2. When Holdco A redeems the shares of its only shareholder, A’s estate, it will be wound up
unless issuing new shares to another shareholder is contemplated. The decision to wind up
Holdco A will depend on a number of factors, such as the existence of other assets that
cannot be moved or that have significant latent capital gains that would be triggered on
their removal from Holdco A.
2. Cross-purchase of Opco shares by Holdco—Opco owned insurance
This structure is the same as the previous one, except that Opco, as opposed to the
respective Holdcos, is the beneficiary of the insurance on the lives of the two shareholders.
Opco can be the owner, as illustrated here. As an alternative, the Holdcos can be the
owners or co-owners.
In this structure:
1. The parties to the buy-sell agreement are the Holdcos and Opco.
2. Opco buys life insurance on the lives of the shareholders and pays the premiums.
This could be a single policy or two policies. Opco is also the beneficiary.
When A dies:
3. Opco receives the life insurance proceeds.
4. Holdco A sells its Opco shares to Holdco B.
5. Holdco B provides a demand promissory note in exchange for the shares.
6. Now that Holdco B owns 100% of the shares, it causes Opco to pay a dividend.
7. To the extent of the capital dividend account created by the life insurance proceeds,
Opco files an election to cause this to be a tax-free capital dividend.42 The remainder
of the dividend will be taxable. Alternatively, if Opco has sufficient previously taxed
surplus, it could pay a tax-free intercorporate dividend to Holdco B and retain the value
of its capital dividend account for future use.43
41
42
43
See comment in the preceding footnote regarding the taxation of low rate “eligible” and high rate “non-eligible” dividends beginning in 2006. The additional redemption
strategy may reduce tax liability in some provinces if the capital dividend qualiﬁes as an “eligible” dividend.
See the note on “Implementing the 50% solution” under “3. Share redemption (‘50% solution’)–Opco owned insurance” for a discussion of technical issues relating to the
capital dividend election.
The dividend amount deducted under ITA s. 112(1) (intercorporate dividends) offsets the dividend amount included under ITA s. 82(1)), provided there was previously taxed
surplus (“safe income”) in Opco equal to the deemed dividend (see ITA s. 55(2)).
Buy-sell agreements
Sun Life Financial
31/43
8. Holdco B uses the proceeds of the dividend to pay the promissory note.
9. Holdco A cancels the promissory note.
Holdco B now owns 100% of Opco and Holdco A has received fair market value in cash for
the Opco shares previously owned by Holdco A.
Cross-purchase of Opco shares by Holdco—Opco owned insurance
Today
A
B
100%
100%
Holdco A
Holdco B
50%
50%
Opco
(The business)
1. Premiums
At death
Insurance
company
2. Tax
free $
Opco
(The business)
5. Capital
dividend
A
100%
B
100%
3. Note
Holdco A
4. Opco shares
6. Cash
Holdco B
7. Note cancelled
Opco
(The business)
1.
2.
3.
4.
5.
6.
7.
Buy-sell agreements
Holdco A and Holdco B pay premiums to insure B and A, respectively, naming Opco the beneficiary.
Insurance company pays Opco insurance proceeds on A’s life.
Holdco B pays Holdco A for Opco shares, with a demand promissory note.
Holdco A transfers Opco shares to Holdco B.
Holdco B, the 100% shareholder of Opco, causes Opco to pay Holdco B a tax-free capital dividend.
Holdco B pays Holdco A to redeem the note.
Holdco A cancels and returns the note to Holdco B.
Sun Life Financial
32/43
Tax consequences
The deceased shareholder
The consequences for the deceased do not differ from the other structures with holding
companies. The deceased A is taxable only on the deemed disposition at death of shares in
Holdco A.
Deemed disposition of Holdco A shares
ACB
Capital gain
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Taxes payable (45% rate)
225,000
Additional planning option
See comments under the previous strategy, “Cross-purchase of Opco shares by HoldcosHoldco owned insurance,” for an additional planning option to eliminate the capital gain
of the deceased shareholder by using the money Holdco A receives for the Opco shares to
redeem its own shares from A’s estate.
Holdco A
Holdco A sells its Opco shares, resulting in a capital gain since proceeds exceed Holdco’s
ACB in the shares of Opco.
Proceeds on sale of 50% of Opco shares
ACB
Capital gain
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Taxes payable (45% rate)
Capital dividend account available (from 50% non-taxable capital gain)
225,000
500,000
Holdco B
Following is the summary of tax consequences to Holdco B.
ACB of Holdco B’s Opco shares after purchase from Holdco A
ACB of Holdco B’s Opco shares before purchasing new shares
Increase in ACB from direct purchase from Holdco A
Total value of Opco shares owned by Holdco B after transaction
Value of Opco shares owned before purchase
Additional value of Opco shares purchased directly from Holdco A
2,000,000
(1,000,000)
1,000,000
Potential gain on sale or death after purchase
Potential gain on sale or death before purchase
Increase in potential gain on shares purchased from Holdco A
1,000,000
(1,000,000)
0
Capital dividend account available
(from capital dividend originating in insurance proceeds)
Buy-sell agreements
1,000,000
0
1,000,000
Sun Life Financial
1,000,000
33/43
Holdco B has a tax cost equal to what it paid for the new shares. No new potential gain has
been created.
Summary
The ultimate tax consequences of this structure for all involved are identical to the
preceding cross-purchase strategy where the owners and beneficiaries of the insurance
are the respective Holdcos.
Again, a sale of the operating company shares between the holding companies generally
favours the Holdco of the survivor because:
1. The ACB of the shares acquired by Holdco B is equal to the purchase price since the
shares were purchased directly for full consideration.
2. Upon receipt of the life insurance proceeds, a capital dividend account is created
in Opco. If the capital dividend account election is utilized on the payment of the
$1,000,000 dividend from Opco to Holdco B, an identical capital dividend account
will be created in Holdco B. Since no capital dividend election is required on the direct
purchase of shares by Holdco B, Holdco B can retain the capital dividend account to
elect to pay future tax-free capital dividends, when the cash becomes available to do so.
In the Opco-owned cross-purchase method, the ability of Opco and its controlling
shareholder to allocate the CDA created by Opco’s receipt of insurance proceeds between
Opco and Holdco B by means of Opco’s capital dividend election may confer a significant
advantage over the Holdco owned cross-purchase method.
3. Redemption of shares by Opco—Opco owned insurance
In this structure:
1. The parties to the buy-sell agreement are the two Holdcos and Opco.
2. As in the preceding structure, Opco buys life insurance on the lives of the shareholders
and pays the premiums. This could be a single policy or two policies. Opco is also
the beneficiary.
When A dies:
3. Opco receives the life insurance proceeds.
4. Opco redeems its shares that are owned by Holdco A using the life insurance proceeds
to fund the redemption.
5. Holdco B now owns 100% of Opco.
Buy-sell agreements
Sun Life Financial
34/43
Redemption of shares by Opco—Opco owned insurance
Today
A
B
100%
100%
Holdco A
Holdco B
50%
50%
Opco
(The business)
1. Premiums
At death
2. Tax free
Opco
Insurance
company
$
(The business)
5. Holdco B owns 100%
3. Redemption
proceeds
B
4. Opco shares
A’s estate
100%
100%
Holdco B
Holdco A
100%
Opco
(The business)
1.
2.
3.
4.
5.
Opco pays premiums to insure the lives of A and B.
Insurance company pays Opco insurance proceeds on A’s life.
Opco redeems Opco shares from Holdco A, using the insurance proceeds.
Holdco A transfers Opco shares to Opco for cancellation.
Holdco B owns 100% of Opco shares.
Tax consequences
The deceased shareholder
Again, the consequences for the deceased do not differ from the other structures with
holding companies. A is taxable only on the deemed disposition at death of shares in
Holdco A.
Deemed disposition of shares of Holdco A
ACB
Capital gain
Buy-sell agreements
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
Taxes payable (45% rate)
225,000
Sun Life Financial
35/43
Holdco A
Opco redeems the shares owned by Holdco A, which receives the proceeds of the
redemption as a deemed dividend. The deemed dividend reduces Holdco A’s proceeds
of disposition for the shares by the same amount. The buy-sell agreement stipulates that
Opco shall elect that the dividend created by the redemption is a capital dividend.
Portion of insurance proceeds received by Opco deemed to be tax-free capital receipt 1,000,000
Capital dividend election
(1,000,000)
Taxable dividend to Holdco A44
0
Proceeds received by Holdco A from share redemption
Portion deemed to be a dividend
Adjusted proceeds for purposes of calculating capital gain for Holdco A
Adjusted cost base to Holdco A of the shares
Capital gain (loss) for Holdco A
1,000,000
(1,000,000)
0
0
0
Holdco B
In this scenario, Holdco B acquires the potential taxable gain of Holdco A. This occurs
because Holdco B’s interest in the business has increased without actually paying anything
for it. There are no immediate tax consequences to Holdco B or B on Opco’s redemption
of its shares from Holdco A. However, since they did not pay anything for this increase
in their share value, they do not receive an increase in the ACB of their investment. Their
percentage of ownership increases in proportion to their existing level of holdings.
Adjusted cost base of shares after transaction
Adjusted cost basis of Holdco B shares in Opco before transaction
Increase in adjusted cost base from direct purchase from estate
Total value of shares owned after transaction
Value of shares owned by Holdco B before transaction
Additional value of shares purchased directly from Holdco A
2,000,000
(1,000,000)
1,000,000
Potential gain on sale or death after transaction
Potential gain on sale or death before transaction
Increase in potential gain on shares purchased from Holdco A
2,000,000
(1,000,000)
1,000,000
Capital dividend account available for the future
44
0
0
0
0
ITA s. 83(2) Some or all of this dividend could be a tax-free intercorporate dividend deductible under ITA s. 112(1) without the use of the capital dividend account election,
provided there was previously taxed surplus (“safe income”) in Opco equal to the deemed dividend. See ITA s. 55(2)(b).
Buy-sell agreements
Sun Life Financial
36/43
Summary
In this structure, Holdco B, and therefore B, its shareholder, acquire the latent gain that
existed in the shares of Holdco A. On the other hand, Holdco B and, indirectly, B have
acquired the other 50% of the value of Opco without any out-of-pocket payment.
Holdco A has no tax to pay, as it has not sold its shares in Opco. Rather, its shares have
been redeemed in a transaction that creates a tax-free capital dividend. Holdco A has
a residual $1,000,000 capital dividend account. Therefore, it can flow the $1,000,000
in redemption proceeds out to the estate of A. Alternatively, it may be able to use a
redemption or windup strategy to eliminate some of the tax on the final tax return of A.
On balance, this is the most advantageous strategy for A unless A has a capital gains
exemption equal to all or most of the deemed gain at death. It could also be considered
an attractive strategy for B as Holdco B’s future tax bill from acquiring Opco is indefinitely
deferred.
Additional planning options
See comments under the earlier strategy, “Cross-purchase of Opco shares by Holdcos—Holdco
owned insurance,” for an additional planning option to eliminate the capital gain of the
deceased shareholder by using the money Holdco A receives for the Opco shares to redeem
its own shares from A’s estate, in effect exchanging the capital gain for a taxable dividend.
It may also be possible to eliminate the capital gain of the deceased shareholder if Opco first
redeemed its shares from Holdco A and then Holdco A redeemed its shares from A’s estate
and wound up. When Opco redeemed its shares from Holdco A, the redemption proceeds
would be treated entirely as a dividend for income tax purposes. Opco would file a capital
dividend election in respect of this dividend and an equivalent capital dividend account would
arise in Holdco A.45
Holdco A would then redeem a sufficient number of its shares from the estate to create a loss
in the estate that could be carried back to eliminate the $225,000 of tax on the capital gain
reported in A’s final return. To avoid triggering the stop-loss rules, a capital dividend election
would be made on only half of the deemed dividend on the redemption and the remainder
would be a taxable dividend.46 The net result would be to effectively eliminate half of the
tax of the deceased and to convert the other half into a taxable dividend for the estate
rather than a capital gain for A.47
Another option would be for Holdco A to simply use the capital dividend account created
by the redemption of Opco shares to pay a tax-free dividend to the estate of A.
Many further variations on the preceding structures are possible but are beyond the scope
of this paper.
45
46
47
ITA s. 83(2) and s. 89(1)(b).
See the note on “Implementing the 50% solution” under “3. Share redemption (‘50% solution’)–Opco owned insurance” for a discussion of technical issues relating to the
capital dividend election.
Estate planning measures would also have to be taken to avoid the stop-loss provisions in ITA ss. 40(3.6) and (3.61), which prevent carrying back a loss which is greater
than the loss allowed under ITA s. 164(6)).
Buy-sell agreements
Sun Life Financial
37/43
Comparing the three strategies
Cross-purchase
Holdco- owned
insurance
Deceased shareholder (A)
Deemed disposition of Holdco A shares
ACB
Capital gain
Cross-purchase
Opco-owned
insurance
Share
redemption
Opco- owned
insurance
1,000,000
0
1,000,000
1,000,000
0
1,000,000
1,000,000
0
1,000,000
Taxable capital gain (50% inclusion)
500,000
500,000
500,000
Taxes payable (45% rate)
225,000
225,000
225,000
n/a
n/a
1,000,000
Holdco A
Portion of insurance proceeds received by Opco
deemed to be tax-free capital receipt
Capital dividend election and tax-free capital
dividend to Holdco A
Taxable dividend to Holdco A48
Capital dividend account increase
Proceeds received on sale or redemption of
Opco shares
Portion deemed to be a dividend
Adjusted proceeds
Adjusted cost base to Holdco A of the shares
Capital gain (loss) for Holdco A
(1,000,000)
0
1,000,000
1,000,000
0
1,000,000
0
1,000,000
1,000,000
0
1,000,000
0
1,000,000
1,000,000
(1,000,000)
0
0
0
500,000
225,000
500,000
225,000
0
0
500,000
500,000
0
ACB of shares after transaction
1,000,000
1,000,000
0
ACB of Holdco B’s Opco shares before transaction
0
1,000,000
0
1,000,000
0
2,000,000
2,000,000
2,000,000
(1,000,000)
(1,000,000)
(1,000,000)
1,000,000
1,000,000
1,000,000
1,000,000
(1,000,000)
1,000,000
(1,000,000)
2,000,000
(1,000,000)
0
0
1,000,000
1,000,000
1,000,000
0
Taxable capital gain (50% inclusion)
Taxes payable (45% rate)
Capital dividend account increase
(from non-taxable 50%)
Holdco B
Increase in ACB from direct purchase from estate
Total value of shares owned after transaction
Value of shares owned by Holdco B before the
transaction
Additional value of shares purchased or redeemed
from Holdco A
Potential gain on sale or death after transaction
Potential gain on sale or death before transaction
Increase in potential gain - shares purchased from
Holdco A
Capital dividend account available for the future
(from insurance proceeds)
48
0
ITA s. 55(2). Some or all of this dividend could be tax-free without the use of the capital dividend account election, provided there was previously taxed surplus (‘safe
income’) in Opco equal to the deemed dividend.
Buy-sell agreements
Sun Life Financial
38/43
Cross-purchase
Holdco- owned
insurance
Cross-purchase
Opco-owned
insurance
Share
redemption
Opco- owned
insurance
Combined tax results
A and Holdco A
Tax payable by A
Tax payable by Holdco A
Total tax payable at time of death by A and Holdco A
Capital dividend account acquired by Holdco A
B and Holdco B
Future gain acquired by Holdco B
Capital dividend account acquired by Holdco B52
225,000
225,000
450,000
225,000
225,000
450,000
225,000
0
225,000
500,00049
500,00050
1,000,00051
0
0
1,000,000
1,000,000
1,000,000
0
Summary
Among the three scenarios, the two cross-purchase methods may favour the surviving
shareholder, B, by:
1. increasing the ACB on Holdco B’s Opco shares, thereby reducing the capital gain on a
subsequent disposition, and
2. increasing Holdco B’s capital dividend account for future use by the full amount of the
insurance proceeds received by Holdco B (compared with the non-taxable 50% portion
of the capital gain realized by Holdco A).
The two cross-purchase options produce the same outcome. If creditor protection is a
concern, there may be an advantage in the cross-purchase using Holdco owned insurance
since the insurance proceeds will never be an asset of Opco and will therefore be less
exposed to Opco’s creditors, unless the Holdco or its owner have guaranteed Opco’s debts.
Option three, the share redemption method using Opco-owned insurance, may favour
A’s estate by:
1. minimizing tax payable by A and A’s estate after A’s death, and
2. increasing Holdco A’s capital dividend account for future use by the full amount of the
capital dividend received from Opco.
The balance will tilt away from the redemption solution if A had unused lifetime capital
gains exemption to offset the gain on A’s Holdco shares on death or it is expected that
the gain can be deferred for a considerable period of time by rolling the shares over to
A’s spouse.
49
50
51
52
Created by the 50% non-taxable portion of the capital gain realized on the sale of the Opco shares.
Same.
Created by Holdco A’s receipt of a tax-free capital dividend from Opco using the capital dividend account credit from Opco’s receipt of tax-free life insurance
proceeds. The intercorporate dividends retain their character as capital dividends originating in tax-free insurance proceeds provided that the paying corporation
elects to treat the dividend as a capital dividend. A payment debits the capital dividend account of a paying corporation and credits the capital dividend account
of the receiving corporation.
Created by Holdco B’s receipt of tax-free life insurance proceeds or a capital dividend originating in insurance proceeds.
Buy-sell agreements
Sun Life Financial
39/43
Appendix 1: Buy-sell planning with a surviving spouse—Put-call
and capital gains exemption
Where a spouse survives the deceased shareholder, additional planning alongside the buy-sell
structure may allow the spouse to utilize his or her capital gains exemption, in addition to any
capital gains exemption that the deceased shareholder may have claimed.
To accomplish this, the shares of the deceased shareholder must “vest indefeasibly” with
the spouse within 36 months of transfer.53 That is, the spouse must legitimately become
the owner of the shares without any pre-determined obligation to sell the shares to the
surviving shareholders.
One potential means to establish that the shares have vested indefeasibly is the so-called
“put-call” option. The deceased shareholder leaves shares to the spouse so that they vest
indefeasibly with the spouse. The spouse also enters into a put-call option before the shares
are transferred so that, if either the spouse of the deceased shareholder wants to sell (put) or
the surviving shareholders want to buy (call), the transaction must take place. The essential
condition is that the deceased shareholder, the shareholder’s estate or the spouse should not
be under an obligation to sell the shares before they are transferred to the spouse.54
Strictly speaking, as either the spouse or the surviving shareholders have to make a choice
to exercise the option, this does not constitute a previously determined obligation for
the spouse to sell. Therefore, the shares vest indefeasibly with the spouse. This approach
does, however, require the spouse to carry out the arrangements under the buy-sell if it is
to achieve its intended results and necessarily creates an element of uncertainty that the
spouse may not complete the put-call arrangement after the shares vest indefeasibly.
When the spouse puts the shares or the survivor shareholders call them, the spouse may
have an opportunity to shelter his or her capital gains on the transfer of the shares with any
existing capital gains exemption that is available.
Assume, as in the earlier examples, that the shares of the deceased shareholder have
a fair market value of $1,000,000 and an ACB and PUC of zero. Each of the deceased
shareholder and the spouse has at least $500,000 remaining in their $750,000 lifetime
capital gains exemption.
The shareholder leaves the shares to the shareholder’s spouse. Half are rolled over at the
shareholder’s adjusted cost base of $0 under the spousal rollover provision of the Income
Tax Act.55 The proceeds of disposition to the estate of the shareholder are $0, which
becomes the adjusted cost base of the shares to the spouse. The spouse subsequently
sells those shares to the surviving shareholder for $500,000, realizes a capital gain in that
amount and claims the capital gains exemption.
53
54
55
ITA s. 70(6). Note that, in 2003, the CRA withdrew without explanation its 1987 Interpretation Bulletin, IT-449R “Meaning of “vest indefeasibly,” but relocated it in a group
of archived bulletins, with a warning to use “with great caution.” Other interpretation bulletins continue to refer to IT-449R. When it was current, the bulletin stated:
“A property vests indefeasibly in a spouse or child when such a person obtains a right to absolute ownership of that property in such a manner that such right cannot
be defeated by any future event, even though that person may not be entitled to the immediate enjoyment of all the beneﬁts arising from that right” (para.1) “Where
the terms of the buy-sell agreement provide that it is compulsory for the executor of the taxpayer’s estate to sell and the other party to buy the shares, the shares will
not be considered to vest indefeasibly in the beneﬁciary. Where, however, the terms of the buy-sell agreement merely give the other party an option to acquire the
taxpayer’s shares which may or may not be exercised and the taxpayer’s executors transfer the shares to the beneﬁciary before the option is exercised, the shares will be
considered to vest indefeasibly in the beneﬁciary at the time of the transfer” (para. 8(d)).
See Parkes Estate, 86 DTC 1214 (T.C.C.), in which the shares did not vest indefeasibly in the spouse when the shareholder had entered into an agreement that required a
share transfer to surviving shareholders, and Estate of Philip Van Son v. The Queen, 90 DTC 6183 (F.C.T.D.), in which the buy-sell agreement created an obligation on the
survivor shareholders to purchase but did not create an obligation on the decedent or the estate to sell. In that case, the shares did vest indefeasibly.
ITA s. 70(6).
Buy-sell agreements
Sun Life Financial
40/43
The deceased shareholder’s legal representative elects to transfer the other half of the
shares to the spouse at their fair market value of $500,000, opting out of the spousal
rollover that would otherwise apply automatically.56 The deceased shareholder is deemed
to have disposed of those shares immediately before death at their fair market value
of $500,000, crystallizing a capital gain of $500,000 and a claim against the deceased
shareholder’s capital gains exemption.
No
put-call
A
(deceased)
$1,000,000
deemed
disposed at
FMV
1,000,000
0
1,000,000
Proceeds of disposition
ACB
Capital gain
Taxable capital gain (50%)
Capital gains deduction57
Capital gain subject to tax
Taxes payable (45% rate)
With a put-call
Spouse
A
(deceased)
$500,000 sold
$500,000
to survivor
deemed
at FMV
disposed
at FMV
500,000
500,000
0
0
500,000
500,000
Total
$1,000,000
1,000,000
0
1,000,000
500,000
(375,000)
125,000
250,000
(250,000)
0
250,000
(250,000)
0
500,000
(500,000)
0
56,250
0
0
0
The put-call arrangement eliminates the $56,250 of tax that would otherwise have
been payable.
56
57
The election to transfer a part of the property at fair market value is permitted under ITA s. 70(6.2).
Because taxable capital gains and allowable capital losses are calculated at 50% of the underlying reported capital gains and losses, the $750,000 lifetime capital gains
exemption is given effect by allowing a shareholder to claim a $375,000 capital gains deduction from taxable income. ITA s. 110.6(2.1) provides the capital gains deduction
for “qualiﬁed small business corporation shares” by cross-referencing the calculation of the deduction for “qualiﬁed farm property” in ITA s. 110.6(2). See f.n.1 for legislation
that implements the increase in the capital gains exemption to $750,000.
Buy-sell agreements
Sun Life Financial
41/43
Appendix 2: The “stop-loss” rules
An understanding of the “stop-loss” rules is critical to planning for a shareholders’ buy-sell using life
insurance. This appendix provides additional background and details relating to the stop-loss rules.
Prior to the introduction of the stop-loss rules on April 26, 1995, it was possible to
eliminate tax on the deemed disposition of shares by the deceased shareholder. This was
accomplished with a share redemption buy-sell funded by life insurance, as follows:
• The payment to the shareholder’s estate for the redemption of the shareholder’s shares
was deemed to be a dividend equal to the difference between the redemption proceeds
and the paid-up capital (PUC) of the shares. Where insurance to fund the buy-sell was
paid to the corporation following the death of a shareholder, the insurance amount was
credited to the corporation’s capital dividend account. It was possible to elect that the
deemed dividend paid on the redemption was a tax-free capital dividend. Therefore no
tax was payable by the estate on the redemption.
• The estate of the shareholder was deemed to receive the shares at fair market value.
For the purposes of determining the capital gain to the estate on the disposition of the
shares, and to avoid taxing the same amount as both a capital gain and a dividend, the
amount that the shareholder estate received for the shares was reduced to nil by the
amount that it received as a deemed dividend. The redemption therefore also created a
loss in the estate that could be carried back to offset the gain on the final tax return of
the deceased shareholder.58
The end result was no tax was payable by the deceased shareholder or the estate of the
deceased. Tax on the latent capital gain of the deceased shareholder would be payable only
when a subsequent owner disposed of the shares, provided the shares retained their value
at the time of the shareholder’s death.
The Department of Finance determined that this was an unwarranted deferral of the capital
gains tax. The government introduced legislation, applicable to transactions after April 26,
1995, to reduce the tax loss that could be claimed through the use of the share redemption
buy-sell method on the death of a shareholder.
Calculating the amount of loss “stopped”
It is the loss that is created by the redemption in the estate that is ground down or
“stopped” by these new rules. The amount of the loss that is “stopped” is calculated as:
The lesser of
1. The capital dividend received by the estate, and
2. The capital loss minus any taxable dividends received by the estate.
Minus 50% of the lesser of
1. The estate’s capital loss, and
2. The deceased’s capital gain from the deemed disposition on death.59
Essentially, the stop-loss rules allow the estate to carry back losses created by the redemption
only to the extent of the non-taxable portion of the capital gain on the disposition of the
shares. The end result is an increase of the tax on redemptions from zero to roughly half
or more of what the tax would be without a share redemption. It also means that use of
a capital dividend election in excess of this amount may be effectively “wasted”.
58
59
For details, see “Loss carryback” earlier in this paper in “Section II – Structuring the funded buy-sell” under “Introduction—Review of basic planning concepts”.
ITA s. 112(3.2) for loss on a share held by a trust, including a testamentary trust that administers the estate of a deceased shareholder.
Buy-sell agreements
Sun Life Financial
42/43
Grandfathering
Soon after the legislation was passed, the insurance industry and other interested parties
began to negotiate with the Department of Finance to correct some of the unintended
results of the legislation and to make the grandfathering rules relating to insurance or
buy-sells in place as of April 26, 1995 more fair. These grandfathering provisions apply to
shares that were owned on April 26, 1995 (or to shares received for those shares in certain
corporate reorganizations).60 Following is a high level overview of the grandfathering rules.
Grandfathered life insurance
If insurance was in place at April 26, 1995, and it can be demonstrated that one of the main
purposes of the insurance at that date was to redeem shares, then a subsequent redemption
at death will be grandfathered to the old rules. In addition, additional insurance purchased
by the corporation after April 26, 1995 for this purpose will also qualify for grandfathering.
The original policy may be replaced or converted and coverage may be increased.61 It will
be up to the taxpayer, if challenged, to demonstrate through documentation or otherwise
that one of the main purposes of the insurance at that time was to redeem shares.
Grandfathered buy-sell agreement
Grandfathering will also be available where shares are redeemed pursuant to an agreement
that was in place on April 26, 1995. This test is far more restrictive than the insurance
test. One of the biggest concerns is the CRA position that any amendment to this
agreement, subsequent to April 25, 1995, will cause the grandfathered agreement to lose its
grandfathered status.
One possible way around this concern is to draft a new and separate agreement to create
any necessary changes to the shareholder’s agreement. However, while this new agreement
might add new provisions, it must not in any way “cancel, modify or replace” the
provisions of the original agreement.
Making the necessary ongoing changes to an agreement (e.g., adding or replacing
shareholders) may require the loss of grandfathering protection. But the loss of
grandfathered status is irrevocable and should never be allowed to occur inadvertently. The
changes should always be undertaken carefully after first ascertaining that the agreement
is grandfathered and, if so, after weighing the benefits of the changes against the value of
grandfathered share redemptions in future.
60
61
The grandfathering rules appear in the coming-into-force provisions for amendments to s. 112(3) and s. 112(3.2) (the stop-loss rules) in the Income Tax Amendments Act,
1997 (Bill C-28), enacted as S.C. 1998, c. 19, ss. 131(11) and (12). The CRA published its interpretation of the rules in “Stop-Loss Provisions—Grandfathering,” CRA Technical
News No.12, February 11, 1998.
CRA Views 2005-0124311E5 (June 28, 2005).
Buy-sell agreements
Sun Life Financial
43/43