Four tax questions private companies should ask now

Authored by Irina Rakhimova, Senior Manager, Private Tax and Gabriel Baron, Partner, Private Tax

As we close out a year that has been anything but simple, private companies have a lot to consider from a wealth preservation perspective. 

Market volatility. Inflationary measures. Regulatory change. Today’s operating environment is complex, and it’s hard to predict what 2023 might bring. Circumstances like these make tax planning an ever more important priority for owners and their families. 

Getting strategic about tax in the runup to calendar year end can unlock a host of different opportunities to fuel progress, preserve wealth and support the bottom line. Asking these four questions now can be a great way to help you understand the many ways strategic tax planning can support a sustainable and profitable future:

1.  Is a cooling real estate market the right time to freeze our estate?

We’ve all seen real estate valuations drop in recent months. That said, this shift could also depress corporate valuations. Now could be the right time to consider an estate freeze. What does that mean?

On death in Canada, any appreciated assets held personally are subject to a capital gains tax as if the assets were sold for their then-prevailing value. This specifically includes shares of private companies — meaning operating companies or holding companies that may hold portfolio investments or real estate.

An estate freeze tax planning transaction involves fixing the value of an investment — typically the shares of a private group of companies — and redirecting the growth of that investment so it can be passed on to a family trust, individuals or a holding company to benefit the next generation. At the same time, existing shareholders will be able to lock in the depressed corporate value at the time of the freeze, giving certainty to their own tax liability on death. This allows more wealth to be transferred to successors.

Completing an estate freeze can be complex and requires broad discussions with tax accountants and legal advisors who are familiar with taxation, trust and family law. If you consider this route, be sure to inquire about the 21-year deemed disposition rules associated with the use of trusts. Also consider buying a corporately owned life insurance policy to fund taxes payable that result from passing away. With appropriate tax structuring, the mere act of buying insurance can itself reduce the tax liability on death. 

2. Could a charitable foundation solidify our legacy and estate plan? 

Charitable giving can unlock numerous tax planning benefits. For example, making the donation today results in a tax benefit associated with the principal amount of the endowment donation. This can be used to shelter the contributor’s high-income years, or in the five tax years following if the donation tax write-off benefits are not all used right away.

In general, making a corporate donation to a registered charity generates a corporate donation tax deduction of up to 75% of taxable income. If making the donation personally, a donor resident in Ontario will receive a tax credit of approximately 50 cents on each dollar donated.

In addition, a donation of public company shares in Canada carries favourable treatment since disposition of these shares on donation are exempt from capital gains tax. It is recommended to consider an optimal mix of donations to be made as part of your overall tax planning strategy.

Let’s say you sell shares of a company or realize another type of capital gain in the corporation. Donating 37.5% of the proceeds received could reduce the tax liability associated with that capital gain, which would normally be taxed at the rate of 25%, to an effective tax rate of approximately 6.3%, or possibly even lower if other tax planning is undertaken. And this tax planning strategy isn’t limited strictly to the sale of a business. It can also be used as part of an overall estate planning strategy to reduce taxes owing on a company with frozen interest.

Last but not least, philanthropy can also be considered if you’re thinking about implementing an estate freeze or settling a family trust — in which case individual charities and foundations can be written in as trust beneficiaries.

Establishing a private foundation for your family and/or an estate provides you with greater control over how the gifts are invested, which organizations will benefit and whether you want to change the foundation’s charitable goals over time. Charitable foundations may also form part of a family’s legacy, empowering everyone to make gifts through a single entity.

The size of planned donations and benefits of setting up a private foundation should be carefully considered, as organizing and operating a private foundation carries a higher administrative burden rather than making donations to selected charitable organizations. Annual compliance includes filing information returns with the Canada Revenue Agency (CRA) and ensuring the disbursement quota is met by making sufficient annual donations, currently calculated as 3.5% of property not used in charitable activities. What’s more, those thresholds could increase to 5% in 2023 as a result of recent legislative proposals passed in August 2022.

There’s a lot to think about. Be sure to explore this option fully. As an alternative to the private foundation option, externally administered donor-managed funds can also be used to achieve similar goals, minimize compliance obligations and more. 

3.  Are we maximizing employee incentives to stave off quiet quitting?

The talent market is transforming in real time. Evolving technologies are opening up entirely new career paths. Generational rifts are creating significant gaps. Employee resignations and turnover are disrupting teams already strained from nearly three years of pandemic disruption.

Wage and salary increases can only go so far — especially in an inflationary market like this one. That said, blending unconventional thinking with strategic tax planning can help recruit and retain talent. For example, deferred compensation strategies allow private companies to offer employees contractual equity participation. The upside? The payout is deferred to a future event, such as the sale of the business or a retirement.

Alternatively, restricted share unit plans (RSUs) tie payment to a specific time or performance milestone. This helps private companies retain key employees now and motivate them by a longer-term financial benefit.

On a similar front, stock options can take advantage of the tax benefit that only Canadian-controlled private corporations (CCPCs) employers can provide, which means the options issued are not taxable to the employee when exercised. In this case, a taxable benefit only arises when the employee actually disposes of the shares, providing a meaningful incentive — and a significant tax deferral opportunity.

If certain criteria are met, an employee could also deduct 50% of the taxable benefit they would otherwise have had to include as employment income, even if the stock options were in the money and dilutive at the time of grant. If the options are exercised, the shares continue to appreciate in value and are held for two more years, and the capital gains on the growth from the date of the exercise may be sheltered by an employee’s lifetime capital gains exemption, provided certain conditions are met.

These alternative compensation options could prove valuable for private companies looking to retain top talent in a shifting market. That said, pursuing one of these options requires careful analysis of the costs and benefits along with the legal intricacies that come with them. That’s especially true for stock options, which may provide real equity to an employee who may ultimately leave the company anyway but remain a shareholder. 

4. How can we combat rising interest rates right now? 

Interest rates are up, and with them the prescribed loan rate for family income splitting purposes, now subject to the 3% prescribed rate. Also important: taxable benefits on low-interest loans for employees and shareholders are subject to the same 3% prescribed rate.

Taken together, these rising interest rates mean that CRA financing is becoming more expensive. For instance, late-filing of a corporate tax return results in penalties calculated at 5% of balance owing, plus an additional 1% for each full month after the due date. Interest is charged on the penalties and balance owing at the prescribed rate of 7%, which is compounded daily. That’s a big jump from this time last year.

Layer in the fact that the CRA will now be charging 7% interest on all tax debts owing, compounded daily — and the nuance that interest isn’t tax deductible — and it’s even more important to make sufficient installment payments by required deadlines. Otherwise, the arrears interest may be higher than the possible yield on invested funds.

Therein lies an opportunity to get ahead of interest rates and preserve cash by monitoring installment payments more strategically this year. Now is a good time to reflect on how you’re handling tax payments, anticipated refunds and general cashflow plans.