Tax Planning: Warming up to the refreeze in a COVID-19-impacted economy

Stephanie Stapleford and Brent McCumber, P.Eng.

In the span of mere months, COVID-19 has significantly impacted lives and livelihoods all over the world. The pandemic has affected individuals’ health, well-being and financial stability, and measures taken to slow the spread of the virus have caused countless businesses to grind to a halt. Investment portfolio values and business revenues have fallen sharply since the start of the year, sparking fears of an economic fallout akin to the global financial crisis of 2008—or worse.

As devastating as these recent events have been, they may present valuable tax saving opportunities for individuals who had previously implemented an estate freeze and who have since seen a decline in the value of their underlying businesses and/or investments.

This Thought Leadership piece discusses one such opportunity, known as the estate refreeze. An estate refreeze is, essentially, a do-over of an estate freeze, so let’s look at freezes first.

The estate freeze, explained

An estate freeze is a common planning tool that can be used by an individual (the “Freezor”) who owns shares in a private corporation (a “Corporation”) to minimize his or her future tax liability where those shares are expected to appreciate in value. It involves a reorganization in which the value of the Freezor’s shares is “frozen” and future growth in value is passed on to others (the “Successors”), often via a discretionary trust benefiting, among others, the Freezor’s children. Among other possible benefits, the use of a discretionary trust can give the Freezor time to determine how to distribute the Corporation’s shares to his or her children.

There are various ways to implement a freeze, including by exchanging the Freezor’s growth shares for fixed-value preferred shares with a redemption amount equal to the then-current fair market value (“FMV”) of the exchanged shares. The Successors then subscribe for new common shares at a nominal cost; these shares will soak up the future growth in value of the Corporation.

Among the many advantages offered by a freeze, one of the main tax benefits is that it limits the amount of tax payable by the Freezor on disposition of his or her shares of the Corporation, particularly the tax arising as a result of the deemed disposition of these shares on the Freezor’s death.

Why refreeze?

An estate freeze contemplates that the Freezor’s shares will increase in value post-implementation. In strained economic times, however, there may be a significant decline in the value of these shares, due to loss in value of the underlying businesses or investments. Freezors who have implemented freezes, particularly in recent years, may now be holding preferred shares that are underwater (meaning their FMV is less than their redemption price), and the Successors may now be holding common shares with nil value.

Enter the refreeze. A refreeze can be used to reduce the redemption price of a Freezor’s preferred shares to their current FMV, thus further reducing the possible tax burden that would otherwise arise on death.

In addition to enabling the Freezor to lock in at a lower value, a refreeze allows the Successors to participate in the growth during the Corporation’s recovery from the current downturn. As well, if a trust had been created on the initial freeze, the refreeze may have the added benefit of allowing the Freezor to reset the trust’s 21-year “clock”. The Income Tax Act deems most trusts to dispose of and reacquire, at FMV, all trust property every 21 years, generally leading to tax payable by the trust; this rule is meant to prevent the indefinite deferral of tax on increases in the FMV of the trust property. Often the 21-year deemed disposition rule is avoided by winding-up the trust shortly before the 21-year mark—though in winding-up the trust the Freezor is usually forced to determine how to distribute the trust property (i.e., the shares of the Corporation) among his or her children.

A simple example will help to illustrate the benefits of a refreeze.

Example of freeze and refreeze

Freeze

In Year 1, a taxpayer (“Z”) incorporates an operating company (“OpCo”) and subscribes for all common shares of OpCo at an aggregate cost of $100. OpCo’s business takes off and in Year 5 OpCo is valued at $3,000,000. Assuming Z is still OpCo’s sole common shareholder, this means that the FMV of Z’s shares has increased from $100 to $3,000,000. If Z were to die in Year 5, he would realize a capital gain of $2,999,900 as a result of the deemed disposition of his OpCo shares.

Z believes that OpCo’s business will continue to grow, and wants to transition the business to his children while minimizing the tax that will become payable on death. To do this, Z implements a freeze by exchanging the common shares of OpCo for preferred shares having an aggregate redemption value equal to the FMV of the common shares at that time ($3,000,000). The exchange is done on a “rollover” basis, so that no tax is triggered on the transaction. OpCo then issues new common shares to a discretionary trust (“Trust #1”) set up by Z for the benefit of Z and Z’s children. (Z’s children are all under the age of 20, and Z is not sure which of his children he wants to take over the business.) Since the FMV of OpCo at that time has been “frozen” in the preferred shares, these new common shares can be issued to Trust #1 at a nominal price.

The preferred shares issued to Z reflect OpCo’s then-current value; the common shares issued to Trust #1 will appreciate in value along with the business. In this way, all future growth in OpCo is passed on to the beneficiaries of Trust #1, and Z’s tax liability at death is “frozen” based on OpCo’s FMV in Year 5. If Z had not implemented a freeze, and if OpCo’s value increased to $5,000,000 by the time of Z’s death, then Z’s estate would have to pay tax on a much larger capital gain—$4,999,900 instead of $2,999,000.

Refreeze

Unfortunately, in Year 9, OpCo’s value falls to $1,500,000. Z, who believes the business will ultimately recover, can make the best of this bad situation by converting the existing preferred shares into a new class of preferred shares of OpCo having an aggregate redemption value equal to the current FMV of OpCo ($1,500,000). If the business recovers, the refreeze effectively reduces Z’s capital gains on death from $2,999,900 to $1,499,900. In other words, in this simple example a refreeze can help Z avoid up to approximately $375,000 in taxes that may otherwise arise when he dies.

Further, on the refreeze, Trust #1 can be terminated and a new trust, with a new 21-year clock, can be created to hold OpCo’s common shares. If Trust #1 were retained on the refreeze, it would have 17 years remaining on its 21-year clock; with a new trust, its deemed disposition won’t occur until 21 years thereafter. This potentially gives Z four extra years to determine which of his children are going to take over the business.

Conclusion

While the economy is reeling from the impacts of COVID-19, some taxpayers may see a silver lining in the form of tax-planning opportunities. For taxpayers who had previously carried out an estate freeze, a refreeze should be considered, especially where the current value of the underlying businesses and/or investments is significantly less than what it was at the time of the initial freeze.

Freezes and refreezes are complex transactions with many possible permutations and many possible adverse tax implications if implemented improperly. Please contact a member of our Tax Group if you are considering these or other tax-planning opportunities.

This update is intended for general information only. If you have questions about the above, please contact a member of our Tax Group.

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