1. 2004 Stop Loss Rules

2. 2004 Agenda Overview  What are Stop Loss rules?  What is their effect? Examples Solutions

3. 2004 Stop Loss Rules I ncome Tax Act ss.112(3.2) What are they?  Rules that impact business and estate planning where… Method used is corporate share redemption Funding is with life insurance

4. 2004 Stop loss rules I ncome Tax Act ss.112(3.2) What’s the effect?  Assuming the rules apply to a share disposition by the estate…. Double tax exposure Estate loss reduced by up to 50% of capital dividend Capital gain taxed on terminal return is increased  Double taxation occurs because…. Surviving shareholders receive NO ACB increase The gain is taxed in hand’s of deceased The gain is taxed again when surviving shareholder disposes of shares

5. 2004 Company Profile XYZ Inc. FMV = $2,000,000 Owners  John owns 50% of shares ACB of John’s shares $10,000 PUC of John’s shares $10,000  Mary owns 50% of shares ACB of Mary’s shares $10,000 PUC of Mary’s shares $10,000

6. 2004 Company Profile Growth rate of company2% Personal marginal tax rate on income50% Personal marginal tax rate on dividends33% Capital gains inclusion rate50% Assume John died last night Assume Mary sells the business in 10 years

7. 2004 Share Redemption with corporate owned insurance XYZ Inc. buys $1,000,000 of life insurance on John’s life and $1,000,000 of life insurance on Mary’s life Agreement Premiums 50% XYZ Inc.

8. 2004 Share redemption with corporate owned insurance John dies

9. 2004 As per Buy-Sell Returns shares XYZ Inc. For cancellation 3 Share redemption with corporate owned insurance $1,000,000 Death Benefit 1 XYZ Inc. $1,000,000 To purchase shares 2 John’s estate

10. 2004 Taxation 1.Premiums paid by corporation are a non-deductible expense 2.Proceeds received by the company are tax-free 3.Proceeds in excess of ACB are credited to the CDA 4.Proceeds received by the shareholder’s estate in excess of the PUC deemed a dividend. The dividend could be elected as a capital dividendAdvantages 1.After-tax premium cheaper if the company is in a lower tax bracket 2.Fewer policies are required (one per shareholder) 3.Premium disparities are not an issueDisadvantages 1.No increase in the ACB for the surviving shareholder 2.Insurance proceeds subject to claims from the company’s creditors Share redemption with corporate owned insurance

11. 2004 Mary now owns 100% of XYZ Inc. Share redemption with corporate owned insurance

12. 2004 Tax Implications – John *Exemptions may help shelter

13. 2004 Tax Implications – John’s Estate

14. 2004 *Exemptions may help shelter Tax Implications – Mary

15. 2004 Stop Loss Rules Prior to the introduction of these rules, it was possible to eliminate all tax on the disposition of shares for a deceased shareholder The department of finance determined that this was an unwarranted deferral of capital gains tax and introduced the legislation The Stop Loss rules apply to transactions after April 26, 1995

16. 2004 Calculating the loss stopped The lesser of  The capital dividend received by the estate, and  The capital loss minus any taxable dividends received by the estate Minus 50% of the lesser of  The deceased’s capital gain from the deemed disposition on death, and  The estate’s capital loss The lesser of $990,000 $990,000 – 0 = $990,000 Minus 50% of the lesser of *$990,000 $990,000 – (0.5 X $990,000) =$495,00 *Exemptions may help shelter

17. 2004 Tax Implications – John Pre-April 26, 1995 vs Post-April 26, 1995 *Exemptions may help shelter

18. 2004 Tax Implications – John’s Estate Pre-April 26, 1995 vs Post-April 26 1995

19. 2004 *Exemptions may help shelter Tax Implications – Mary Pre-April 26, 1995 vs Post-April 26 1995

20. 2004 Grandfathering Opportunities Where a corporation was the beneficiary of a life insurance policy on the life of a taxpayer, on or before April 26,1995, where the main purpose of the insurance was to redeem shares held by the taxpayer grandfathering will be available  Applies even if coverage is increased  Policy is converted or replaced  Policy lapses and is reinstated

21. 2004 Grandfathering Opportunities It is up to the taxpayer to provide CCRA with ample documentation to prove that the main purpose of the life policy was to redeem shares

22. 2004 Grandfathering Opportunities Grandfathering will also be available for agreements that were in place prior to April 27, 1995  As long as the agreements are not modified in any way

23. 2004 One way to reduce the effects of the Stop Loss Rules is to use the Hybrid Method

24. 2004 Hybrid Method with corporate owned insurance The insurance would be corporately owned but the agreement would allow flexibility in determining at death how many shares would be purchased by the surviving shareholders and how many shares will be redeemed by the corporation.

25. 2004 XYZ Inc. buys $1,000,000 of life insurance on John’s life and $1,000,000 of life insurance on Mary’s life Agreement Premiums 50% XYZ Inc. Hybrid Method Hybrid Method with corporate owned insurance

26. 2004 Hybrid Method with corporate owned insurance John dies

27. 2004 $500,000 Promissory note To purchase shares Mary 4 As per Buy/Sell returns 50% of shares XYZ Inc. For cancellation 3 Mary Now owns 100% of XYZ Inc. As per Buy/Sell returns 50% of shares to Mary 5 XYZ Inc. declares a capital dividend of $500,000 7 Hybrid Method with corporate owned insurance $500,000 To purchase shares 2 John’s estate $1,000,000 Death Benefit 1 XYZ Inc.

28. 2004 Tax Implications – John *Exemptions may help shelter

29. 2004 Tax Implications – John’s Estate $500,000 of shares redeemed

30. 2004 Tax Implications – John’s Estate $500,000 of shares sold

31. 2004 *Exemptions may help shelter Tax Implications – Mary

32. 2004 Taxation 1.Premiums paid by corporation are a non-deductible expense 2.Proceeds received by the company are tax-free 3.Proceeds in excess of ACB are credited to the CDA 4.Proceeds received by shareholder’s estate in excess of PUC deemed to be a dividend. The dividend could be elected as a capital dividendAdvantages 1.After-tax premium expense cheaper if company is in a lower tax bracket 2.Fewer policies are required (one per shareholder) 3.Premium disparities are not an issue 4.Surviving shareholder gets an ACB step up Disadvantages 1.Insurance proceeds subject to claims from the company’s creditors 2.Somewhat complicated arrangement Hybrid Method with corporate owned insurance

33. 2004 Comparing the Strategies Results for each of the relevant parties

34. 2004 Tax Implications – John *Exemptions may help shelter Share Redemption Hybrid

35. 2004 Tax Implications – John’s Estate Share Redemption Hybrid

36. 2004 *Exemptions may help shelter Tax Implications – Mary Share Redemption Hybrid

37. 2004 Total Tax Payable Share Redemption Hybrid

38. 2004 Summary Both strategies have their pros and cons Corporate redemption is better from John’s perspective Hybrid from Mary’s The best strategy  see if the client can benefit from grandfathering