Structuring life insured buy-sell agreements with the intent of maximizing the tax benefits to both the deceased and surviving shareholders can be “tricky” to say the least. There are a number of competing tax considerations which can arise including:
- Structuring the agreement to permit the deceased shareholder to access his or her lifetime capital gains exemption to reduce capital gains taxes on the shares in the year of death
- Having arrangements in place to allow the deceased’s shares to “vest indefeasibly” with the surviving spouse or a spousal trust in order to benefit from the spousal rollover on death
- Providing the surviving shareholders with a “bump” in the cost base of their interest in the company as part of the purchase and sale transaction
- Minimizing the impact of “stop-loss” rules relating to capital losses arising on the redemption of the deceased’s shares held by his or her estate
Another tax issue can arise where the deceased owns operating company (Opco) shares through a holding company (Holdco) and those shares are to be redeemed by Opco using funds received from corporate-owned life insurance. In circumstances where there is a deficiency in the life insurance funding (or the policy’s adjusted cost basis reduces the credit to Opco’s capital dividend account arising from the receipt of the insurance proceeds), part of the redemption proceeds will be treated as a taxable dividend to Holdco. While this dividend would normally qualify as a tax-free intercorporate dividend, the potential application of subsection 55(2) needs to be considered. Subsection 55(2) is an “anti-avoidance” rule designed to prevent the conversion of capital gains that would otherwise arise on the disposition of shares into a tax-free intercorporate dividend in certain circumstances. Where subsection 55(2) applies, the dividend will be deemed to be a capital gain. This result can be avoided if one of the exceptions in subsection 55(3) apply to the transaction or there is sufficient “safe income on hand” (essentially taxed retained earnings) attributable to the shares being redeemed.
The following example illustrates the concern:
A and B own 100% of the shares in A Corporation (ACo) and B Corporation (BCo), respectively, each of which, in turn, owns 50% of the shares in an operating corporation (Opco). The shares owned by ACo and BCo have a nil adjusted cost base and paid-up capital. Pursuant to the terms of a shareholders’ agreement between ACo and BCo, Opco owns life insurance policies on A and B’s lives, each in the amount of $1 million; the terms of the shareholders’ agreement provide that, on the death of either A or B, Opco is to use the proceeds of the life insurance policy to fund all or a portion of a redemption or purchase for cancellation of the Opco shares held by the deceased shareholder’s holding company.
B dies at which time the 50% of the shares of Opco held by BCo have a fair market value of $1.3 million. Opco receives a death benefit of $1 million from the life insurance policy on B’s life; the life insurance policy had a nil adjusted cost basis such that the full amount of the death benefit is added to Opco’s capital dividend account.
As required under the terms of the shareholders’ agreement, Opco purchases for cancellation all of its shares owned by BCo for their fair market value of $1.3 million; $300,000 worth of shares are first purchased for cancellation resulting in a deemed taxable dividend; the remaining $1 million worth of shares are then purchased for cancellation using the life insurance proceeds, and Opco elects under subsection 83(2) for the full amount of the resulting deemed dividend to be a tax-free capital dividend. Pursuant to paragraph (j) of the definition in section 54, the proceeds of disposition for those shares do not include the deemed dividend arising on the redemption, resulting in the proceeds being significantly less than the fair market value of those shares.
A and B are unrelated to each other for the purpose of section 55. The $300,000 taxable dividend exceeds the safe income on hand for BCo’s shares in Opco.
In these circumstances, because A and B deal with each other at arm’s length, it would appear that the any dividend received by BCo on the redemption of Opco will be subject to subsection 55(2) and will not be excepted by paragraph 55(3)(a) as one or more the exceptions in subparagraphs 55(3)(a)(i)-(iv) will come into play As a result, a capital gain will arise on the purchase for cancellation of the first $300,000 worth of BCo’s shares. This interpretation was confirmed in the Department of Finance 1977 Technical Notes relating to subsection 55(3) and appears to continue to be the view of the Canada Revenue Agency.
The potential application of subsection 55(2) therefore needs to be kept in mind when the buy-sell agreement contemplates Opco redeeming Holdco’s shares on the death of Holdco’s shareholder, and a taxable dividend arises from the redemption. This conversion of a tax-free intercorporate dividend into a capital gain can at least be mitigated by ensuring there is sufficient life insurance coverage (and a corresponding credit to Opco’s capital dividend account) to minimize the taxable dividend that would otherwise arise on the redemption of Holdco’s shares.
Kevin is the author of a new guide on buy-sell agreements entitled “The Essential Canadian Guide to Insured Buy-Sells” available on Amazon.ca and Kindle.