Insurance Financed Estate and Business Succession Planning Strategies

By: William F. Strain, FCA

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Introduction

Bill C-28 includes extensive amendments to the 'stop-loss' provisions found in subsections 112(3) to (7) of the Income Tax Act. These new rules were originally proposed in a "technical amendment" released by the Department of Finance on April 26, 1995. Although significant modifications of a relieving nature have been made to the original proposals, when enacted the amendments will generally take effect from April 26, 1995.

These amendments significantly impact insurance-based estate and business succession planning arrangements that were commonly used by many owners of private Canadian companies. This paper describes how such arrangements might be modified in light of the new rules and outlines several new strategies involving the tax-effective use of life insurance to fund income tax liabilities arising on death and buy-sell provisions of shareholders' agreements.

Background

Before amendment, the provisions of subsections 112(3) to (7) generally applied to corporations, either directly or as members of a partnership or beneficiaries of a trust. The basic thrust of the stop-loss rule was to reduce the amount of the loss that a corporation could otherwise claim from the disposition of a share by the amount of all non-taxable dividends received by the corporation on the share. Presumably the rationale for this rule was that tax relief should not be provided for a 'loss' that was, in fact, offset by amounts received as non-taxable dividends.

The amendments in Bill C-28 extend the application of the corporate provisions to individuals (including the estates of deceased individuals).

The loss from the disposition of a share that is capital property will now be reduced by:

"(a) where the taxpayer is an individual, the lesser of:

the total of all amounts each of which is a dividend received by the taxpayer on the share in respect of which an election was made under subsection 83(2) where subsection 83(2.1) does not deem the dividend to be a taxable dividend, and
the loss determined without reference to this subsection minus all taxable dividends received by the taxpayer on the share."

In general, where an individual suffers a loss on the disposition of a share, the amount of the loss otherwise determined will be reduced by the amount of all tax-free dividends received by the individual on the share. If, however, a capital dividend is recharacterized as a taxable dividend pursuant to the anti-avoidance rule in subsection 83(2.1), the stop-loss rule will not apply.

In addition, capital dividends will reduce an individual's capital loss on the disposition of a share only to the extent that the loss exceeds the total amount of taxable dividends received by the individual on the share. This provision recognizes that even in circumstances where dividends received by an individual might be viewed as the recovery of all or part of the cost of the individual's shares, it would not be appropriate to deny a loss on the disposition of the shares to the extent that the dividends were taxable.

The amendments in Bill C-28 also extend the application of the stop-loss rules to trusts and individual members of partnerships which receive capital dividends.

Special rules apply to the estate of an individual and spousal trusts.

In the case of an individual's estate, a capital loss realized on the disposition of a share by the estate during its first taxation year will be reduced only to the extent that the capital dividends received by the estate exceed

"1/4 of the lesser of

the loss determined without reference to this subsection (subsection 112(3.2), and
the individual's capital gain from the disposition of the share immediately before the individual's death…"."

Where a spousal trust disposes of a share after the death of the spouse, any capital loss arising from the disposition will be reduced only to the extent that the capital dividends received by the trust after the death of the spouse exceed

"1/4 of the lesser of

the loss from the disposition, determined without reference to subsection (3.2) and this subsection (subsection 112(3.3), and
the trust's capital gain from the disposition immediately before that time (i.e. the death of the spouse) of the share because of subsection 104(4)…"

These special provisions (the "25% solution") are intended to mitigate the potential impact of double taxation on death where capital property is owned by an individual or spousal trust through a holding company. The operation of these special rules is illustrated in the example on Appendix A.

The stop-loss rules included in subsections 112(3) to (7) generally do not apply where the shares in question were held for at least 365 days before the disposition and the taxpayer and non-arm's length persons did not own more than 5% of the shares of any class of the dividend paying corporation. The amendments in Bill C-28 also modify and clarify these 365 day and 5% threshold tests.

The amendments to subsections 112(3) to (7) generally apply to dispositions of shares that occur after April 26, 1995. However, there are extensive transitional rules to provide relief for dispositions of shares made pursuant to agreements in writing made before April 27, 1995 and for insurance financed share redemption arrangements that were in place on April 26, 1995. These 'grandfather rules' are included in Appendix G. However, the planning strategies described in this paper assume that grandfather relief is not available and consequently the amendments in Bill C-28 are fully applicable.

Insurance Financed Share Redemption to Pay Tax

Redeeming shares from the estate of a deceased shareholder with life insurance proceeds received by the corporation has been an extremely effective technique to fund the tax liability arising on death. The share redemption strategy provides the liquidity to pay the tax while at the same time substantially reducing the amount of tax payable on death. The amendments to the stop-loss rules will not significantly reduce the benefits that can be realized from using this tax planning strategy. However, the method of accomplishing the desired result may have to be modified.

Redemption Technique

The 25% Solution - Capital dividends received by an estate will not reduce the amount of a loss realized on the disposition of shares to the extent of

1/4 of the lesser of:

(a) of the deemed gain on death, and

(b) of the loss realized by the estate on the disposition of the shares (determined before application of the stop-loss rules).

As a result, the use of life insurance proceeds to redeem shares of a deceased from the estate within one year after death can still reduce the tax otherwise payable on death by at least 25%. By redeeming the shares it is also possible to convert the tax that would have been payable by the deceased on the deemed gain on death into tax on a taxable dividend deemed to be received by the estate on the share redemption. This generally results in an additional saving because the maximum effective tax rate on dividends (on average about 36% after the dividend tax credit) is lower than the effective rate on capital gains (on average about 40% of the capital gain).

Redeem All Shares - Generally all of the shares owned by the deceased immediately before death should be redeemed within the first taxation year of the estate (generally within 12 months after the date of death). Redeeming only a portion of the shares with the insurance proceeds will not produce a deductible loss sufficient to maximize the benefits of the insurance funding. Redeeming all the shares will also maximize the benefits of the lower effective tax rate applicable to dividends by completely eliminating the amount of the deemed gain on death and triggering taxable dividends in the estate.

Payment of Redemption Price - A portion of the redemption price is paid by the corporation with the cash proceeds received from the insurance policy. The balance is paid in the form of non-cash consideration, either new shares or possibly debt instruments such as debentures or promissory notes.

Use of Proceeds by Estate - The cash received by the estate is used to pay the tax on the taxable dividend that is triggered by the redemption of shares. The new shares and/or debt instruments may be distributed to the intended beneficiaries or sold to the surviving shareholders depending on the particular estate or business succession planning arrangements.

Income Tax Consequences

Deemed Gain on Death - On death, the deceased is deemed to realize a capital gain on the disposition of the shares equal to the excess of their fair market value immediately before death over their adjusted cost base (ACB) to the deceased.

Cost to Estate - The estate of the deceased is deemed to acquire the shares on death at a cost (ACB) equal to their fair market value immediately before death.

Disposition on Redemption - The excess of the redemption price of the shares (including both the cash and non-cash consideration) over their paid-up capital (PUC) is deemed to be a dividend received by the estate. For purposes of calculating the deemed dividend, the redemption price is considered to be equal to the total of the cash and the fair value of any other non-share consideration. However, where new shares are issued as part consideration on the redemption, only the PUC of the shares is taken into consideration for this purpose.

The directors of the company may fix the PUC of the new shares at an amount less than their fair value. In addition, the directors can reduce the PUC of the shares that are to be redeemed before the redemption takes place thereby increasing the amount of the deemed dividend on redemption. This discretionary ability to adjust the PUC of both the shares that are to be redeemed and the new shares that are issued as consideration on the redemption provides flexibility in establishing the desired amount of the deemed dividend that will be triggered on the redemption of the shares. The excess of the fair value of all consideration (including cash, shares and any other property) over the amount of the deemed dividend is considered to be proceeds of disposition of the shares for purposes of calculating the estate’s capital gain or loss.

Estate’s Capital Loss - The excess of the ACB of the shares to the estate (i.e., fair market value at the time of death) over their proceeds of disposition, calculated in the manner described above, is treated as a capital loss realized by the estate. The amount of such loss is reduced by capital dividends received by the estate but only to the extent that the amount received exceeds

1/4 of the lesser of:

(a) the deemed gain on death, and

(b) the loss otherwise determined.

Treatment of Deemed Dividend - To avoid any reduction in the amount of the capital loss available to the estate, the portion of the deemed dividend arising on the redemption that is treated as a tax-free capital dividend should not exceed the lesser of 25% of the deemed gain on death and 25% of the estate’s loss calculated before applying the stop-loss rules. In most cases, the deemed gain on death will be the lesser amount. The procedures required to treat only a portion of the deemed dividend as a capital dividend are cumbersome and may require some additional planning steps (see comments under Capital Dividend Election).

After deducting the amount of the tax-free capital dividend, the remaining amount of the deemed dividend is a taxable dividend in the hands of the estate.

Loss Carry Back - The amount of the "allowable capital loss" (75% of the loss) realized by the estate may be applied to offset the taxable capital gain of the deceased shareholder. Should the allowable capital loss exceed the deemed taxable capital gain, the excess can be applied to reduce other taxable income reportable by the deceased for the taxation year during which death occurred. However, no amount may be deducted in respect of the loss realized by the estate in computing the deceased shareholder's income for a taxation year preceding the year of death.

The Results

Some Examples - Two examples of the impact of the insurance financed share redemption strategy to pay the tax arising on death are set out on Appendix B and C.

For purposes of both examples, it is assumed that the effective rate of tax on capital gains is 40% (a top marginal rate of just over 53% applied to 75% of the gain) and the effective rate of tax on dividends is 36% (after deducting the dividend credit). These are representative of an average across Canada, but actual rates vary from province to province.

The first example (Appendix B) involves a simple situation where both the ACB and the PUC of the deceased’s shares is only a nominal amount. The fair market value of the shares immediately before death is $1,000.

The second example (Appendix C) is somewhat more complicated. It involves a situation where the ACB of the deceased’s shares is $700 and their PUC is $500. (The PUC of the shares will rarely exceed their ACB.) The fair market value immediately before death is also $1,000. This scenario reflects circumstances where the deceased shareholder may have purchased all or a portion of the shares from a previous owner and where more than a nominal amount of capital had originally been invested in the company.

Example 1 - The capital gain triggered by the deemed disposition of the shares immediately before the death of the shareholder is $1,000. Tax otherwise payable is $400.

By redeeming the deceased’s shares from the estate, in part for insurance proceeds received by the company on death and in part for the issue of new shares, the tax liability is reduced to $270, an overall reduction of 32.5%. The tax-free capital dividend of $250 accounts for 25% of the saving. The additional 7.5% is achieved by converting the effective rate of tax on the $750 taxable dividend from a capital gains tax rate of 40% to a dividend tax rate of 36%.

Assuming that the full amount of the insurance proceeds of $270 were eligible to be included in the capital dividend account (i.e. the ACB of the policy was nil at the time of death), $20 is available for distribution to other shareholders as a tax-free dividend (see comments under Capital Dividend Election).

The ACB of the new shares issued to the estate on the redemption is $730, an amount equal to their fair value.

Example 2 - In this example, the deemed gain on death is only $300 (FMV $1,000 less ACB $700). The taxable portion is $225 (75% of $300). The tax otherwise payable is $120.

However, the capital loss realized by the estate as a consequence of the share redemption is $500 (the redemption price of $1,000 less the deemed divided of $500). The deductible loss is $375 (75% of $500). The $375 loss completely eliminates the $225 taxable gain realized by the deceased on the deemed disposition of the shares and the balance of $150 is available to reduce other income in the deceased’s final tax return. The tax payable on the deceased’s other income is thus reduced by about $80.

The deemed dividend triggered on the redemption of shares is $500 (the excess of the redemption price of $1,000 over the PUC of the shares of $500). The maximum amount that can be treated as a capital dividend without reducing the loss is $75 (the lesser of 25% of the deemed gain on death of $300 and 25% of the estate’s loss otherwise determined of $500). Consequently, the estate must pay tax of $153 on a taxable dividend of $425 (36% x $425). After deducting the $80 tax recovery realized by applying the deductible capital loss against the deceased’s other income, the net tax payable as a result of the insurance financed redemption strategy is only $73. This is a reduction of $47 from the $120 of tax otherwise payable on the deemed gain, a savings of 39%.

In situations such as this, care should be taken to ensure that the loss realized by the estate can be fully absorbed against the deceased’s other income in the year of death. If the loss cannot be fully absorbed against income otherwise taxable at high rates, the PUC of the new shares issued as part consideration on the redemption could be reduced. Such a reduction would have the effect of reducing both the amount of the loss and the amount of the taxable dividend deemed to be received by the estate. This will avoid a situation where the estate pays tax on a taxable dividend with no offsetting tax recovery on the deceased’s final return.

If, on the other hand, income of the deceased in the year of death would still be subjected to tax at top rates, the PUC of the shares that are to be redeemed might be reduced before the redemption takes place. This would increase the amount of both the deemed dividend and the allowable capital loss on redemption. The additional tax payable by the estate on the increased amount of the dividend would be less than the additional tax recovered by applying the increased amount of the loss against the deceased’s other income, resulting in additional saving.

Joint/Last to Die Life Insurance Policies

In many cases, upon death a shareholder will transfer his or her shares in a family company to his or her surviving spouse. In these circumstances, the tax liability on the deemed gain will be triggered only at the time of the second death. An insurance policy which insures the lives of both the shareholder and his or her spouse with the proceeds payable at the time of the second death is ideally suited for this purpose. Such policies are significantly less costly than a separate policy for the same amount on either or the two lives. In addition, some joint/last to die policies offer the owner the option to claim a death benefit upon the first death, generally not to exceed the cash surrender value of the policy at that time. The amount of any optional death benefit claimed on the first death will reduce both the cash surrender value of the policy and the amount of death benefit payable on the second death.

This feature provides added flexibility in estate plans where liquidity may be required on the first death or where the plan involves the transfer of some shares to the second generation on the death of the shareholder and the transfer of the balance of the shares to the surviving spouse.

Potential Loss Denial

The Control Trap - A potential trap awaits the unwary planner of insurance financed share redemption applications. The capital loss that would otherwise be realized as a consequence of a redemption of shares is deemed to be nil where the corporation is "affiliated" with the shareholder immediately after the redemption.

Under the present law, the loss is denied where the shareholder or his or her spouse controlled the corporation immediately after the redemption. An amendment in Bill C-28 introduces a new affiliation concept. Under this new concept, an individual and his or her spouse are affiliated. In addition, a corporation is considered to be affiliated with

(a) a shareholder who controls the corporation "directly or indirectly in any manner whatever",

(b) each member of an "affiliated" group of persons which controls the corporation, and

(c) the spouse of any person described in (a) or (b).

As a practical matter, the introduction of the affiliation concept does not pose any greater threat of a denial of a loss on a redemption of shares from the deceased’s estate than already exists under the current rules.

For the purpose of the affiliation test, control means not only ‘de jure’ (legal) control, generally evidenced by the ownership of shares having sufficient voting control to elect the Board of Directors, but also control ‘de facto’ (in fact) of the corporation through the exercise of ‘direct or indirect’ influence. The power of an estate to exercise control of a corporation rests in the hands of the executors. Where the executors, in their own right, own sufficient shares to control the corporation, the question arises as to whether the estate also controls the company, even though the estate itself may not own any shares. In the past, Revenue Canada has indicated that the ownership of a majority of the voting shares by the executors of an estate in their personal capacity would not, in and of itself, be considered to result in the estate having control of the corporation. However, the Department’s position is being reconsidered and may be subject to change. Even where debt instruments are issued as part consideration on the redemption, Revenue Canada might argue that the estate can control the corporation ‘in fact’ by exercising its influence as a major creditor.

Avoiding the Control Trap - In most circumstances when planning for a redemption of shares from an estate, it should be possible to ensure that the estate is not affiliated with the corporation immediately after the redemption. However, where new shares are issued to the estate as part of the consideration for the redemption, care must be taken to ensure that the terms and conditions of the new shares do not put the estate in a position of controlling the corporation.

For example, the new shares in most cases should be non-voting or, if they do have voting rights, they should not have sufficient votes to control the corporation under any circumstances. The shares generally should not be redeemable at the option of the holder because this feature might be considered to give the holder the power to control by threatening to call the shares for redemption.

Debentures or promissory notes should be issued on the redemption only if the corporation clearly has the financial capacity to service the debt (both principal and interest) without encountering financial difficulty. If the existence of the debt puts the corporation into a precarious financial position, the creditors might be viewed as having enough ‘clout’ to control.

Family members (or their spouses) who hold a controlling interest in the corporation should generally not be executors of the estate for the reasons noted above in the comments under "The Control Trap".

It may be desirable for the shares that are to be redeemed on death to be owned through a special purpose holding company. After the death of the shareholder, the shares would be redeemed from the holding company in the manner described above.

The holding company would then be wound up and its assets distributed to the estate. The capital loss realized by the estate could not be denied because the holding company ceases to exist on liquidation and therefore cannot be affiliated with the estate immediately thereafter.

It may even be possible for the estate to transfer the shares to such a special purpose holding company after death and then wind up the company within the first taxation year of the estate. However, Revenue Canada may seek to apply GAAR in circumstances where the holding company is formed only to be liquidated shortly thereafter.

Capital Dividend Election

Full Amount of Dividend - To treat a dividend as a tax-free capital dividend, the corporation must file a prescribed election on or before the time the dividend becomes payable. An election can be made only in respect of the "full amount of the dividend". No part of the dividend is included in computing the income of the shareholder. However, if the full amount of the dividend, in respect of which the election was made, exceeds the balance in the capital dividend account, the corporation is subject to a penalty tax equal to ¾ of the excess under Part III of the Act.

Based on these rules, it does not seem to be possible to treat a dividend in part as a capital dividend and in part as a taxable dividend. For example, if shares are redeemed triggering a deemed dividend of $1,000, the full amount of the dividend (i.e., $1,000) is treated as a taxable dividend unless the corporation elects to treat the entire amount as non-taxable. If the capital dividend account is only $250, such an election would expose the corporation to the penalty tax on the excess of $750. However, there are solutions to this apparent problem.

The Solutions - Where an excessive election has been made, the corporation can avoid the penalty tax by filing yet another election to treat the amount of the excess as a separate taxable dividend. Such an election requires the concurrence of all the shareholders who received any part of the dividend.

As cumbersome as it may sound, the following procedures must therefore be adopted to treat only a portion of a dividend as a capital dividend with the remainder treated as a taxable dividend.

(a) the corporation files one election to treat the full amount of the dividend as a tax-free capital dividend ($1,000 in the above example), and

(b) the corporation (with the concurrence of the shareholders) files a second election to specify that part of the dividend should now be treated as a separate taxable dividend.

The ability to treat the excess of the deemed dividend on a redemption of shares over the balance in the capital dividend account may not solve the entire problem. In the first example (Appendix B), the balance in the capital dividend account before the redemption was $270 (an amount equal to the life insurance proceeds). The deemed dividend was $1,000 of which only $250 was to be treated as a capital dividend.

By following the procedures described above, the corporation could elect to treat the excess of the dividend over the balance in the CDA ($730) as a separate taxable dividend. However, this would still have left a capital dividend of $270; not the desired amount of $250. Consequently, $20 of the CDA would have been wasted.

To accomplish the desired result in this example, it is necessary to distribute the $20 to either other shareholders or as a dividend on a different class of shares before the redemption takes place. By so doing, the CDA is reduced to the desired amount of $250 at the time of the redemption.

The rules appear to be a totally unnecessary administrative complication and representations have been made to the Department of Finance to permit partial elections. Although Finance officials seem sympathetic to the problem, Bill C-28 does not include any amendments to remedy the situation.

However, Revenue Canada officials have indicated that, as an administrative practice, they will not require separate elections in circumstances where the corporation wishes to elect capital dividend treatment for only a portion of a dividend. Evidently, the department will not impose the Part III penalty tax where an election pursuant to subsection 83(2) is filed with a notation that the excess of the amount of the dividend over the balance in the capital dividend account is being treated as a separate taxable dividend.

While Revenue Canada's administrative concession is welcome, a statutory amendment is required so that there is clear legislative authority for corporations to make a partial capital dividend election.

Where all of the shares of a particular class are to be redeemed, another technique may be used to avoid the excessive election problem described above. Before redeeming the shares, the corporation could increase the paid-up capital of the shares by the desired amount of the capital dividend. The amount by which the paid-up capital is increased is deemed to be a dividend and an election under subsection 83(2) may be filed in respect of such deemed dividend. When the shares are redeemed, the excess of the redemption proceeds over the stepped-up paid-up capital will be treated as a separate taxable dividend.

Insurance Financed Buy/Sell on Death

In many cases before the introduction of the amendments to subsection 112(3), life insurance was used as the funding mechanism to redeem all of the shares owned by a deceased shareholder from the estate and thereby avoid the incidence of any tax on death. The following simple scenario illustrates the impact of such an insurance-financed share redemption.

Assume that A and B each own 50% of the shares of Opco. Opco is the beneficiary of insurance policies on the lives of the shareholders. After A's death the insurance proceeds received by Opco are used to redeem all of A's shares from the estate (within the first taxation year of the estate). Immediately before A's death the fair market value of his shares was $1,000 and the adjusted cost base and paid-up capital were only a nominal amount.

A's Position

FMV of Shares on Death $ 1,000
ACB Nil
Capital gain 1,000
Capital loss from estate (S.164(6)) (1,000)
Taxable capital gain Nil
Tax payable Nil
Estate's Position
Redemption price $ 1,000
Deemed dividend (capital dividend) (1,000)
Net proceeds Nil
ACB (1,000)
Capital loss (1,000)
Tax payable Nil

After A's shares have been redeemed, B becomes the sole shareholder of Opco. The ACB of B's shares remains unchanged. Had B purchased A's shares from the estate, the ACB of his shares would have increased by $1,000. The tax burden on the $1,000 gain has not been avoided but has been shifted to B and deferred until such time as B disposes (or is deemed to dispose) of the Opco shares.

It is important to remember that this complete "tax deferred rollover" on death can still be accomplished in the manner described above where the shareholder's shares qualify for grandfathered status.

While the new stop-loss rules will prevent the complete elimination of tax on death in many cases, life insurance remains an extremely attractive alternative to fund buy/sell provisions of shareholders' agreements. The following is a summary of selected techniques to maximize the tax advantages from life insurance funding.

Rollover and Redeem

Spousal Rollover on Death - If a deceased shareholder is survived by his or her spouse, the shares of the deceased may still be redeemed after death without any tax consequences. Upon death, the deceased transfers the shares to his or her spouse or to a spouse trust. No gain or loss is realized for tax purposes; the shares are deemed to have been disposed of by the deceased and acquired by the spouse or trust at their ACB.

Tax Free Redemption - After the rollover, the shares are redeemed from the spouse or trust with insurance proceeds received by the corporation upon the death of the deceased. The deemed dividend arising on the redemption is treated as a capital dividend and no tax is payable by the spouse or the trust.

Holding Company Avoids Vesting Problem - To qualify for a tax-deferred rollover, the shares must "vest indefeasibly in the spouse or the spouse trust" upon the transfer. If the shares are subject to a mandatory purchase by the surviving shareholders, this condition will not be satisfied.

The best way to avoid this vesting problem is for the shareholder to hold the shares of the operating company in a family holding company. The shareholders' agreement is then entered into between the holding company and the surviving shareholders. It provides for the redemption of the shares of the operating company held by the holding company on the shareholder's death. The shares of the holding company are not subject to the provisions of the shareholders' agreement. The shareholder is therefore free to transfer the holding company shares to his or her spouse (or to a spouse trust) on a tax-deferred basis.

When the shareholder dies, the shares of the operating company are redeemed from the holding company with the insurance proceeds received by the operating company as a consequence of the death of the shareholder. The deemed dividend arising on the redemption is elected to be a capital dividend received by the holding company. The holding company, in turn, redeems the shares now held by the spouse of the deceased shareholder (or the spouse trust). The deemed dividend on this redemption is also elected to be a tax-free capital dividend.

Puts and Calls Avoid Vesting Problem - Where a holding company is not used to own the shares that are subject to the buy/sell provisions of the shareholders' agreement, it is still possible to have the shares "vest indefeasibly in the spouse or spouse trust" before a sale takes place as long as the agreement is structured to permit such a transfer. If the surviving shareholders have a ‘call option’ on the shares and the spouse or trust has a ‘put option’, either party can force the purchase of the shares by the surviving shareholders but such sale does not become mandatory until the call or put option is exercised. This technique allows the shares to vest indefeasibly in the spouse or trust immediately after death, thus satisfying the criterion for a tax-deferred rollover.

Care in the drafting of the buy/sell provisions of the shareholders' agreement must be taken to ensure that the shares can vest indefeasibly in the spouse or trust and also to ensure that the sale of the shares is concluded in accordance with the wishes of the shareholders.

Transfer for Value Does Not Prevent Tax Deferred Rollover - The rollover and redeem technique can be used effectively in circumstances where the shareholder may not wish all, or even any, of the proceeds from the share redemption to be transferred to the surviving spouse or a spouse trust. In such circumstances, the shareholder and his or her spouse can enter into an agreement providing for the purchase of the shares by the spouse (or spouse trust) upon the death of the shareholder in exchange for a note.

For tax purposes, the transfer is treated as a tax deferred rollover even where fair value consideration is received by the transferor. The shares are redeemed from the spouse (or spouse trust) after the transfer has taken place and the redemption proceeds are used to pay off the note to the estate. The estate then distributes the proceeds among the various beneficiaries in accordance with the wishes of the deceased shareholder.

Joint/First to Die Life Insurance Policies - Insurance to fund the shareholders' agreement might be placed jointly on the lives of the shareholder and his or her spouse, with proceeds payable on the death of the first to die. If the spouse survives the shareholder, the shares can be rolled over to the spouse or a spouse trust and then redeemed as described above.

If the spouse predeceases the shareholder, the insurance proceeds received by the corporation on the death of the spouse can be used to redeem the shareholders' shares at that time on a tax-free basis. Alternatively the shareholder's shares might initially be redeemed but replaced with new shares (or a note or debenture) so that the shareholder retains his or her interest in the corporation.

A deemed dividend would be triggered on such a redemption but an election would be made to treat it as a tax-free dividend from the capital dividend account arising from the receipt of the insurance proceeds. The actual insurance monies could be invested in the business or held as a reserve fund to redeem the shareholders shares or pay off the note on death. The new shares (or note or debenture) would be acquired with an ACB equal to the paid up capital of the new shares (or fair value of the note or debenture). The deemed gain arising upon the death of the shareholder, will be only the excess (if any) of the fair value of the shares (or note or debenture) over their stepped-up ACB.

Insurance placed on the lives of the shareholder and his or her spouse with the proceeds payable on the first death will be considerably more costly than the same amount of insurance placed on either life separately. However, the assurance of a tax-free buyout on death may well justify the increased cost of the added protection.

The 25% Solution

Reduce Taxes on Death by 25% - After the death of the shareholder, life insurance proceeds received by the corporation are used to redeem the deceased's shares from the estate. However, only a portion of the deemed dividend arising on the redemption is elected to be treated as a capital dividend. The amount so elected is

1/4 of the lesser of:

(a) the deemed gain on death, and

(b) the loss realized by the estate.

This technique reduces the tax otherwise payable on the deemed gain arising on death by at least 25% and perhaps as much as 35% depending on the shareholder's province of residence.

Tax Free Dividends for Surviving Shareholders - The balance in the capital dividend account is retained by the corporation and used for the distribution of future corporate earnings to the surviving shareholders as tax-free dividends. Just because the cash for the share redemption may be derived from life insurance proceeds does not mean that the deemed dividend arising on the redemption need be elected to be a capital dividend.

Redeem and Cross-Purchase

Step-up ACB to Surviving Shareholders - After the death of the shareholder, the deceased's shares are redeemed from the estate. However, cash in the amount of only 25% of the deemed gain on death is distributed to the estate and treated as a tax-free capital dividend. The balance of the redemption price is satisfied by the issue of new shares (or demand debenture) to the estate. The remaining insurance proceeds are distributed to the surviving shareholders as a tax-free capital dividend and used by them to purchase the newly issued shares (or demand debenture) from the estate, generally without further tax consequences.

This technique results in a reduction in the tax liability to the deceased of about 25% and a step-up in the ACB of the shares to the surviving shareholders equal to about 75% of the deemed gain arising on death.

Defer Tax on Death With Stock Dividends

Using Stock Dividends to Reorganize Capital - Upon the death of a shareholder, it may be desirable to change the attributes of the shares owned by the deceased before they are distributed to the beneficiaries of the estate. A change in the terms and conditions of the shares can be accomplished in several different ways, including:

amending the articles of incorporation,
organizing the capital through an exchange of one class of shares for another, and
exercising rights attached to the shares to convert them into a different class.

However, there is another innovative, and perhaps simpler approach, to achieve the desired result that may also eliminate the tax otherwise payable on the deemed gain arising on death.

This technique which involves the payment of stock dividends is best described by way of example.

The Estate Plan - Assume that Father has frozen the value of his shares in an operating company (Opco) by transferring them to a holding company (Holdco) in exchange for fixed value preferred shares of Holdco. Son, who is active in the business, acquired all of the common shares of Holdco at the time of the freeze.

Upon this death, Father intends to transfer his shares to Daughter, who is not active in the business and who, may or may not continue to hold them as an investment. In this manner, Father believes that the value of his estate will be divided fairly between his two children.

The Problem With the Attributes of the Preferred Shares - The preferred shares held by Father have sufficient voting rights to enable Father to control Holdco throughout his lifetime. They are redeemable by the company and retractable by the holder at any time for an amount equal to the value of the Opco shares at the time of the freeze. This feature and various other terms and conditions attached to the shares are designed primarily to ensure that the freeze is effective for tax purposes.

After his death, Father wants his son, not his daughter, to control Holdco. In addition, he does not think his daughter should have the right to call for the redemption of the shares which could cause serious financial difficulties for Holdco.

Changing the Attributes of the Shares With Stock Dividends - To address Father’s concerns about continuing the voting rights and retractable feature attached to the preferred shares after his death, the following special condition is added. The redemption price for the preferred shares is reduced by the fair value of any shares that may be issued from time to time as a stock dividend on the preferred shares. A special class of shares having the attributes Father desires for the shares to be held by his daughter is authorized but no such shares are issued during Father’s lifetime.

After Father’s death, Holdco will pay a stock dividend on the preferred shares to the estate. The dividend will be paid by issuing to the estate special shares having a redemption price (and fair value) equal to the redemption price of the preferred shares. However, the paid-up capital of the special shares will be fixed at only a nominal amount.

The special shares received by the estate in payment of the stock dividend will be distributed to the daughter. The preferred shares will then be redeemed from the estate. However, because the redemption price of such shares is reduced by the value of the special shares issued as the stock dividend, the amount payable by Holdco on the redemption is only a nominal sum.

Tax Deferred on Death - The income tax consequences that flow from the transactions described above are as follows:

Father is deemed to have disposed of the preferred shares immediately before his death for proceeds equal to their fair market value at that time. The resulting capital gain is included in Father’s final tax return.
Father’s estate is deemed to acquire the preferred shares at an ACB equal to their fair market value immediately before Father’s death.
The amount of the stock dividend received by the estate is considered to be an amount equal to the paid-up capital of the special shares that were issued in payment of the stock dividend (i.e. only a nominal amount). Consequently, the stock dividend is substantially tax-free to the estate.
The ACB of the special shares to the estate is also deemed to be equal to their paid-up capital (i.e. only a nominal amount).
The transfer of the special shares from the estate to the daughter is deemed to be made for proceeds equal to the ACB of the special shares. Consequently, no taxable gain or loss is triggered at the time of transfer.
The proceeds received by the estate from the redemption of the preferred shares is only a nominal amount. Consequently, the estate realizes a capital loss for tax purposes equal to the excess of the ACB of the preferred shares (their fair market value immediately before death) over the proceeds of disposition (a nominal amount).
The stop-loss rules do not apply because no capital dividends were paid on the preferred shares.
The capital loss realized by the estate on the redemption of the preferred shares may be applied to offset the capital gain arising from the deemed disposition of the shares immediately before Father’s death. Consequently no tax is payable on the deemed gain arising on death.
In summary:
No tax is payable by Father on the gain triggered by the deemed disposition of the preferred shares immediately before death,
No tax is payable by the estate on the stock dividend, and
The ACB of the special shares to the daughter is equal to their paid-up capital (only a nominal amount).

Tax Free Redemption of Special Shares - As part of Father’s estate plan, insurance is placed on Father’s life to finance a redemption of all or a portion of the special shares after his death. After the special shares have been transferred to the daughter, the insurance proceeds received by Holdco are used to redeem the shares. An election is filed to treat the deemed dividend arising on the redemption as a tax-free capital dividend. As a result, no tax is payable by the daughter on the share redemption.

Will GAAR Apply? - The stock dividend technique as described above results in a tax-deferred rollover of the shares of the family holding company from Father to his children. The technique could be applied in a wide variety of other circumstances to avoid the tax otherwise payable on gains from the deemed disposition of shares at the time of death.

The overall scheme of the Income Tax Act is to impose tax on deemed gains at the time of death. The purpose of the general anti-avoidance rule (GAAR) in the Act is to provide Revenue Canada with the power to recharacterize a transaction (or a series of transactions) to deny the tax benefits that might flow from a strict interpretation of the statutory provisions in circumstances where the transaction has been entered into primarily to obtain the tax benefits.

Where a transaction results in a tax benefit, the taxpayer must be able to satisfy one of two tests to avoid the application of GAAR.

It must be "reasonable to consider" that the transaction was undertaken "primarily for bona fide purposes other than to obtain the tax benefit", or
It must be "reasonable to consider" that the transaction does "not result directly or indirectly in a misuse of the provisions of this Act or an abuse having regard to the provisions of this Act" read as a whole.

The second criterion outlined above, is the so-called ‘object and spirit’ test. It would seem highly unlikely that a court could be convinced that a series of transactions which resulted in a tax-deferred rollover (other than to a spouse) on death is in keeping with the object and spirit of the legislation. Consequently, to avoid the application of GAAR, it would be necessary to establish that the series of transactions involving the stock dividend and redemption of shares form the estate was undertaken primarily for non-tax reasons.

In the specific circumstances outlined in the example above, a reasonable argument could likely be made that the stock dividend technique was used primarily to change the attributes of the preferred shares on Father’s death. However, such an argument might be significantly weakened if, the special shares were to be redeemed shortly after being transferred to the daughter.

Structuring to Facilitate Flexible

Business Succession Planning Strategies

The shareholders of a private company may be best served by an ownership structure and a shareholders' agreement which provide a great deal of flexibility to conclude the succession sell arrangements in the most tax effective manner when they are triggered. However, flexibility comes at a price - complexity. In some situations, shareholders may opt for arrangements that are simple but may not take advantage of all possible tax benefits. In other situations, planning to realize all possible tax benefits may provide the selling shareholders with a significantly enhanced return at a lower cost to the purchasing shareholder than would otherwise be possible.

Simple Approach

The simple approach to business succession planning is depicted in Appendix D. Each of the shareholders directly owns his or her shares in the operating company (Opco). The shareholders and Opco enter into a shareholders' agreement providing, among other things, for the purchase and sale of shares upon the happening of specified future events such as disability, death, retirement or perhaps the receipt of an offer of purchase from a third party. The buy/sell arrangements are structured either as a cross-purchase by the continuing shareholders or as a purchase of shares for cancellation by Opco. The terms and conditions of the buy/sell provisions are mandated and the price is often fixed or calculated according to a specified formula.

Life insurance to fund the buy/sell provisions on death is usually owned by either the individual shareholders or Opco. The agreement ordinarily provides that the insurance proceeds will be used to conclude the purchase of the shares from the deceased shareholder's estate. If the shares are to be purchased by the corporation for cancellation, the agreement typically provides that any deemed dividend is to be treated as a tax-free capital dividend to the maximum possible extent. The agreement also generally provides that the price for the shares is to be determined without regard to the insurance proceeds that will be received on the death of a shareholder.

In the past, agreements structured in this fashion may have, at least implicitly, acknowledged various trade-offs. Where Opco uses life insurance proceeds to purchase shares from the deceased shareholder's estate, the estate realizes a tax-free capital dividend and has been able (until the stop-loss amendments in Bill C-28) to reduce or eliminate the tax otherwise payable by the deceased on the deemed gain on death through the loss carry-back provisions of subsection 164(6).

The trade-off from the perspective of the estate was that the redemption price is determined without regard to the insurance proceeds and the deceased shareholder has borne a portion of the cost of the insurance on his or her life.

From the perspective of the surviving shareholder, the value of the business acquired has been enhanced because the buyout has been accomplished with the insurance proceeds that were not taken into account in determining the price. On the other hand, the surviving shareholder inherits the tax liability of the deceased because the cost base of the surviving shareholder's interest in the business is not increased as a result of the buyout.

These trade-offs may or may not have been reasonable in the particular circumstances. However, frequently they are accepted by the parties as "rough" justice and perhaps as part of the price to be paid for simplicity.

The implementation of the amendments to the stop-loss provisions fundamentally alters the 'balance' of the costs and benefits among the shareholders. The estate of the deceased shareholder may no longer be able to eliminate tax on the deemed gain arising on death. However, if the price to be paid on a redemption continues to ignore the insurance proceeds and if the deceased shareholder continues to bear perhaps a disproportionate share of the cost of insurance to fund the buy/sell arrangement, the estate of the deceased shareholder will be relatively worse off.

The surviving shareholder may not be any better off, unless the capital dividend that would otherwise be wasted on the estate of the deceased shareholder is saved and used for the benefit of the surviving shareholder. Unless, the deemed capital dividend on a redemption of shares from the estate results in a loss that can be used to offset the deemed gain arising on death, it is wasted on the estate. All parties to a shareholders' agreement will be better served by flowing capital dividends to the estate of a deceased shareholder only to the extent that such dividends do not reduce the amount of the loss that may be applied against the deemed gain arising on death.

Because the stop-loss rule will tend to result in a shift of the benefits of the capital dividend account to the surviving shareholder, the parties to a shareholders' agreement can be expected to compensate by either increasing the buy-out price to include some recognition of the insurance proceeds or altering how the insurance costs are shared among the shareholders, or both. Hence, even the simple approach is likely to become more complex.

The simple approach usually involves the ownership by Opco of insurance policies on the lives of the shareholders. Premiums are paid with 'cheap' corporate dollars and proceeds are included directly in Opco's capital dividend account for distribution as tax-free capital dividends to either the estate of the deceased or the surviving shareholders. However, there are also risks involved with the ownership of the insurance policies by Opco, including:

The policies and ultimately, the insurance proceeds are exposed to creditors of the business,
Increasing cash values in the policies will likely increase the value of Opco's shares and thus increase the tax liability on the deemed gain arising on death,
Increasing cash values in the policies could also disqualify the shares of the company for purposes of the $500,000 capital gains exemption and perhaps trigger adverse tax consequences for the shareholders from the application of the corporate attribution rules, and
Where the shareholders are not dealing at arm's length, Revenue Canada may not accept a price determined without regard to the insurance proceeds as 'fair market value'.

Adding 'Bells and Whistles'

Various 'bells and whistles' are added to the simple approach to business succession plans where the shareholders are not prepared to accept all of the inherent trade-offs or risks involved. Examples of more complex arrangements (see Appendix E) include the following:

Shareholders frequently wish to own their shares in Opco through family holding companies. A shareholder has much more tax planning flexibility concerning the mix of salary and dividend compensation and income splitting arrangements with family members where the shares of the operating company are owned by a family holding company. In addition, the holding company can be effectively used to "creditor proof" assets of the business. Where holding companies are used, the shareholders' agreements usually involve the holding companies, the operating company and the individual shareholders.
To take advantage of the $500,000 capital gains exemption, a shareholder must sell shares of Opco to other shareholders - a sale back to Opco does not qualify. Consequently the business succession plan may involve the creation of a special class of shares for purposes of isolating the potential capital gains exemption and/or a hybrid buy/sell arrangement where some shares are purchased from the deceased's estate by the surviving shareholders and some shares are redeemed or repurchased by Opco.
The shareholders may wish to adjust the purchase price of shares to take into account the tax benefits that flow from the use of life insurance proceeds to redeem shares from the estate of a deceased shareholder.
The shareholders may wish to share in the insurance funding costs in proportions that differ from their respective shareholdings in Opco. This may involve the ownership of policies by their holding companies on a criss-cross basis, funding the policies on a full or partial cost recovery basis or the shareholders entering into shared ownership arrangements with Opco.
The ownership of the insurance policies might be moved up into a holding company or into the shareholders' personal holding companies to shield the policies from exposure to the business creditors. The beneficiaries of policies owned by such holding companies may be designated as the holding company or the operating company. If the holding company is the designated beneficiary, the plan may also involve an amalgamation of the holding company and the operating company after the death of a shareholder. The amalgamation permits the capital dividend account to flow through and be used for the redemption of shares of the amalgamated company from the estate of the deceased.

New bells and whistles will have to be added to shareholders' agreements and succession plans to implement the planning strategies outlined above in response to the introduction of the amendments to the stop-loss rules. Examples of the modifications that may be required include the following.

Puts and Calls - If shares owned by a deceased shareholder are first rolled over to a surviving spouse and then purchased by either Opco or the surviving shareholders, the shareholders' agreement cannot mandate the purchase. If the purchase of shares is triggered on the death of a shareholder, the ownership of the shares cannot 'vest indefeasibly' in the spouse or spousal trust because they are subject to a binding agreement requiring their transfer to another party.

As described above, the best and probably the simplest way to avoid the vesting problem is for the shareholder to own the shares of the operating company through a holding company. The shareholders' agreement is entered into between the holding company and the surviving shareholders. Because the shares of the holding company are not subject to the buy/sell provisions of the shareholders' agreement, they can be transferred to the shareholders' spouse (or a spousal trust) without restriction.

However, where the shareholder owns the shares of the operating company directly, the desired result can also be achieved through the use of "puts" and "calls" in the shareholders' agreement. The first requirement is to ensure that the shareholders' agreement is binding on the shareholders, their heirs and assigns, including surviving spouses or trusts established for their benefit. The agreement confers on the estate (and surviving spouse or trust) the right to "put" the shares to the surviving shareholders or Opco. The agreement also confers on the surviving shareholders and Opco the right to "call" the shares owned by the deceased from the spouse or trust.

Time limits, priorities and various other terms and conditions relating to the puts and calls should also be incorporated into the agreement. Using puts and calls in this fashion will permit ownership of the shares to vest indefeasibly in the surviving spouse, because a sale is not binding until either a put or a call is exercised. The transfer of shares pursuant to the terms of the agreement is also assured because either the vendor or purchaser can force the transfer by exercising their option.

Redemption Before Death - If joint/first insurance is used as the funding instrument, the shareholders' agreement must provide the mechanics for either a redemption of the shareholder's shares before death or an exchange of shares to step-up the paid-up capital and cost basis of the shareholder's interest in Opco. The agreement should also specify how the insurance proceeds are to be used until such time as the shareholder is bought out.

25% Solution - The shareholders' agreement should specify the extent to which a capital dividend will be elected in connection with a deemed dividend arising on the redemption of shares from a deceased shareholder. Such provision might need to be relatively complex to ensure that the capital dividend account is not wasted on the estate.

Redeem and Cross-Purchase - If the shares of a deceased shareholder are to be redeemed in part for new shares (or debentures), the shareholders' agreement should so specify. In addition, the capital structure of Opco may have to be modified to ensure that Opco has the appropriate class of shares authorized for the purpose.

Ultra Flex Structure

The introduction of the amended stop-loss rules not only makes business succession planning more complex but also heightens the need for flexibility in structuring the arrangements.

An "ultra-flex" structure for business succession planning is depicted on Appendix F. This structure provides a great deal of flexibility to conclude a purchase and sale of shares to the maximum advantage of both vendor and purchaser. The structure has also been designed to avoid many of the risks and exposures involved with corporate ownership of life insurance.

The most important features of this 'ultra-flex' structure are as follows:

InsureCo - InsureCo is established as a corporation to own the insurance policies on the lives of the shareholders. InsureCo is also designated as the beneficiary under the policies.

The policies owned by InsureCo are not exposed to the creditors of Opco. In addition, after the death of a shareholder, the insurance proceeds received by InsureCo are not exposed to the creditors of Opco. If shares of Opco are to be redeemed from the estate of a deceased shareholder, InsureCo and Opco can be amalgamated after the death of the shareholder to make the capital dividend account available for deemed dividends to the estate on the redemption of shares of the amalgamated company.

InsureCo holds special shares in Opco and/or the personal holding companies of the shareholders. This provides a great deal of flexibility for the shareholders to share in the insurance costs. Dividends from Opco and/or the shareholders' holding companies can be paid on a tax-free basis to InsureCo to provide funds for the payment of premium deposits.

Survivor Trust - Each of the shareholders is a beneficiary of the trust during his or her lifetime. However, the interest of a shareholder in the trust expires upon his or her death without any value. Consequently, neither the value of the insurance policies nor the insurance proceeds on death are included in the value of the Opco shares or the value of the holding company shares of the deceased shareholder.

After the death of a shareholder, the surviving shareholder(s) retain the ownership interests in the insurance policies on their lives.

Appendix A

Illustration of the Potential Double Tax Problem

B owns all of the shares of Holdco. Holdco owns all the shares of Opco. Holdco and Opco are both Canadian-controlled private corporations. The details of the shareholdings are as follows:

Holdco shares owned by B
Adjusted Cost Base and Paid-up Capital Nominal
Fair Market Value $ 1,000
Opco shares owned by Holdco
Adjusted Cost Base and Paid-up Capital Nominal
Fair Market Value $ 1,000

B dies, triggering a capital gain of $1,000 on the deemed disposition of shares for proceeds equal to fair market value immediately before death. In order to pay the income taxes arising on death and to settle the estate, Holdco sells the shares of Opco for $1,000. Holdco is then wound-up and the net proceeds, after income tax on the capital gain realized on the sale, are distributed to the estate.

Holdco's Position
Capital Gain $ 1,000
Taxable Portion 750
Federal and Provincial Tax (40% basic tax plus 6-2/3% additional tax
on investment income $ 350
Available for Winding-up Distribution

capital dividend $ 250
taxable dividend (including dividend refund of $200, i.e., $1 for

every $3 of taxable dividends paid) 600
$ 850

Net Taxes Paid by Holdco $ 150
Estate Position
With 25% Without 25%
Solution Solution
Capital Dividend $ 250 $ 250
Taxable Dividend $ 600 $ 600
Federal and Provincial Tax Payable by
Estate (37.5% after dividend tax credit) $ 225 $ 225
Disposition of Holdco Shares
Proceeds Nil Nil
ACB $ 1,000 $ 1,000
Capital Loss $ 1,000 A $ 1,000
Reduction - Capital dividend 250 (250)
Less - 1/4 of lesser of A & B (250) N/A
Net Loss Available $ 1,000 $ 750

B's Position
Deemed Capital Gain $ 1,000 B $ 1,000
Loss Offset (subsection 164(6)) (1,000) (750)
Net Capital Gain Nil 250
Taxable Portion Nil 188
Federal and Provincial Tax Payable by Deceased (50%) $ Nil $ 94
Total Combined Tax Payable $ 375 $ 469
Effective Tax Rate on Taxable Capital Gain 50% 62.5%
continued...
Appendix A
(continued)

If Holdco had sold the shares of Opco for $1,000 during B's lifetime and had then wound-up and distributed the after-tax proceeds to B during his lifetime, the combined federal and provincial taxes payable would have been $375.

If B had owned the shares of Opco directly, instead of through a holding company, tax of approximately $375 would have been payable on the capital gain of $1,000 triggered by the deemed disposition of the Opco shares immediately before B's death. No taxable gain or loss would have been realized by the estate on a subsequent sale of the Opco shares for proceeds of $1,000.

As this example illustrates, the stop-loss rules without the 25% solution would result in a substantial element of double taxation on death in many situations. The combination of the integration provisions and the carry-back of capital losses on death permitted by subsection 164(6) were intended to provide relief from the imposition of double tax in these very circumstances.

Appendix B

Example 1

Deceased’s Position
FMV of Shares on Death	$1,000
ACB	Nil
Capital Gain	$1,000
Taxable Portion (75%)	$750
Tax Otherwise Payable ($400)
Allowable Capital Loss from Estate	(750)
Taxable Capital Gain	Nil
Estate’s Position
Redemption Price
Insurance Proceeds	$270
New Shares (PUC)	730 $1,000
Deemed Dividends
Capital Dividend	$250
Taxable Dividend	750 ($1,000)
Net Proceeds	Nil
ACB	$1,000
Capital Loss	($1,000)
Reduction for Capital Dividends
Capital Dividend	$250
Deduct 1/4 of the lesser of	(250) Nil
capital loss ($1,000)
deemed gain ($1,000)
Net Capital Loss	($1,000)
Allowable Portion (75%)	($750)
Tax on Taxable Dividend (36% x $750)	$270

Example 2 Appendix C

Deceased’s Position
FMV of Shares on Death	$1,000
ACB (PUC = $500)	700
Capital Gain	$300
Taxable Portion (75%)	$225
Tax Otherwise Payable ($120)
Allowable Capital Loss from Estate	(375)
Loss Available to Offset Other Income	(150)
Tax Recovery	$80
Estate’s Position
Redemption Price
Insurance Proceeds	$75
New Shares (PUC)	925 $1,000
Deemed Dividends
Capital Dividend	$75
Taxable Dividend	425 ($500)
Net Proceeds	$500
ACB	($1,000)
Capital Loss	($500)
Reduction for Capital Dividends
Capital Dividend	$75
deduct 1/4 of the lesser of
Capital loss ($500)
deemed gain ($300)
(75)	Nil
Net Capital Loss	($500)
Allowable Portion (75%)	($375)
Tax on Taxable Dividend (36% x $425)	$153
Tax Recovery by Deceased	(80)
Net Tax Payable	$73

Grandfather Rules

The amendments to the stop-loss provisions in subsections 112(3) to (7) generally apply

"To dispositions that occur after April 26, 1996, other than

a disposition that occurs pursuant to an agreement in writing made before April 27, 1995;
a disposition of a share of the capital stock of a corporation that is made to the corporation i

on April 26, 1995 the share was owned by an individual (other than a trust) or by a particular trust under which an individual (other than a trust) was a beneficiary,
on April 26, 1995 a corporation, or a partnership of which a corporation is a member, was a beneficiary of a life insurance policy that insured the life of the individual or the individual's spouse,
it was reasonable to conclude on April 26, 1995 that a main purpose of the life insurance policy was to fund, directly or indirectly, in whole or in part, a redemption, acquisition or cancellation of the share by the corporation that issued the share, and
the disposition is made by

the individual or the individual's spouse,
the estate of the individual or of the individual's spouse within the estate's first taxation year,
the particular trust where it is a trust described in paragraph 104(4)(a) or (a.1) of the Act in respect of a spouse, the spouse is the beneficiary referred to in subparagraph (i) and the disposition occurs before the end of the trust's third taxation year that begins after the spouse's death, or
a trust described in paragraph 73(1)(c) of the Act created by the individual in respect of the individual's spouse, or a trust described in paragraph 70(6)(b) of the Act created by the individual's will in respect of the individual's spouse, before the end of the trust's third taxation year that begins after the spouse's death;
a disposition of a share of the capital stock of a corporation owned by an individual on April 26, 1995 that was made by the individual's estate before 1997;

a disposition of a share of the capital stock of a corporation owned by an estate on April 26, 1995, the first taxation year of which ended after that day, that was made by the estate before 1997; or
a disposition of a share of the capital stock of a corporation owned by an individual on April 26, 1995 where the individual is a trust described in paragraph 104(4)(a) or (a.1) of the Act in respect of a spouse, that was made by the trust after the spouse's death and before 1997."

Endnotes

At the time of writing, Bill C-28 has been passed by the House of Commons and is currently at the second reading stage in the Senate.
RSC 1985, C.1 (5th Supp.), as amended (hereinafter referred to as the "Act"). Unless otherwise stated, all statutory references are to the Act.

Canada Department of Finance, Draft Amendments to the Income Tax Act, the Income Tax Application Rules, the Canada Pension Plan, the Children's Special Allowances Act, the Customs Act, the Old Age Security Act, the Unemployment Insurance Act and a related Act, April 26, 1995.

Paragraph 112(3)(a), as amended.
See subsections 112(3.2) to (3.32), as amended.
Subparagraph 112(3.2)(a)(iii), as amended.
Subparagraph 112(3.3)(a)(iii), as amended.
See subsections 112(3.01), (3.11), (3.31), (3.32), (4.01), (4.11), (4.21), (4.22) and (5.21) and Clauses 112(3.2(a)(ii)(C) and (3.3)(a)(ii)(C).
Clause 131(11) of Bill C-28.
Supra, footnote 6.
See paragraph 70(5)(a).
Paragraph 70(5)(b).
Subsection 84(3).
Subsection 84(5).
Paragraph (j) of the definition "Proceeds of Disposition in section 54 provides that the proceeds of disposition do not include any amount deemed to be received as a dividend pursuant to subsection 84(3).
Supra footnote 6.
Paragraph 164(6)(c), as amended.
Subsection 111(2).
Paragraph 164(6)(f).
A corporation's capital dividend account (as defined in subsection 89(1)) includes inter alia the excess of the proceeds of a life insurance policy of which the corporation was a beneficiary in consequence of the death of any person over the adjusted cost basis of the policy (within the meaning of subsection 148(9)).
Subsection 40(3.6), as amended.
Subsection 85(4).
Section 251.1 as amended.
See question 42 "Revenue Canada Round Table," Report of Proceedings of the Forty-third Tax Conference, 1991 Conference Report (Toronto, Canadian Tax Foundation, 1992), 50:25. The Department was of the view that control of a corporation by a deceased taxpayer's legal representative, in a personal capacity, does not, by itself constitute control of the corporation by the estate for the purposes of subsection 85(4). In a subsequent letter, Revenue Canada document 5-943152, June 23, 1995, the Department stated that this position would also apply for the purposes of determining whether an estate and a corporation are "affiliated persons" for purposes of the application of subsection 40(3.6). However, the Department also cautioned that this position is currently under review. At the time of writing of this paper, Revenue Canada has not concluded its review and continues to apply the position as described above.

Subsection 245(2).
Subsection 83(2).
Subsection 184(2).
Subsection 184(3).
Subsection 84(1).
Subsection 70(6).
Ibid.
Supra footnote 6.
See section 86.
See section 51.
Supra footnote 11.
Supra footnote 12.
Definition of "amount" in subsection 248(1).
Subsection 52(3).
Subsection 107(2).
Supra footnote 17.
Supra footnote 25.
'Cheap', from the perspective that funds have not been distributed by the corporation to the shareholders in the form of additional compensation or dividends to enable them to pay the premiums. Such distributions would result in additional tax payable by the shareholders.
Subsection 70(5.3).
See definition of "qualified small business corporation share" in subsection 110.6(1).