Frozen Over
By David A. Altro and Ben Jeske

Estate freezes have been in Canada since the introduction of federal capital gains taxation 40 years ago. Along with the capital gains tax (CGT) on properties sold by taxpayers, the so-called death tax was also brought in. Essentially, when a taxpayer dies, they are deemed to have sold all their assets at fair market value, and will be assessed for CGT on all accrued gains. The estate freeze, in essence, is an attempt to cap the value of the assets owned by a taxpayer that would be subject to the death tax. Therefore, the estate freeze generally involves the conversion or exchange of assets susceptible to capital appreciation for assets that retain a fixed monetary value.

Capping CGT

In the context of a closely held private corporation, the estate freeze consists of the well-known mechanism of the taxpayer exchanging common shares (susceptible to capital appreciation) for fixed-value preferred shares. Immediately thereafter, the taxpayers’ children, or a trust established for their benefit, subscribes for new common shares. Following the completion of the estate freeze, all the corporation’s assets continue to generate income and/or growth for the family – at the level of the shareholders the shares to which such future growth is attributed are the common shares, which are now no longer part of the taxpayer’s property, but are safely in the hands of the next generation. Thus, unless the shares of the corporation are sold to a third party, accrued gains on these shares will not be subject to CGT until the death of the taxpayer’s children. The taxable capital gain being realised on the taxpayer’s death is now capped at today’s current value of the taxpayer’s shares.

Market value

Any one of a number of provisions in the Income Tax Act placed at taxpayers’ disposal allow such share exchanges to take place on a fully tax-deferred basis, but for such common-to-preferred share exchange to be tax-deferred, the taxpayer must ensure the frozen preferred shares they receive have fair market value equal to the value of the exchanged common shares. The safest and surest way of ensuring the frozen preferred shares have the correct value is to:
- obtain an independent valuation of the corporation
- provide an adjustment clause whereby the value of the frozen preferred shares will be adjusted if the tax authorities disagree with the taxpayer on the value of the common shares prior to the freeze; and
- provide that the frozen preferred shares are redeemable at the option of the shareholder.

Where shareholder effectively has a ‘put’ option on the shares, the shares are referred to as being retractable. Canada Revenue Agency is of the view that preferred shares lacking a retraction feature are not worth their stated value.

Accrued gain

When the freeze is complete, the taxpayer’s exposure to the death tax is capped. Now you can look at ways of reducing or eliminating the death tax by reducing the value of the frozen preferred shares held by the taxpayer. Often a taxpayer who implements such a freeze still wishes to draw income from the corporation through either salary or dividends. If the corporation is a Canadian-controlled private corporation and earns investment income, a portion of the corporation’s tax payable on such investment income is added to the corporation’s refundable dividend tax on hand (RDTOH). When a corporation with RDTOH pays taxable dividends to its shareholders, it receives a tax refund of one dollar for every three dollars of dividends paid. Finally, if the corporation sells any of its capital property and realises a capital gain, one-half of the gain is added to the corporation’s capital dividend account and is available for tax-free distribution to the corporation’s shareholders by way of dividends.

Golden opportunity

A well-known provision of the Income Tax Act stipulates when a corporation redeems shares of its own capital stock from a shareholder, the amount paid to the shareholder (less the stated capital attributable to the redeemed shares) is treated as a dividend for all purposes of the Act. This provision affords taxpayers who have implemented estate freezes a golden opportunity to reduce the frozen preferred shares’ value, reducing the eventual death tax.

Whenever the taxpayer would otherwise wish to draw dividends from the corporation, either to extract the corporation’s tax-free capital dividend account, to allow the corporation to obtain its RDTOH refund, or simply to provide personal funds to the taxpayer, redeeming some of the frozen preferred shares is recommended. The taxpayer will be treated as having received dividends, but the value of the frozen preferred shares will be diminished and the eventual death tax reduced.

Price adjustment

While redeeming frozen preferred shares is an excellent strategy for reducing the death tax, if not structured properly, it is fraught with difficulty. For the freeze to be tax-deferred, it is always advisable to include a retroactive price adjustment clause in the valuation of the frozen preferred shares. Although the price adjustment clause ensures a fully tax-deferred freeze, it is dangerous to redeem shares whose value could be subject to retroactive adjustment.

To illustrate this danger, take the example of a taxpayer who holds 100 per cent of a corporation valued at CAD 10 million. To freeze this taxpayer’s estate, they convert their common shares of the corporation into 10 million preferred shares, each redeemable for CAD1, subject to the aforementioned adjustment clause. When the taxpayer wishes to receive a CAD 1 million dividend, it is tempting to have the corporation redeem 1 million frozen preferred shares, reducing the taxpayer’s shareholdings to 9 million preferred shares, and reducing the eventual death tax.

But if the tax authorities subsequently intervene, and successfully assert that the pre-freeze value of the corporation was not CAD 10 million but CAD 14 million, to retain the tax-deferred nature of the freeze, the retroactive price adjustment would be invoked and the frozen preferred shares would be retroactively valued at CAD 1.40 per share. Now, although the taxpayer receives only CAD 1 million on the redemption, they are deemed to have retroactively received the new fair market value attributable to the redeemed shares, namely CAD 1.40 per share. The result is tax on an extra CAD 400,000 dividend that the taxpayer didn’t even receive.

Negative tax consequences also flow if the value of the frozen preferred shares is overstated. Suppose that in the earlier example, the tax authorities successfully assert that the pre-freeze value of the corporation was only CAD 7.5 million, not CAD 10 million – and, therefore, pursuant to the adjustment clause, the frozen preferred shares are retroactively valued at CAD 0.75 per share. When you reconsider the redemption of 1 million preferred shares, the taxpayer was entitled to receive only CAD 750,000. But as they received CAD 1 million they run the risk of being taxed as if they appropriated CAD 250,000 of corporation assets.

Thus, the garden-variety estate freeze, involving the exchange of common shares for frozen preferred shares subject to a typical price adjustment clause, is effective in capping a taxpayer’s CGT on death exposure. If you want to do better, if you want to allow the taxpayer to erode their potential death tax exposure, and if you want to do so without tax risk, a properly structured estate freeze will involve issuing at least two separate classes of preferred shares to the taxpayer on the exchange, one class of which would expressly not be subject to the price adjustment clause.

So, while the Income Tax Act offers an interesting planning opportunity to reduce or eliminate exposure to estate CGT, it also contains traps that could translate in high-tax liabilities if affairs are not carefully arranged.

Creditor protection

Now consider another client concern: protection from creditors. As mentioned, one of the requirements to effect a tax-deferred estate freeze is that the frozen preferred shares must be retractable. While this achieves tax objectives, it places the taxpayer at considerable risk should they subsequently face action from personal creditors. While the constituting documents of all private corporations contain provisions restricting the transfer or seizure of shares, the effectiveness of such restrictions to defeat a creditor is far from certain; and if a creditor succeeds in seizing retractable preferred shares, the creditor can demand payment from the corporation.

As all bankruptcy and insolvency lawyers agree, the time to plan creditor protection is when there are no known creditors, so the implementation of a tax-driven estate plan is the ideal time to plan for protection against future unknown creditors.

Although you cannot remove the retraction feature attached to the frozen preferred shares, other structures can be put in place. One possible solution is to interpose a new holding corporation (Newco) between the taxpayer and the original corporation (Oldco). The taxpayer would own Newco, and Newco would now hold the retractable frozen preferred shares. Generally, as long as the common shareholders of Oldco are related to the taxpayer, the retractable frozen preferred shares could be redeemed in the hands of the Newco on a fully tax-free basis in exchange for a demand note. After the demand note is issued, Newco would recapitalise the note’s value in non-retractable preferred shares. Therefore, while the taxpayer would continue to hold all the Newco shares, its only asset would be the hard-to-realise-upon non-retractable preferred shares of the original corporation.

© Copyright (c) Society of Trust and Estate Practitioners. Article first published in STEP Journal Volume20/Issue1.

U.S. property investment pitfalls easy to overcome

SHARON SINGLETON, QMI Agency
The Toronto Sun
November 10, 2011

A growing number of Canadians are tempted by property bargains in the U.S., but are being put off by bad information about the possible tax pitfalls, according to David Altro, a lawyer and author of a book on the subject.

The baby boomer generation is looking for a warm place to retire and being lured by property at bargain-basement levels, making Canadians the biggest foreign investors in U.S. real estate.

“I wrote this book because there is a lot of mis-information out there for Canadians wanting to buy or move to the U.S.,” Altro said, whose Owning U.S. Property The Canadian Way is now into its second edition.

Much of it revolves around the potential tax bill and bureaucratic headaches for family members trying to sort out the estate upon the death of the property owner.

Altro said a lot of these problems can be avoided completely by setting up an irrevocable cross-border trust. That will help provide protection from creditors for your children and get around expensive U.S. laws on probate.

Similarly, placing your property in a trust is also beneficial if either you or your spouse becomes incapacitated. Under U.S. law, if one person becomes incapacitated the property can effectively be frozen and will require a series of costly headaches to un-freeze.

“A trust can’t become incapacitated,” Altro said.

Many property advisers recommend setting up a corporation to hold and manage U.S. property assets, though Altro said that is not tax effective.

Capital gains on a cross-border trust are taxed at about 15%, compared with a rate of more than 40% for corporations in Florida.

Although there are fees involved with setting up such a trust, Altro says “they are very small” compared with the costs of a potential tax bill or legal help to sort out problems once they have occurred.

There may be another upside for Canadians wanting to buy U.S. property. If they choose to become U.S. residents their income tax bills will drop substantially. Altro said the maximum U.S. income tax is 35% and that kicks in on earnings of more than $375,000. In Canada, the high rate is 46% on income of more than $125,000.

But for many that requires obtaining an elusive Green Card. A bill put forward by two U.S. senators eager to promote further investment in the country’s sagging real estate market may put a visa within reach.

The bipartisan proposal put forward last month would grant a visa to foreigners spending at least $500,000 on residential property.

Residential sales of U.S. properties to foreigners and recent immigrants totalled $82 billion in the 12-month period ended March 31, up from $66 billion the previous year, according to the National Association of Realtors. California accounted for 12% of those sales, second only to Florida.

There’s no place like a second home for wealthy investors

AUGUSTA DWYER
The Globe and Mail
November 18, 2011

As wealthy foreign buyers snap up more and more luxury homes in Canada, high-net-worth Canadians are similarly showing strong interest in purchasing multimillion-dollar residences abroad. But while their sights were once set on a French château, perhaps, or a Tuscan villa, the trend now is towards buying in the United States.

“We’ve really seen a fall-off in buying in Europe because of all the confusion over the past 12 months or so,” says Don Campbell, president of Abbotsford, B.C.-based Cutting Edge Research Inc. and the author of five best-selling books on real estate investing.

With so much volatility in Europe, especially in Spain, Portugal and Italy, “people don’t know in which direction the market is heading, or the direction of the potential tax implications,” he says. France has just added a new tax on foreign property owners, and the market in Dubai “is getting hammered,” he explains.

Currency fluctuations can cause real estate values to plummet in real terms, while economic woes often leave European governments with little choice but to raise taxes on properties belonging to the super rich.

As a result, says Mr. Campbell, there’s a lot of confusion about where high-net-worth individuals should buy that second property. Hence the popularity of buying in the U.S., where as Mr. Campbell says “you know what you’re getting”.

Other destinations of choice right now are stable tropical nations, such as Costa Rica and Panama. But, he says, “No.1 is the U.S. There’s no question about that.”

The financial incentives for buying luxury residences south of the border are obvious. “They’re at a historic low in terms of pricing,” said Chris Potter, a partner in the Toronto PricewaterhouseCoopers real estate practice.

Lawyer David Altro, author of Owning U.S. Property: The Canadian Way, also finds high-net-worth Canadians are increasingly attracted to real estate prospects south of the border. He says his clients in the eastern part of the country tend to buy in south Florida, while those in the West are eyeing properties in exclusive California cities such as Palm Springs, Desert Palms and Rancho Mirage, or in Hawaii.

The main reasoning behind such preferences is ease of access. Direct and relatively short flights mean less stress and hassle in travelling back and forth between Canadian and U.S. homes.

“They are also liking those areas because they have health care there, too,” he says. “But the bottom line is, we like to go south in the winter to get out of the Canadian weather and play golf and go to the beach. So no matter what the U.S. real estate market is like, it’s always going to be busy.”

Mr. Altro says many boomers and high-net-worth Canadians are taking up permanent residence in the U.S. With a much lighter tax regime “on a regular annual income basis,” he points out, “we have a steady stream of high-net-worth Canadians who are moving to the States. I have a client in Vancouver, worth about $50-million, and all that invested money in Canada is being taxed at such a high rate. Move to the U.S. and it’s like they have a new annual revenue.”

Hunter Milborne, a partner at Sotheby’s International Real Estate, explains why buying a property needs to be planned correctly. If a Canadian owns a property personally, “they have a fairly onerous estate tax [on inheritances], whereas if you own something corporately or through a trust, then that’s not the case.”

For Mr. Campbell, another issue implicit in owning foreign property is having sound insurance advice. “Being such a litigious country, you better have an incredibly good insurance agent for liability, fire and all the things you need to protect yourself for down there,” he says.

“If you’re buying into a gated community or a high-end condo, check to make sure how many of those properties are actually in use, as opposed to being in arrears, foreclosure or owned by a bank,” he says.

“Because the community still needs money to run … a lot of people who buy into those semi-deserted gated communities because it’s relatively inexpensive, find that their fees and operating costs can start to really go through the roof.”

There are, however, many Canadian multimillionaires opting to simply stay put, keeping the Canadian market in luxury real estate buoyant.

“The real favourite right now is keeping money in your hands and in your own country,” says Mr. Campbell, “especially with the global confusion that’s going on, and economic and political confusion in the U.S.”

BuzzBuzHome.com, a website that is, “focused on cataloguing all new residential projects in Canada, connecting purchasers directly with sellers, and providing social tools that enable collaboration amongst purchasers and industry experts” recently interviewed David for their blog.

Tax law extraordinaire, David A. Altro, teaches us how to own US property the Canadian way

BuzzBuzHome Blog
November 14, 2011

Today we had the opportunity to speak with David A. Altro, the managing partner at the law firm Altro and Associates. With 30 years of experience and offices in several Canadian and American cities, David is the go-to guy for advice if you’re considering purchasing property or moving to the US.

Now we’re sure he wouldn’t mind if you showed up at his office or gave him a call on his cell with your question about purchasing property in the US, but why inconvenience yourself when you could just read the latest edition of his book “Owning U.S. Property the Canadian Way.”

In our interview David discusses the important points contained within the updated and expanded second edition and talks about why purchasing property in the US doesn’t have to be a hassle.

This Friday (November 18) there’s a seminar in Toronto at the Westin Prince called “Moving to the US the Canadian Way.” If you’re interested in learning more, you can register for the seminar on the Altro and Associates website.

And now, here’s David!

BBH: Tell us a bit about your firm?

DA: I’m managing partner at the law firm Altro and Associates. We’ve got offices in Toronto, Montreal, Calgary and Vancouver and three in Florida and one in Phoenix.

BBH: How long have you been involved in this industry?

DA: When I moved to Florida in 1982, I got a US law degree and became a member of the Florida Bar in 1984. Since then, I’ve been working in tax and cross border planning. In 1988 I moved back to Canada with my family and continued on. The whole practice grew and grew.

BBH: This is the second edition of your book “Owning US Property the Canadian Way” was just published. When did the first edition come out?

DA: 2009.

BBH: What did you hope to accomplish when you set out to write the initial edition of the book?

DA: I wanted to help demystify the issues people were raising. These issues were causing Canadians to worry about buying US property. The book is meant to help Canadians understand the issues and to plan properly to avoid the problems.

BBH: What’s new in the second edition of the book?

DA: On December 17, 2010, the US signed in a new tax law that affects Canadians. I wanted to explain it and provide new tax planning to avoid the problems. The other reason is a lot of Canadians want to move to the US so I did a chapter on moving to the US “the Canadian way.” On Friday I’m the speaker at a seminar at the Westin Prince in Toronto put on by Cross Border Planning Partners and it’s called “Moving to the US the Canadian Way”.

BBH: Some people might say, considering the economic climate in the US, why is it still a good time to buy property in the US for Canadians?

DA: Because the Canadian dollar is historically low, all the US real estate is on sale and interest rates are very low.

BBH: What are some of the most popular places to invest in the US for Canadians?

DA: Florida is number one. Traditionally, most Canadians go to Florida and Ontarians go to Florida the most. It’s got the ocean and it’s traditionally been a great direct flight down. If you look at Florida, Arizona, California or Texas, all of them have seen the prices come down dramatically.

BBH: What are some common mistakes people make when purchasing property in the US?

DA: Putting the title to the property in their name personally. That leaves them exposed to a few problems. Number one if Florida probate on death. That’s the legal procedure required in Florida when you die to transfer the property to your beneficiary. It’s expensive, time consuming and it freezes the estate. If you put it in a “cross-border irrevocable trust” then it avoids that problem.

The second problem is if you pass away then you may have the US estate tax, but if you have it in trust, the trust doesn’t die. You own the trust, the trust owns the property so upon death, there’s no tax.

BBH: You bring up some “red flags” in the book. What are some of the most important red flags to look out for?

DA: One of the red flags is if you put in a corporation, the red flag is you’re going to have high capital gains tax. Another red flag is if you need financing, you can’t get financing in a corporation. You need to watch out for those type of things. Another one is if you become mentally incapacitated and you have the property in your name personally, you’re going to have to go through a Florida guardianship procedure which can be very expensive. Put it in the trust so these red flags aren’t going to hit you.

BBH: Do you think you’ll keep putting out new editions of the book in the future?

DA: Absolutely! There’s one thing we know about tax law, it’s always going to change. It’s always tied to the politicians, politicians trying to get into power and making new tax plans.

Thanks for chatting with us David!

David was interviewed by Sharon Singleton of QMI Agency for Sun Media. The article appeared in the Toronto Sun, Calgary Sun, on Canoe.ca and many other news outlets and law and tax websites.

U.S. property investment pitfalls easy to overcome

Sun Media
Sharon Singleton, QMI Agency
November 10, 2011

A growing number of Canadians are tempted by property bargains in the U.S., but are being put off by bad information about the possible tax pitfalls, according to David Altro, a lawyer and author of a book on the subject.

The baby boomer generation is looking for a warm place to retire and being lured by property at bargain-basement levels, making Canadians the biggest foreign investors in U.S. real estate.

“I wrote this book because there is a lot of mis-information out there for Canadians wanting to buy or move to the U.S.,” Altro said, whose Owning U.S. Property The Canadian Way is now into its second edition.

Much of it revolves around the potential tax bill and bureaucratic headaches for family members trying to sort out the estate upon the death of the property owner.

Altro said a lot of these problems can be avoided completely by setting up an irrevocable cross-border trust. That will help provide protection from creditors for your children and get around expensive U.S. laws on probate.

Similarly, placing your property in a trust is also beneficial if either you or your spouse becomes incapacitated. Under U.S. law, if one person becomes incapacitated the property can effectively be frozen and will require a series of costly headaches to un-freeze.

“A trust can’t become incapacitated,” Altro said.

Many property advisers recommend setting up a corporation to hold and manage U.S. property assets, though Altro said that is not tax effective.

Capital gains on a cross-border trust are taxed at about 15%, compared with a rate of more than 40% for corporations in Florida.

Although there are fees involved with setting up such a trust, Altro says “they are very small” compared with the costs of a potential tax bill or legal help to sort out problems once they have occurred.

There may be another upside for Canadians wanting to buy U.S. property. If they choose to become U.S. residents their income tax bills will drop substantially. Altro said the maximum U.S. income tax is 35% and that kicks in on earnings of more than $375,000. In Canada, the high rate is 46% on income of more than $125,000.

But for many that requires obtaining an elusive Green Card. A bill put forward by two U.S. senators eager to promote further investment in the country’s sagging real estate market may put a visa within reach.

The bipartisan proposal put forward last month would grant a visa to foreigners spending at least $500,000 on residential property.

Residential sales of U.S. properties to foreigners and recent immigrants totalled $82 billion in the 12-month period ended March 31, up from $66 billion the previous year, according to the National Association of Realtors. California accounted for 12% of those sales, second only to Florida.