An In-Depth Analysis of the Estate Freeze and Refreeze

Corporate tax reorganizations and strategies to defer certain amounts of income tax have become important planning tools for business owners over the course of time.

Pursuant to the tax laws of Canada, taxpayers are deemed to dispose of all of their assets at fair market value (“FMV”) immediately prior to death and their estate reacquires the assets at FMV immediately thereafter. The proceeds are taxed as capital gains in the deceased’s final tax return. This can produce a significant income tax liability in the year of death, thereby eroding the assets in the estate to be inherited by the beneficiaries. While this deemed disposition can be deferred when assets are left to a spouse or a spousal trust, this is only a temporary solution to the problem and does not solve the issue of transferring assets to children on a tax-deferred basis.

Benefits of an Estate Freeze

One of the main purposes of an estate freeze is to transfer the future increase in value of the assets that the transferor owns (for example, the growth of a business) to another taxpayer (a family trust, holding corporation, or other individuals). The “freeze” occurs when the value of the shares in a company is “frozen” on a tax-deferred basis. This is accomplished by converting the shares to a new class of special freeze shares with certain attributes. A company is always “frozen” at its FMV, meaning the initial shareholder retains non-participating freeze shares which have a redemption and retraction value equal to the FMV at the time they were frozen. The benefit of this strategy is that the transferor retains only the value of his or her shares at the date of the freeze, while deferring the income taxes payable on the taxable capital gain on death. When the transferor dies, he or she pays tax only on the gain accruing to the freeze shares, while any additional growth in value since the freeze accumulates in favour of the next generation.

In times of crisis, the values of many companies may decrease significantly. It is precisely at times like these that we should be considering whether this is the appropriate time to freeze (or re-freeze at a lower value), so that taxpayers can defer the maximum amount of capital gains tax to the next generation or maximize the capital gains exemption, which is discussed below.

Doing a freeze allows the transfer of the future growth of the business to the next generation, while allowing the transferor to retain control of the business and, if he or she needs, provide a source of income by paying dividends on (or gradually redeeming) his or her freeze shares.

When implementing an estate freeze, it may also be beneficial to introduce a family trust. This technique can be used to multiply the capital gains exemption amongst trust beneficiaries on a future sale of the company to a third party. The capital gain realized by the trust on a sale of the shares of the company can be shared amongst the beneficiaries who, if certain conditions are met, can shelter part or all of the gain from income tax by claiming their lifetime capital gains exemptions.

An Example of a Typical Estate Freeze

The typical estate freeze can best be described by way of a realistic example. Consider the following facts:

1. Bob and Vanessa, both age 65, are Canadian residents for income tax purposes and they each own 50% of a reasonably successful business started years ago named ABC Co.
2. Bob and Vanessa have three adult children who are interested in taking over the business and are currently working within the business.
3. Bob and Vanessa sought professional valuation advice and were told the business is worth $2,000,000.
4. They anticipate that in the next ten years, the value of ABC Co. will grow another $2,000,000.

Bob and Vanessa originally incorporated ABC Co. by subscribing for 100 common shares for $100. If Bob and Vanessa were to pass in ten years from now, there would be a deemed disposition of all of their property, including the shares of ABC Co., which would generate a capital gain of nearly $4,000,000 on the shares alone.

If Bob and Vanessa were to decide to carry out an estate freeze today, they would retain freeze shares worth $2,000,000. A family trust would then subscribe for new common shares of the company and would benefit from the future appreciation in its value. Several family members, including Bob and Vanessa’s children, would be beneficiaries of the family trust. If Bob and Vanessa were to die in ten years, the capital gain at that time would only be calculated on the $2,000,000 value set today.

The Refreeze

A refreeze is precisely what one would think it would be. A refreeze is implemented by introducing a new estate freeze in a corporation in order to freeze the value at the current (lower) value.

Taking our above example, assume our shareholders Bob and Vanessa implemented an estate freeze 10 years ago. At that time, the shares of ABC Co. had a FMV of $2,000,000. As a result, they currently own “frozen” preferred shares of ABC Co. with a FMV of $2,000,000. Today, Bob and Vanessa realize that the FMV of ABC Co. has dropped to $1,000,000.

Bob and Vanessa should reorganize the share capital of ABC Co. so that their $2,000,000 in preferred shares are exchanged for new preferred shares equal to the current $1,000,000 value.  New growth shares would be issued to the family trust (or a new trust). Now Bob and Vanessa have lowered the value of their preferred shares, which in turn means less tax owing upon their deaths.

Due to the current COVID-19 situation, the FMV of most businesses may be lower than it usually would be due to the crisis. If this FMV is lower than the redemption/retraction value of the frozen preferred shares, a refreeze is an ideal planning tool because once the economy recovers, all future growth of the business will accrue to the family trust. Most importantly, by reducing the value of the preferred shares held personally, the capital gains tax is limited to the current low value.

Another possible planning opportunity to be considered which can be implemented in conjunction with a refreeze is the ability to reset the clock on the 21-year rule. Since the FMV of many corporations has ostensibly decreased due to the COVID-19 crisis, on an exchange of freeze preferred shares for new preferred shares, the common shares owned by an older trust could be redeemed for a nominal amount and a newly created trust could be introduced into the structure by subscribing for common shares at a nominal price. When contemplating this type of plan, please call your Crowe BGK advisor, as there may be specific planning considerations and tax consequences to consider.

Determining the FMV of the Corporation

Determining the value of a corporation is of critical importance for effectively freezing the current value of the company, as the valuation may be scrutinized by the tax authorities in the event of a subsequent audit. Obtaining an independent valuation of the corporation from an independent qualified business appraiser is the optimal way to maximize the chances that the tax authorities accept the value at which the corporation was frozen. Additionally, a price adjustment clause in the corporate documents implementing the freeze preserves the ability to adjust  the value of the converted shares if the taxation authorities audit the transaction and revise the value of the company as of the freeze date, as long as a reasonable effort has been made in arriving at the valuation. Essentially, the price adjustment clause would adjust the price of the shares to increase or decrease the price to the price the taxation authorities determine.

Ensuring the Proper “Freeze Shares” Are in Place – A Prerequisite to the Ability to Implement an Estate Freeze

Keeping in mind that now may be an opportune time to consider an estate freeze, a company’s share capital should be verified to ensure that there are appropriate classes available to implement a freeze, and, if not, file articles of amendment now in order to add the appropriate classes of shares. This would allow the company to implement a freeze (ideally at the lowest value) any time after the articles of amendment are implemented. If the appropriate class of shares is not available, the opportunity to freeze or re-freeze at the lowest value may be lost.

Potential Traps and Pitfalls When Implementing an Estate Freeze

If not properly planned and executed, implementing an estate freeze can result in negative tax consequences to the parties involved, including, but not limited to, the application of the attributions rules, the application of the Tax on Split Income (TOSI) rules and inadvertent association of the company with other companies, etc.

It must be noted that there may be negative tax consequences if the refreeze is seen as a “strip” of corporate assets. For example, dividends paid on common shares, unless paid out of retained earnings, or bonus or salary paid to the beneficiary of an estate refreeze in connection with a post-freeze asset sale to the extent such bonus or salary is not commensurate with the value of the services performed, could be potential issues indicating a strip.

Careful attention must also be paid to the capital dividend account. Consideration must be given as to whether planning should be undertaken to “crystallize” the available capital dividends prior to disposing of loss assets, which will reduce the available amount capital dividend account. Professional tax guidance is essential in successfully implementing an estate freeze.

For additional information on whether implementing an estate freeze may be beneficial, please contact your Crowe BGK advisor.

About the Authors:

Aaron Patrick Belcher, CPA, CGA, is a Tax Specialist at Crowe BGK

Connect with him: [email protected]

Erin Lesser, LL.B, JD, is a Tax Specialist at Crowe BGK

Connect with her: [email protected]