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About a year ago, a colleague of mine wrote about what is commonly known in the tax community as a ‘pipeline plan’. That blog explored the then-newly released Tax Court of Canada decision in McDonald v The Queen, in which the Canada Revenue Agency (CRA) challenged the pipeline plan. The judge ruled in favour of the taxpayer and the validity of the pipeline plan. On a very high level, the plan is commonly used for post-mortem tax planning to avoid double taxation when removing funds from a private corporation at capital gains rates rather than dividend rates. A detailed description as to how the plan works is included in my colleague’s blog, which can be found here.
The Crown disagreed with the judges’ decision in the McDonald case and appealed to the Federal Court of Appeal. In April, the Federal Court of Appeal released its decision. This time, the courts ruled in favour of the CRA and applied subsection 84(2) of the Income Tax Act, which effectively deems a dividend to be received by a taxpayer when funds have been distributed from a corporation on the winding-up, discontinuance or reorganization of its business. Even though Dr. McDonald used a variation of the pipeline plan, the amount he intended to have taxed as a capital gain was taxed as a dividend. This decision raises doubt about whether or not the pipeline plan will work.
There have been numerous Advanced Tax Rulings and Technical Interpretations issued by the CRA regarding the pipeline plan. In some Technical Interpretations, such as 2005-0142111R3, the Canada Revenue Agency states that subsection 84(2) of the Income Tax Act should not apply. Conversely, another Technical Interpretation (2010-389551) was issued in which the CRA states that subsection 84(2) may apply to a pipeline transaction. In another Ruling (2010-0377601), the CRA stated that if shares with high paid up capital are taken back, subsection 84(2) of the Income Tax Act would not apply. In yet another Ruling (2011-0403031R3), the ruling request stipulated the business would be continued for one year and the CRA approved the reorganization, stating that subsection 84(2) of the Income Tax Act would not apply. In addition to these diverse Rulings and Technical Interpretations, we now have the Tax Court of Canada and Federal Court of Appeal decisions to consider. As you can see, it’s all become a bit complicated.
So does the pipeline plan still work? In my opinion, there are still some situations in which the answer is yes. For example, if a business is carried on as a corporation for a period of time (longer than the CRA’s one-year period), the Federal Court of Appeals’ decision may not apply. However, if someone is attempting to use the plan to immediately strip all value out of a corporation and into his or her personal hands, the CRA will argue its merit and use the Federal Court of Appeals decision to support its position to deny the claim.
So what is available if the pipeline plan is essentially dead? There is a second, less advantageous alternative to avoid double taxation when dealing with post-mortem tax planning: the application of subsection 164(6) loss carryback provisions. This provision allows an Executor of an Estate to carry back losses realized in the first year of an estate to the terminal tax return of the deceased taxpayer. When an individual who holds shares of a private company dies (assuming his or her spouse has already passed away), that individual is deemed to realize a capital gain, to the extent that the fair market value of the shares exceed their cost base. This deemed capital gain will be reported on his or her terminal tax return. If these shares are redeemed, a deemed dividend will be reported by the Estate and will be subject to income taxes.
In addition, the Estate will realize a capital loss on the redemption that can be carried back to the terminal tax return of the deceased individual. This capital loss will offset the capital gain realized on the terminal tax return. This loss can only be carried back to the terminal return if it is realized in the first taxation year of the estate. If it is realized after the first taxation year of the estate, it cannot be carried back. So while the net result of this is that taxes are paid at dividend rates, rather than at the more beneficial capital gains rates, at least only one level of tax is paid.
The uncertainty regarding the pipeline plan causes a dilemma when deciding which method to use to avoid double taxation on the death of a taxpayer. If the pipeline plan is implemented, and if the CRA is successful in arguing that subsection 84(2) of the Income Tax Act applies, the Estate will effectively pay tax on the same income twice, with no means of correcting this problem. Alternatively, an Executor could decide to use subsection 164(6) of the Income Tax Act, but will end up paying a higher rate of tax.
In summary, you must carefully consider all the facts and conduct a risk / benefit analysis before deciding whether or not you should apply the pipeline plan.
Related Topics:Canada Revenue Agency; Estate Planning
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