As we are all aware, a consequence of the covid-19 pandemic is the current "down market" in which we find ourselves. In light of these times, we have been receiving a number of questions relating to tax planning opportunities to take advantage of the current markets. We wanted to address some of your questions and will continue to send these updates as they arise.
If you would like to further discuss planning opportunities, please do not hesitate to contact one of our tax and estate planning lawyers.
Estate Freeze or Re-Freeze
What is an estate freeze?
A freeze is a common tax planning strategy whereby the owner of an asset can "freeze" the value of that asset at its current value (thereby limiting the tax liability on that asset at death) and shift the future growth (and future taxation on that growth) to other family members. A trust is often used to control access to the asset and to provide flexibility in distributions of the future growth of the asset and any income earned thereon. An estate freeze is most commonly used to freeze the value of shares of a business or real estate, but can also be implemented in respect of other asset classes. An estate freeze is particularly attractive in a down market because it provides the opportunity to limit the tax liability of an asset on death at a low value, and to shift more of the future growth of an asset to future generations.
If I did an estate freeze already, can I take advantage of the current lower values?
For estate freezes that have already occurred, it may be possible to conduct a "re-freeze" to take advantage of the opportunity to freeze at a lower value and to further shift future growth to your family members.
My assets have lost value - are there ways that I can take advantage of these losses?
There may be opportunities to use the decline in value of certain assets to offset capital gains. For example, public securities that have declined in value can be sold on the open market, or assets that have gone down in value may be sold to family members. The resulting loss may be applied against capital gains realized in the past 3 years (and potentially net you a refund of tax previously paid), or applied against future capital gains to reduce your tax owing.
If your loss is in a corporation, you may wish to pay out previously realized capital gains as tax-free capital dividends before you trigger a loss.
If you intend to gift or sell your assets to your spouse or common-law partner, or repurchase the assets yourself, be aware that there are complex tax rules that may apply to deny or delay your realization of the capital loss (known as the "stop-loss" rules). These stop-loss rules may also apply if you are selling the asset to a corporation.
There may also be planning opportunities if you have losses in one corporation in your corporate group and gains in another.
Prescribed Rate Loan Trust Planning
What is prescribed rate loan trust planning?
This strategy involves a high income-earning individual loaning funds to a trust, the beneficiaries of which are typically the individual's children with little or no income and therefore lower tax rates than the lender.
To avoid tax attribution rules (which would cause income earned on the loaned funds to be taxed in the lender's hands), the loan must be made at the “prescribed rate” that is set by Canada Revenue Agency every three months. The current prescribed rate is 2% but it is poised to drop to 1% in July.
This strategy provides income splitting opportunities between the high-income earning lender and the lower-earning beneficiaries, as any interest income earned in the trust in excess of the prescribed rate can be allocated among trust beneficiaries with lower tax rates. The recipients must report and pay tax on income distributed to them. The lender must report and pay tax on the prescribed rate of interest from the trust each year.
This planning is particularly attractive in a down market because the interest rate in place at the time that the loan is made applies for the life of the trust (which is typically 21 years). So planning is implemented while the interest rate is at the anticipated 1%, this rate continues to apply throughout the life of the trust, even if the prescribed rate increases.
As a simple example of how this planning works, assume parent has a $200,000 portfolio with an annual rate of return of 4.0%. Assuming a marginal tax rate of 54%, this simple investment structure earns parent $8,000 of investment income on which parent pays $4,320 in tax.
Now instead assume parent loans the $200,000 to a discretionary family trust that invests in that same portfolio for the benefit of minor children. Assume the children pay no tax as the taxable income they receive is less than their basic personal exemption. The trust executes a simple promissory note to parent for $200,000, which is payable upon demand at the new prescribed rate of 1% with interest paid annually. Interest paid by the trust is deductible assuming the borrowed funds are used for the purpose of earning income. So now the trust makes $8,000 and can deduct $2,000. Parent pays $1,080 in tax on the $2,000 of interest income instead of the $4,320 above. Greater savings are possible the longer the loan remains in place and the higher the yield on the investment.
Where income splitting strategies are contemplated, the "tax on split income" rules should also be considered, which can apply to impose the highest marginal rate on certain income (regardless of the recipient's own tax rate).
If I already made a prescribed rate trust loan, can I take advantage of the lower rate?
Those of you who already have these structures in place at higher interest rates and want to take advantage of the lower rate need to undertake any such planning carefully as there are only limited options for refinancing within the tax legislation and these transactions tend to come under a high amount of scrutiny by CRA. A member of our tax team would be happy to discuss the available options.