Serial Redemptions (Wasting Freezes)
As part of an estate freeze the business owner typically receives fixed value preference shares which are redeemable and retractable for an amount equal to the common shares that are exchanged at the time of the freeze. The preference shares will normally have a pre-determined capital gain that will be triggered upon the death of the business owner. However, a serial redemption program may be undertaken to provide the business owner with a source of income during retirement, as well as reduce the amount of capital gains tax associated with the preference shares on death.
The serial redemption strategy, sometimes referred to as a wasting freeze, involves the company redeeming a certain number of frozen preference shares on a periodic basis. Under many estate freezes, the shareholder of the frozen shares receives income through dividends. However, when a wasting freeze is used, cash flow to the shareholder is created through the redemption of shares. One of the main benefits of this approach is that it reduces, or “wastes away”, the ultimate value of the shareholder’s frozen shares (and the associated capital gains on death)
From a tax perspective, the redemption gives rise to a deemed dividend equal to the proceeds of redemption less the paid-up capital of the redeemed shares for tax purposes. The tax rate on this deemed dividend will depend on whether the dividend is classified as an eligible or non-eligible dividend. The tax rate on dividends varies by province, but in Ontario the top marginal tax rate in 2018 on a non-eligible dividend is 46.84% and on an eligible dividend it is 39.34%. The paid-up capital will be received tax-free by the shareholder.
As each redemption takes place, the shareholder owns fewer preference shares. This in turn results in lower taxes payable as a result of a deemed disposition of those shares at death.
By way of example, let’s assume a shareholder has undertaken an estate freeze and holds $1 million of frozen preference shares with a 5% dividend rate. The shareholder is therefore entitled to receive a $50,000 taxable dividend annually and will ultimately have a $1 million capital gain on death (assuming the shares have no adjusted cost base (“ACB”). In contrast, under a serial redemption strategy, the corporation redeems $50,000 of preference shares each year. The shareholder would still have a $50,000 of taxable dividend income each year (assuming nominal paid-up capital), but after 5 years, the fair market value of the remaining shares would be reduced by $750,000, with the potential capital gain on death being reduced by $250,000.
When Does This Strategy Make Sense?
A wasting freeze makes sense in the following circumstances:
- When a shareholder needs income from a corporation but wants to reduce or eliminate the tax liability arising with respect to the shares on death by shifting more of the value in the corporation to the common shareholders, who are typically his/her children.
- Where it is used as a part of RDTOH (Refundable Dividend Tax on Hand) and capital dividend account (CDA) planning. The capital dividend account of a private corporation includes the tax-free portion of capital gains, and amounts credited to the CDA can be paid out tax-free to shareholders. RDTOH represents refundable tax paid by a private corporate on its investment and dividend income. This refundable tax account is refunded to the corporation when a taxable dividend is paid to a shareholder. The rate of repayment in 2018 is $38.33 of dividend refund for every $100 taxable dividend paid out. It is common to do corporate planning to ensure that the RDTOH account is fully refunded (or at least partially refunded) each year. With the tax rates on both eligible and non-eligible dividends exceeding the dividend refund rate (and significantly exceeding the tax rate on capital gains), the benefits of RDTOH planning have been eliminated in most provinces. This in turn mitigates against the use of a wasting freeze unless there is also significant CDA available to reduce the tax cost of the dividends received on the redemption of shares.
When Does This Strategy Not Make Sense?
A wasting freeze may not make sense in the following circumstances:
- Where there is no RDTOH or CDA in the company, and dividend income is e not otherwise required by the shareholder. This is because a wasting freeze results in a pre-payment of taxes at a higher rate of tax that would have otherwise been deferred until the death of the shareholder. Specifically, this strategy results in paying tax at dividend income rates, which are higher than the capital gains tax rate that would apply if the shares were sold or deemed to be disposed at the death of the shareholder. Given that the preference shares are fixed in value and the tax liability is frozen, a wasting freeze results in an acceleration of the tax liability and the loss of the time-value of that money in the family’s hands. There may be more tax-efficient strategies to deal with the capital gain arising on death, such as using life insurance proceeds to redeem the shares of a deceased shareholder.
- When the shareholder will have a continuing need for income from the corporation. The redemption strategy will ultimately erode the capital base of the shareholder and his/her ongoing access to dividends in the future, unless the shareholder was included as a beneficiary of the trust and can therefore access dividends and capital through the trust.
Things to Consider
Before entering into a wasting freeze, the shareholder should consider:
- Whether he or she might need the share capital in the future, and how such capital will be accessed, such as through a trust.
- Whether there is a desire to start relinquishing control of the corporation (if the shares are voting shares).
- Whether there is a strategy which might allow a retention of control under these circumstances (such as issuing a separate class of voting shares).
- Whether the shareholder needs to retain some taxable income until death to utilize tax credits including those related to medical expenses or charitable donations, and how such income will be realized, such as through a trust.
- Whether corporate-owned life insurance is a better overall strategy for the family, as it may be used to defer tax (or possibly eliminate tax, depending upon the circumstances). This would also include consideration of whether the shareholder is insurable.