Pipeline still possible?

On October 19, the federal government continued in the almost-daily announcement of reforms to its original July 18 tax reform proposals.

This latest reform announcement indicates that the government will not be moving forward with measures relating to the conversion of income into capital gains.

As has been the case all week, the actual announcement is vague.  Even worse, one has to be a tax professional in order to understand the announcement. The announcement is also misleading, because the change merely allows taxpayers to avoid double taxation.

To illustrate the point, take a simple example.  Assume that an individual (a parent) dies and leaves shares of a private family corporation to the parent’s children.  As a result of the parent’s death, the shares undergo a deemed disposition for tax purposes at fair market value.  This usually results in payment of capital gains tax.  To keep the numbers simple, assume that the deceased had no cost in the shares and that the shares had a date-of-death value of $100.  This results in a $100 capital gain and requires payment of about $24 in tax.

This is a deemed capital gain.  No actual sale has occurred, which means that the estate has no cash to pay the tax.  In order to pay this tax on the deemed capital gain, the estate usually has to extract cash from the corporation.  If the corporation pays a $100 dividend to the estate, however, the estate will have to pay about $41 in tax on that dividend.  That results in total tax of $65 on a taxable value of $100.

In order to avoid this double taxation, the estate can implement a post-death corporate reorganization.  This form of reorganization is called a “pipeline” by tax practitioners (but has nothing to do with oil flowing from Alberta).  The reorganization allows the estate to extract $100 from the corporation without payment of the extra $41 in tax.  This always seemed fair, given that the Income Tax Act had imposed the original $24 capital gains tax on the death of the parent.  The post-death reorganization merely allowed that already-taxed value to be extracted as an amount that had already been taxed (which was indeed the case).

Today’s announcement is welcome.  It would have been preferable, however, for the government to have called a spade a spade and to have announced that it was withdrawing a proposal that would have resulted in double taxation of value on death.  The government continues to tar entrepreneurs with an implied “tax cheat” brush by referring to the withdrawal of a measure that would have prevented the conversion of income into capital gains.

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