A Simplification of Tax Planning Concepts
We often hear numerous tax planning terms. In this article we are going to explore and provide answers to some questions regarding tax planning terms and strategies:
- What is a section 85 roll-over?
- What is a pipeline transaction?
- What are share reorganizations?
- What is a butterfly reorganization?
- What is a discretionary trust?
- What are flow-through entities?
In order to maximize returns, individuals and corporations should be aware of tax planning strategies that may offer beneficial tax treatment.
As a firm, we often work with tax planners and accounting firms to identify and implement strategies involving trust establishments, roll-overs, pipelines and other tax planning strategies. A good tax plan can enable individuals and corporations to utilize provisions and strategies available under the Income Tax Act (Canada) (the “Tax Act”) to minimize or defer tax consequences.
Below is a brief summary of some of these strategies. Keep in mind that this is not specific advice and each person’s tax position is different so you must consult with your tax advisor for individual tax advice.
What is a Section 85 Rollover?
The general tax rule is that transfers of property take place at fair market value. As a result any gain on a transfer of property may trigger immediate tax consequences.
However, there are certain sections of the Tax Act that allow you to “roll over” property on a tax deferred basis – such as a Section 85 roll-over. The general requirements in a Section 85 of the Tax Act include:
- The transferor (entity transferring the property) must be a taxpayer;
- A joint election form called a T2507 with the transferee corporation (entity purchasing the property) and transferor must be prepared and filed with the Canada Revenue Agency; and
- The property must meet eligibility requirements under the Tax Act.
The basic concept is that you can sell or transfer property (usually being shares or other assets) in exchange for shares in another company on a tax deferred basis.
It is important to note that Section 85 Rollovers and other tax deferral strategies under the Tax Act only provide a deferral of capital gains tax and not a tax avoidance.
What is a Pipeline Transaction?
Section 85 roll-overs are commonly used as part of a “pipeline” transaction which allows Canadian-controlled private corporations (as defined under the Tax Act) through the incorporation of various holding companies and the preparation of promissory notes to extract certain income or assets on a more favourable tax basis. Pipelines can also be used to reorganize the share capital of a company to prepare for a share sale and take advantage of the lifetime capital gains deduction.
What are Share Reorganizations?
A corporation can reorganize its share capital on a tax deferred basis under Section 86 of the Tax Act by drafting certain share provisions with specific characteristics. In addition, taxable Canadian corporations can amalgamate on a tax-deferred basis under Section 87 of the Tax Act. This can also be used as part of a pipeline transaction or other tax planning strategies to move shareholders into different classes of shares on a tax deferred basis.
What is a Butterfly Reorganization?
A “butterfly reorganization” allows shareholders to divide a corporation into two or more entities on a tax deferred basis under Section 85 of the Tax Act, to avoid potential deemed capital gains consequences that may arise under Section 55 of the Tax Act. A “butterfly reorganization” can be effective when two partners in a corporation wish to end their relationship and divide their assets in the corporation, while taking advantage of favourable tax deferral rules. A diagram of a “butterfly reorganization” resembles the wings of a butterfly, thus giving the “butterfly reorganization” its name.
What are Discretionary Trusts?
A discretionary trust, sometimes known as a family trust, can offer beneficial tax treatment, particularly for owners of private corporations involved in the sale of a business. Family trusts are also beneficial for family asset planning. For example, when a company is sold there is normally a capital gain tax that would need to be paid on the sale of the shares. However, if the shares qualify for the capital gains deduction under the Tax Act, then the tax payable would be minimized as each adult beneficiary can utilize their lifetime capital gains exemption as a beneficiary of the trust. To qualify for such treatment, the trust would need to hold shares in the operating company for at least 2 years. In addition, by using certain estate freezing strategies which “freeze” the value of certain share classes (usually common shares to be exchanged for preferred shares with locked in values); a family trust may also allow for less taxes to be paid upon the death of a shareholder depending on how the share ownership of the corporation is structured.
What are Flow-Through Entities? A Brief Summary of Limited Partnerships and Mutual Fund Trusts
Limited partnerships as a business structure or investment vehicle enjoy significant tax planning advantages as a result of their “flow through” tax treatment under the Tax Act. With Limited partnerships, taxation occurs at the level of the individual partner, rather than the limited partnership entity. This allows net losses or tax deductions to “flow through” the partnership to the partners and reduces the partners’ taxable income. It is also important to note that in limited partnerships, the reduction in taxable income and in tax payable by a particular partner is limited to the cost of the investment by that partner in the limited partnership. Income and capital gains are also flowed through to the limited partners and are taxed at the partner level rather than at the partnership entity level. Limited partnerships will generally receive more favourable tax treatment in comparison to a corporation because the revenue of a corporation is effectively taxed twice, once at the corporate entity level and once at the individual shareholder level when distributions are made.
Furthermore, from a legal perspective a limited partnership structure is advantageous because the limited partners (which are basically treated as passive investors) are only liable up to the amount of money or other property that they contribute to the limited partnership.
Mutual fund trusts (“MFTs”) are also an effective investment vehicle given their beneficial tax treatment. Units in the MFT can be considered as qualified investments, which means that they are eligible to be owned in your TFSAs, RRSPs, RESPs, etc. MFTs are created by a declaration of trust and must meet certain tests under the Tax Act, including maintaining a minimum of 150 unitholders in a given taxation year.
CC Corporate Counsel Professional Corporation would be happy to assist you and your tax planner with respect to the tax planning strategies mentioned here in a cost effective and strategic manner or answer any other questions that you may have with respect to those tax planning strategies.
By: Mario Marrelli and Michael Bluestein