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FROM: JAN-FEB 2010 ISSUE | BY MANU KAKKAR
The concept of an estate freeze is simple. It usually applies to private company shares but can apply to partnership interests. The basic freeze transaction works like this: Assume Alexander, a widower, owns common shares of XCO, a private Canadian corporation. The shares of XCO are worth $1 million. Common shares can fluctuate in value and Alexander does not want to pay more tax than he has to, either when he actually sells these shares or when deemed to sell these shares upon his death. Alexander also realizes that he has accumulated enough personal wealth that he does not need to benefit from any future growth in XCO.
Alexander will then, on a tax-deferred basis, transfer his common or growth shares of XCO to the treasury stock of the corporation and take back “freeze” or preferred shares with a redemption amount of $1 million. The CRA insists upon a retraction feature to ensure that the preferred shares retain their value. Retraction feature means that the holder of the shares has the option to sell the shares back to the corporation.
From a corporate law perspective, the issued stock of any corporation must have at least one class of common shares. Typically, Alexander’s children, or a family trust where his child is one of the beneficiaries, would subscribe for common shares of XCO for a nominal amount. The common shares would be worth a nominal amount because the remaining value of XCO would be in the freeze shares held by Alexander. The estate freeze effectively permits a deferral of income tax to the next generation, as well as an actual tax savings.
This example best illustrates the concept of a re-freeze transaction: One year after Alexander implemented the initial freeze transaction, the value of XCO plummets to $500,000 due to the economic recession, so his preferred shares are now overvalued by $500,000. Alexander can implement a re-freeze transaction whereby he exchanges his old preferred shares for new preferred shares with a redemption amount of $500,000. No shareholder benefit shall arise because the decline in value of XCO which necessitated the refreeze transaction was not caused by a strip of the corporate surplus, but rather, a decline in market value.
The tax savings to Alexander is significant: When XCO increases in value back to $1 million, the $500,000 of value will no longer be taxed in his hands but rather in the hands of the next generation. Assuming a personal tax rate of 25 per cent on capital gains, the personal tax savings to Alexander would be $125,000. Even if Alexander’s child were in the same marginal tax rate, there would be a long-term deferral of the tax (at the very least) and probably a large tax savings because of the time value of money.
The impact of the refreeze can reduce the tax on the following:
- Deemed disposition of various assets on the death of the taxpayer;
- Deemed disposition of various assets on the emigration of the taxpayer; and
- Actual disposition of private company shares or partnership interests of the taxpayer.
An accounting practitioner should look at all previous freezes and evaluate whether to implement a refreeze.
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