Preventing Double Taxation on Death via a Pipeline Transaction
When a taxpayer who owns shares in a private company passes away, the estate often faces the significant risk of double or even triple taxation when attempting to extract funds from the company. The first level of taxation occurs when the deceased is deemed to have disposed of all assets at fair market value (FMV), which triggers capital gains tax. This is a substantial burden, as the estate must pay taxes on the appreciated value of the shares, even though no actual sale has occurred. The second layer of taxation arises when the estate subsequently withdraws funds from the company. In some cases, a third level of taxation may be involved if the company itself is subject to corporate taxes before any distributions are made to the estate or its beneficiaries.
To mitigate this double (or triple) taxation, a common post-mortem planning strategy is to implement a pipeline transaction. This strategy allows the transfer of assets from the company to beneficiaries without incurring multiple layers of tax. A pipeline transaction occurs when the estate transfers shares of the deceased’s corporation with a high-cost base to a newly created holding company in exchange for shares and a promissory note. When the underlying company pays out funds to the holding company through a tax-free intercorporate dividend, the holding company can then repay the promissory note back to the estate. This strategy effectively eliminates the second level of tax, ensuring that the estate, or the deceased taxpayer, only pays capital gains tax once-albeit potentially at a higher inclusion rate due to proposed changes. The pipeline strategy can take various forms and be applied in multiple situations (not only in the context of an estate), as will be explained in the sections below.
Section 212.1: Targeting Multinational Companies
In an unrelated development, the government introduced an amendment to section 212.1 of the Income Tax Act in 2019 to address tax avoidance strategies employed by multinational companies. Section 212.1 is an anti-avoidance provision designed to prevent multinational companies from extracting funds from a Canadian subsidiary without paying Canadian taxes. This is typically done through a pipeline-like transaction, where a foreign company sells a Canadian subsidiary at a gain to another Canadian company for a promissory note. Under normal circumstances, gains realized by foreign entities on the sale of Canadian property are not subject to Canadian capital gains tax unless the property is tied to Canadian real estate. By utilizing a pipeline-like transaction, foreign companies could avoid paying any tax in Canada on the gains. Section 212.1 combats this by deeming the foreign parent company to have received a dividend equal to the excess of the sale price over the paid-up capital (PUC) of the Canadian company. This deemed dividend is then subject to Canadian withholding tax.
The Broader Impact of Section 212.1 Amendments
However, the original section 212.1 only applied to foreign companies. This meant that by introducing intermediary entities, such as trusts or partnerships, where the ultimate members or beneficiaries were non-residents, section 212.1 could be circumvented. In response to this, Bill C-86 was introduced on December 13, 2018. This bill expanded section 212.1 by adding look-through rules, which are designed to ensure that if the ultimate member or beneficiary of a trust or partnership is a non-resident, section 212.1 applies, deeming the non-resident to have received a dividend subject to Canadian withholding tax. The deemed dividend is generally calculated based on the non-resident’s relative FMV interest in the shares. For example, if the non-resident’s interest is only 25%, then the deemed dividend would be 25% of the total amount. However, if the beneficiary’s interest is discretionary, the entire amount (100%) is deemed to be a dividend, regardless of whether the non-resident beneficiary receives an actual distribution.
Unintended Consequences for Estates
The amendment to section 212.1 was a targeted response to specific abuses by multinational corporations, but it had broader implications that extended beyond its original intent. The issue with the amended section 212.1 is that it impacts regular taxpayers as well, not just multinational companies. Consider a Canadian estate that has three beneficiaries-two Canadians residents and one non-resident. If the estate undergoes a pipeline transaction, it may inadvertently meet the conditions of the amended section 212.1, as the provision looks through any trusts, including estates, and deems a dividend to any non-resident beneficiaries. For example, suppose the estate owns shares of a Canadian company with an ACB of $100,000 and nominal PUC. If the will stipulates that each child receives one third of the assets, the non-resident beneficiary could face a deemed dividend of $33,333 on a pipeline transaction due to section 212.1. The situation becomes even more problematic if the will grants the executor discretion over the distribution of assets. For example, the executor may need to account for assets outside of the estate or other factors, which could lead to the non-resident beneficiary being deemed to have a 100% interest in the estate asset. This would result in a $100,000 deemed dividend–even if the non-resident beneficiary receives no actual distribution. Such outcomes are clearly unintended and can create significant financial burdens for the beneficiaries of the estate.
Addressing the Issue: A Letter to the Department of Finance
In 2019, my colleague Grace Chow and I wrote a letter to the Department of Finance addressing this particular issue. We requested an exclusion from section 212.1 for all types of trusts, including estates and life interest trusts, that would be subject to the deemed disposition event for shares of Canadian corporations. A comfort letter was subsequently issued later that year by Finance, acknowledging this issue. However, the relief provided was limited, excluding only graduated rate estates (i.e., estates with a 36-month useful life) from section 212.1. Other life-interest trusts, such as alter ego trusts and joint partner trusts, will not receive the exclusion of section 212.1. As such, taxpayers should be cautious when implementing a pipeline transaction with life-interest trusts, as they are prone to the double-tax issue described above.
Additionally, the exclusion is limited to shares acquired solely as a consequence of death. If the shares were exchanged (for example, for preferred shares) after death but before the pipeline, no relief is provided by the comfort letter. There was no indication in the comfort letter that a substituted-property rule would be introduced to address this issue.
A Long-Awaited Resolution
Although the comfort letter was issued almost five years ago, it does not carry the force of law. Fortunately, the Department of Finance released a technical amendment on August 12, 2024, excluding graduated rate estates from section 212.1, as promised. The amendment applies retroactively to transactions occurring after February 26, 2018. While it took Finance five years to address this issue–a timeframe that may seem long or short depending on one’s perspective–the resolution is certainly welcome. Better late than never.
This resolution provides much-needed clarity and relief for taxpayers who were previously caught by the amendments of section 212.1. However, it also serves as a reminder of the importance of ongoing vigilance in tax planning. The evolving nature of tax law requires taxpayers and their advisors to stay informed and proactive in their planning strategies.
About the Author
Henry is the managing director of tax planning at Our Family Office. Henry is highly detailed, experienced, and relies on a variety of tools to create and implement customized tax strategies to meet the objectives of the family. Henry’s tax experience also extends to international countries, often advising families with cross-border issues. In 2022, Henry, along with co-author Grace Chow, was awarded the Canadian Tax Foundation Douglas J. Sherbaniuk Distinguished Writing Award for writing the best paper published by the Canadian Tax Foundation.