Business owners: What are the benefits of an Estate Freeze?

As you may know, I practice corporate & tax law with a focus on the creation of various tax-effective structures for the preservation, accumulation and transfer of wealth for entrepreneurs. One technique that I like to use is called Estate Freeze. Hence, Today, I would like to share an article written by Bessner Gallay Kreisman, Chartered Accountants.

What are the benefits of an Estate Freeze?

For an owner-managed business, tax minimization is central to the overall financial plan. One popular tool is an estate freeze. An estate freeze is a corporate re-organization that allows business owners to freeze the value of the company at today's value. As a result, future increases in the value of the company can be transferred to the benefit of children, key employees or a trust. Such a freeze allows business owners to minimize capital gains tax due to deemed disposition rules at death and provides a deferral of tax.

A freeze in combination with the creation of a discretionary trust can provide a flexible framework that can lead to further tax minimization. The use of a trust facilitates income-splitting strategies between family members, and if properly planned, can also result in each beneficiary being able to utilize their $750,000 capital gain deduction concurrently. In a company that is expected to experience continued growth, the ability to benefit from multiple capital gain deductions can result in substantial tax savings.

For many companies that have already undertaken such a freeze, the current economic climate has unfortunately eroded valuations. However, from an estate planning perspective the decrease in values may have created a unique opportunity to re-freeze shares. Re-freezing at a lower value can help further reduce the tax liability upon death and defer the same to the next generation.

An important factor to consider with any estate freeze is the valuation of the shares being frozen. Given the nature of a freeze, and the potential benefits to non-arms length parties, the need to ensure a fair and impartial valuation is critical. While many may believe an ad-hoc valuation is sufficient, determining the value that may be attained in an open and unrestricted market, between informed and prudent parties, is a complex process that poses several challenges. A formal report ensures that adequate research is conducted and the valuation can be defended in the event the transaction comes under review by the taxation authorities.

Given the unique characteristics of each situation, effectively implementing such a strategy requires careful consideration of both technical and non-technical components. An estate freeze is only one component that can be utilized as part of a global tax and estate plan.

A New Chapter in Taxation of Trusts: The Residency of a Trust

Below is an excellent article published by Collins Barrow, Chartered Accountants.

A New Chapter in Taxation of Trusts

The recent decision of the Tax Court of Canada in Garron Family Trust v. R (2009 DTC 1568) has cast doubt on some common international and inter-provincial tax planning structures that involve the use of trusts. Generally, these trust structures reallocated income to jurisdictions that had either lower tax or no tax at all on certain types of income. This was accomplished by implementing a tax strategy that involved a trust and relying on the residency of that trust to determine the jurisdiction in which the trust's income would be taxed.

For over thirty years, tax professionals have relied on the principles set out in the well-known Thibodeau Family Trust case (78 DTC 6376) to determine the residency of a trust. Now, as a result of the decision in the Garron Family Trust case, we appear to have a new set of rules for determining the residency of a trust. These new rules can have a serious impact on any trust tax planning strategy that relies on the old residency rules of the trust to minimize or eliminate taxation.

Pursuant to the Thibodeau case, the residency of a trust was based on the residency of the managing trustees. The Thibodeau trust had three trustees, one resident in Canada and two in Bermuda. The trust was administered in Bermuda and the books and records of the trust were in Bermuda. The Court concluded that the trust resided in Bermuda because the trust document required that a majority of trustees agree on all matters of trustee discretion, and the majority of trustees resided in Bermuda. The Court rejected the notion that the residence of a trust should be similar to that of a corporation, and therefore disregarded the "management and control" test used for corporations. The Court then concluded that the residence of a trust should be determined based on residency of the trustees.

Just over thirty years later, we now have a different opinion from the Tax Court regarding this issue. With the Garron Family Trust decision, the Court has now embraced the notion that the residence of a trust should be similar to that of a corporation. The Court will look to the management and control of the trust to determine residency of the trust. The Court concluded that adopting a similar test of residence for trusts and corporations promotes the important principles of consistency, predictability and fairness in the application of tax law.

With an update in the jurisprudence related to the residency of trusts, the Canada Revenue Agency (CRA) is now aggressively reviewing tax planning structures involving trusts to reduce tax avoidance through international and inter-provincial tax planning.

The CRA recently hired additional auditors to review the residency of Alberta trusts. During the past several years, it has been attractive and popular for individuals located in provinces other than Alberta to set up an Alberta resident trust to access Alberta's low provincial tax rates. With this review of Alberta Trusts, the CRA is seeking to determine the "management and control" over the trust assets. As a result, it has distributed questionnaires to Alberta trustees, requesting the following information:

•a list of the duties and responsibilities as the trustee;
•the signing and/or contracting authority of the trustees; and
•the responsibility of the trustees for the management of any business or property owned by the trust, the banking and financing arrangements for the trust, and the preparation of the trust's accounts and reporting to the beneficiaries.
If the CRA determines that the management and control over the trust assets rests with any person(s) other than the Alberta trustees, it may determine the residence of the trust to be other than Alberta and reassess the provincial taxes accordingly.

Based on the 2010 Federal Budget, and the Department of Finance's desire to close various loopholes in the Income Tax Act, and to try to find ways to generate revenue to assist in reducing the deficit, we can anticipate the CRA will also apply the same aggressive nature toward international tax planning strategies involving trusts.

This may be a new chapter in the taxation of trusts, but the story is not over yet. The Garron Family Trust has requested leave to appeal to the Federal Court of Appeal. We will have to wait for the outcome of that appeal to see whether a new chapter is written once again, or if the book is closed for the foreseeable future.

Business owners: Should you take a Salary or a Dividend??

Today I would like to share an excellent article written by Tim Cesnick published in The Globe and Mail.

Business owners: Should you take a Salary or a Dividend??

Business owners face all types of challenges. Human resources issues may be the greatest – but tax issues are also near the top of the list. How should you compensate yourself? Should you pay yourself more salary? How about dividends? Are there other alternatives? Let’s talk about your compensation.

The Theory

If you own an incorporated business, there are two primary ways to pay yourself: salary, and/or dividends. If you pay yourself salary, the amount is a deductible expense to your company and is taxable in your hands. Another alternative is to have the income taxed in your corporation and then pay the after-tax earnings to yourself as dividends. Your company doesn’t claim a deduction for dividends paid. You’ll face tax on the dividends paid to you, but at a lower tax rate than salary. Why? Because the corporation has already paid tax on the income. When you receive dividends, the amount is “grossed up” (to approximate the pretax income of the company) and then you’re entitled to a dividend tax credit (to provide a tax credit for the approximate tax that was paid by the company).

Our tax system is based on the theory of integration. The theory is that there should be no difference between earning income personally, or earning it in a corporation and then paying that income out to yourself as dividends. If integration is perfect, the amount of income in your hands would be exactly the same, either way.

In the past, integration only worked, albeit not perfectly, in the case of small, Canadian-controlled private corporations (CCPCs) that have been eligible for a lower rate of tax (on the first $500,000 of taxable income today; this results from the “small business deduction” available only to CCPCs). The government changed this in 2006 when it introduced “eligible dividends.” To make a long story short, eligible dividends are those paid after 2005 out of business income that was taxed at a higher rate – rates applicable, for example, to income earned by publicly traded companies or smaller-company income that is not sheltered by the small business deduction. Eligible dividends have been subject to a different gross-up and tax credit rate. This effectively reduced the level of personal tax paid on those dividends, to make integration work better where the company has paid higher rates of tax.

Today, you’ll face a different tax rate on eligible dividends (paid out of corporate income taxed at higher rates) and ineligible dividends (paid out of corporate income subject to lower rates, thanks to the small business deduction).

The Reality

The fact is, integration doesn’t work perfectly. And so there may be advantages to paying dividends over salary, or vice versa. To complicate things, general corporate tax rates are falling over the next couple of years, which may shift your approach. You see, as corporate tax rates fall, the level of tax you’ll pay personally on eligible dividends is due to increase. Why? To keep integration as close to perfect as possible.

The general federal corporate tax rate is currently 18 per cent in 2010, will be 16.5 per cent in 2011, and 15 per cent in 2012. The top federal marginal tax rate on eligible dividends is 15.88 per cent in 2010, will be 17.72 per cent in 2011, and 19.29 per cent in 2012. Regardless of your province of residence, it’s still true that the tax rate on eligible dividends is going up.

So, what does all this mean for you? First, if you do plan to pay yourself eligible dividends, your best bet may be to accelerate those dividends to pay them out in an earlier year rather than later, to take advantage of the current lower tax rates. There was some confusion from my article last week where I had mentioned that it could be beneficial to wait until 2011 to pay out eligible dividends. That read incorrectly. I had intended to suggest that paying dividends sooner, say in 2010, would be better.

Business owners: Unconventional ways of saving for your child's education

Below is a great article written by Tim Cesnick and published in The Globe and Mail.

Family trusts and life insurance options are often overlooked when thinking of how to pay for a post-secondary education

Now that my kids have decided they want to be brain surgeons, I’ve been thinking about how to pay for their post-secondary education. Two methods of saving for a child’s education are often overlooked. The first is a family trust, and the second is life insurance.

FAMILY TRUST

A trust is simply a legal relationship between three parties: The settlor (the person creating the trust), the trustee (the person who holds and controls the property of trust) and the beneficiary (the person for whom the property of the trust is being held). The nice thing about a trust is that it’s possible to have the income of the trust taxed in the hands of the beneficiaries, who may pay little or no tax if they are minors and have little or no other income.

Setting up a trust does come with a cost, so it’s not generally going to make sense unless you’re willing and able to commit a sustantial sum to the trust over a short period of time. You can make this a loan to the trust if you want, so that you can take back your capital again later, as a repayment of the loan.

Once the money is in the trust, any interest and dividend income earned in the trust will be attributed back to you to be taxed in your hands while the beneficiaries of the trust are minors (unless you charge the taxman’s prescribed rate of interest on a loan to the trust), but capital gains can be taxed in the hands of the beneficiaries. Also, any second generation income (that is, income on the income, even if it’s interest or dividends) can be taxed in the hands of your children.

You can pay for all or part of your child’s education costs out of the income or capital of the trust. The taxman will consider payments to third parties, including reimbursements to you, as being paid to the beneficiary as long as those payments were clearly for the benefit of your child. To the extent that little or no tax has been paid on the income of the trust over the years (by having income taxed in your child’s hands), you’ll effectively be using pre-tax dollars to pay for the child’s education.

The benefits of the trust include: protection of the assets of the trust from creditors, splitting income with your children, maintaining control over the assets, and flexibility to use the trust funds for things other than education. There’s a lot to consider when setting up a trust. Visit a tax pro for help.

LIFE INSURANCE

Life insurance is an interesting tool because you can accumulate investments inside a policy on a tax-sheltered basis. Further, if it is the life of your child that is insured, you’re able to transfer ownership of the policy, including the accumulated investments inside the policy, to your child free of tax once he or she reaches age 18. Your child can then make withdrawals of those investments from the policy to pay for education. While those withdrawals are generally going to be taxable to your child, he’ll likely pay little or no tax if he has little or no other income.

One of the benefits of choosing a whole life insurance policy is that the returns have been incredibly stable over the years, even throughout 2008. The reason for this is that the insurance companies are allowed to smooth, or average, the returns you receive over a period of years.

Consider some numbers. If you pay $2,750 annually into a whole life policy each year until your child is 18, there could be $70,000 to $75,000 in the accumulating fund to be accessed (varies by insurance company), assuming a 5 per cent annual return inside the policy. If you set aside the same $2,750 in a tax-free savings account (TFSA) you could end up with approximately $84,000 earning that same 5 per cent, but this would assume a portfolio that is largely in equities that is subject to the volatility of the markets. If you earned, say, 6 per cent in the TFSA, you’d have close to $92,000 in this case, with the volatility.

Life insurance also offers asset protection, flexibility to use the assets for any purpose, and a death benefit ($265,000 in my example) over and above the investment component of the policy if your child passes away prematurely. Insurance is just another tool to consider.

As usual, please do not hesitate to contact me should you have any questions. hugues.boisvert@andrewsrobichaud.com or +1.613.237.1512 x 255

Family Trust Audits Highlight Need for Proper Trust Records

Today, I would like to share an excellent article written by BDO Canada - As usual, please let me know if you have any questions.

Family Trust Audits Highlight Need for Proper Trust Records

A family trust can provide significant benefits as the
legalities and benefits of ownership can be separated. A
discretionary trust allows the benefits of ownership to flow
to beneficiaries while the trustee maintains control and ownership
of trust property and can ultimately decide on who will receive the
property at a later date. Due to this, family trusts are a powerful tool
in terms of income splitting and capital gains splitting, including
multiplying access to the capital gains exemption.

As is often the case, beneficial tax planning vehicles often carry a
greater recordkeeping and compliance burden, and family trusts are
no different. In particular, one of the key benefits of a discretionary
family trust is the ability to allocate income in different shares to
different beneficiaries, or to retain the income in the trust. For a
discretionary family trust, it is important to note that the default
position is that all of the income belongs to the trust and will be
taxed there if no further action is taken. If it is beneficial to have
income taxed in the hands of a beneficiary, that income can be
allocated in one of two ways:

• It can be paid to them during the year, or the trustee(s) can
declare that the income is payable to the beneficiary at the end
of the year. In other words, the income belongs to the beneficiary.

• It can be allocated by way of a special tax rule called the
preferred beneficiary election (under this election, it is possible to
allocate income to a beneficiary of the trust that is mentally or
physically infirm or disabled without giving them a right to that
income).

Most likely due to the popularity of family trusts and the tax
benefits they provide, the Canada Revenue Agency (CRA)
implemented an audit project on these trusts. The CRA’s audit work
on trusts is focused on the following:

• Has the trust been properly formed? If your trust was set up in writing by a lawyer, this should not be a significant issue.

• Where trust income has been allocated, was the income actually
paid or is there a bona fide obligation to pay that income to a
particular beneficiary? The CRA will be looking for documentation
such as trustee resolutions that allocate the trust’s income, proof
of payment for income paid during the year and promissory notes
or other proof that the trust has made the income payable to the
individual beneficiaries.

• Where the trustees make payments to third parties, was the
payment made for the benefit of the beneficiary? It is also
possible to “pay income” to a beneficiary by making payments
to third parties for the benefit of that beneficiary. In this case,
the trustee will need to document the payments made and
also provide evidence that the payment benefited a particular
beneficiary. For example, if a parent is reimbursed for expenses
incurred on behalf of a child who is a beneficiary, receipts for the
expenses should be retained to prove the child benefited from the
payment and not the parent.

In addition to these particular issues that arise for family trusts, the
CRA will also be reviewing the records of the trust in the same way
it does for other taxable entities to determine whether income has
been calculated and reported properly. So, you should ensure that
bank and investment accounts are set up as needed and proper
records are maintained. Also, your trust agreement and the property
used to settle the trust should be kept in a safe place.