No. 1]
THE CORPORATE FREEZE
The Corporate Freeze
Jean Monet *
L’homme moderne tient plus A ses biens qu’A sa vie m~me, car ses biens sont
sa vie d’abord, puis la vie de sa femme, de ses enfants, de sa post6rit6.
(Lamartine circa 1830)
Lamartine may have been going too far, but assets are important.
Their accumulation is difficult and requires skill. Their protection
against erosion is equally difficult. One of the most constant eroding
agents is the tax collector who insists on his pound of flesh, not only
out of the taxpayer’s income while he is alive but also out of his
property as it passes to future generations. The taxpayer has the right
to apply as much ingenuity in counteracting that agent as he did in
accumulating his property. His liability for tax and hence the col-
lector’s right to levy it, is determined by statutes which specifically
set out the circumstances in which he must pay. If those circumstances
do not exist –
then the taxpayer is not liable. If he has avoided the circumstances le-
gally, he needn’t fear a penalty. This principle has long been recognized
by the leading tribunals. It has been said that:
and taxing statutes must be interpreted litterallyI –
Every man is entitled, if he can, to order his affairs so that the tax
attaching under the appropriate acts is less than it otherwise would be.
If he succeeds in ordering them so as to secure this result, then, however
unappreciative the commissioners of inland revenue or his fellow taxpayers
may be of his ingenuity, he cannot be compelled to pay an increased tax.2
No man in this country is under the smallest obligation, moral or other so
to arrange his legal relations to his business or to his property as to enable
the inland revenue to put the largest possible shovel into his stores. The
inland and revenue is not slow –
to take every advantage
which is open to it under the taxing statutes for the purpose of depleting
the taxpayer’s pocket. And the taxpayer is,
in like manner, entitled to be
astute to prevent, so far as he honestly can, the depletion of his means by
the revenue.3
There are many techniques available to the taxpayer to minimize
the impact of taxation. This article will deal with one of them –
the
holding company. It will outline how the company may be used to
minimize death duties and to facilitate the administration of one’s
property after death.
and quite rightly –
Of the Bar of Montreal.
1Fasken Estate v. M.N.R. [1948] C.T.C. 265 at p. 275-6.
2 The Duke of Westminster v. C.LR. [1936] A.C. 1.
3 Ayrshire v. C.I.R. 14 T.C. 754.
McGILL LAW JOURNAL
[Vol. 13
The Quebec-domiciled decedent has to cope with two sets of death
duties, namely, Quebec succession duties and the federal estate tax.
Death duties are based on the value of the deceased’s assets.4 The
higher the value, the higher the duties. One of the keys to successful
planning is to freeze one’s assets at a maximum value and divert
growth from the taxable estate. The freeze, having “set” the value,
permits the taxpayer to determine the death duties to be supported
by his heirs. He can accordingly arrange for appropriate liquidity at
death, which will permit the immediate release of his assets. This is
where the holding company can be of great help. It will often appear
on the scene in the case of the owner of a prospering company whose
growth is reasonably assured. His assets, plus the fact that he will
be employed with his company as long as he wishes, give him the
assurance that he will be in a constant position to maintain his
standard of living. In other words, he’s happy with that he’s got. Any
increase in the value of his assets will only benefit the tax collector
by giving him more money. The technique this person (“Mr. B”)
will apply in setting up his holding company will be the following.
Assume here that his business is called Growth Enterprises Inc. and
that he owns 100% of its stock worth $500,000.
Step 1. He will incorporate a holding company, say, Holdings
Inc., with an authorized capital of at least $500,000 divided into
199,000 Class “A” preferred shares of the par value of $1 each,
300,000 Class “B” preferred shares of the par value of $1 each and
1,000 common shares of the par value of $1 each. Both classes of
preferred shares will carry a fixed, non-cumulative dividend rate,
will be redeemable at par and will entitle the holders thereof to the
return of their capital on liquidation and to no more. The common
shares will naturally be fully participating in the company’s profits
and assets, subject only to the prior rights of the preferred share-
holders. Both the Class “A” preferred and the common shares will
entitle the holders thereof to one vote per share. The Class “B” pre-
ferred will be non-voting.
Step 2. Mr. B will sell all of his Growth Enterprises stock to
Holdings Inc. for $500,000 and will be paid by the issuance to him of
the preferred and common shares described in Step 1.
4 “An estate tax shall be paid as hereinafter required upon the aggregate
taxable value of all property passing on the death…” (Estate Ta. Act, 2(1)).
“All property, moveable or immoveable, the ownership, usufruct or enjoyment
whereof is transmitted owing to death, shall be liable to duties calculated upon
the aggregate value of the property transmitted…” (Quebec Sueeession Duties
Act, 2).
No. 1]
THE CORPORATE FREEZE
Step 3. Mr. B will then sell or give the common shares of
Holdings Inc. to members of his family or business successors.
As a result of this reorganization:
A. Growth Enterprises Inc. will be wholly-owned by Holdings
Inc. and hence frozen in Mr. B’s estate at a maximum amount of
$499,000, being the value of the preferred shares of Holdings Inc.
This follows from the conditions of the preferred shares which do not
permit participation in the company’s profits and assets beyond a
fixed dividend rate and a return of capital on redemption or liqui-
dation. Consequently, Mr. B now knows that Growth Enterprises Inc.
will not attract death duties on more than $499,000.
B. All of Growth Enterprises’ growth has been diverted to the
common shares of Holdings Inc. This is tied in with A and follows
from the fact that the growth accrues to Holdings Inc. and can be
reflected only in its own common shares since the preferred cannot
increase in value. If, for example, Growth Enterprises is worth, say,
$1,300,000 on Mr. B’s death 20 years after the reorganization (a
growth of about 5% per annum), Holdings Inc. would be worth the
same amount and the shares of Holdings would be worth:
Class “A” preferred: $199,000
Class “B” preferred: $300,000
Common:
$801,000
There will be no gift tax on the transfer of the common shares,
because they will have been sold for real value ($1,000) or, if given,
should be within Mr. B’s gift tax exemption. 5 If sold for real value,
they will not attract death duties. If given, they will attract Quebec
succession duties if Mr. B dies within 5 years of the gift and federal
5 “For the purposes of this Part, “aggregate taxable value” is the aggregate
value of the gifts made by the donor during the taxation year other than those
exempt under subsection (3) or (4) minus
(a) in the case of an individual, either
(i) $4,000, or
(ii) one-half the difference between the taxable income of the donor for
the immediately preceding taxation year as determined under Part I
and the tax that was payable thereon under Part 1,
whichever is greater…”
“Where the value of all gifts made by a donor to an individual in a taxation
year does not exceed $1,000, those gifts are exempt from tax under this Part.”
(Income Tax Act, 12 (2) (3)).
McGILL LAW JOURNAL
[Vol. 13
estate tax if he dies within 3 years.” In either case, the duties will be
on the real value of the shares given at the date of death.
C. Mr. B will continue to control Growth Enterprises as long as
he wishes. This follows from his control of Holdings Inc. (199,000
votes against 1,000) which in turn controls Growth Enterprises.
D. Having so “set” the value of Growth Enterprises, Mr. B can
embark upon an effective estate reduction program. He has already
disposed of the growth-so he need not be concerned that the value of
what he keeps will increase faster than what he gives away. He will
carry out his program by first giving away his non-voting Class “B”
preferred shares within the maximum limits of his gift tax exemptions
and deductions. When this is complete he will have given away
$300,000. He can then start giving the Class “A” voting shares. If
he does not yet wish to distort his percentage of votes, he can convert
part of the “A” into non-voting “B” and restrict his gifts to that class.
E. If Mr. B does not wish to reduce the value of his estate, as
will often happen if he wants to assure that his widow will have a
sufficient income after his death, the division of the equity into
voting and non-voting preferred affords him the opportunity of allow-
ing control to be exercised by business associates or key employees
without interference by his widow. By the same token, his widow
will be fully protected in that she will benefit from the income of
the non-voting stock. He can provide for this in his will by bequeathing
the voting stock in trust to a group of key employees or business
associates and the equity or Class “B” preferred stock to trustees
for the benefit of his widow. The widow will be protected by stipu-
lations in the will to the effect that the trustees holding the voting
6 “There shall be included in computing the aggregate net value of the property
passing on the death of a person the value of…
(a) …
(b) …
(c) property disposed of by the deceased under a disposition operating or
purporting to operate as an immediate gift inter vivos, whether by trans-
fer, delivery, declaration of trust or otherwise, made within three years
prior to his death.”
(Estate Tax Act, 3 (1)).
“For the purposes of this act, the ownership, usufruct or enjoyment of any
property shall be deemed to be transmitted owing to death:
(1) Whenever the deceased has disposed thereof by gratuitous title in any
manner whatsoever and the said disposition has taken effect within the five years
prior to the death of the person by whom it was made.” (Quebec Succession Duties
Act, 23(I)).
No. 1]
THE CORPORATE FREEZE
stock must-vote their shares each year in order to pay out so much
money on the Class “B” shares by way of dividend and/or redemption.
This money would then be remitted to his widow by the trustees of
the “B” stock.
F. Holdings Inc. can also be used to provide tax-free funds at
death to pay death duties. This aspect of the reorganization is tied
in with the notion of designated surplus, Section 138A of the Income
Tax Act, and Holdings Inc.’s “personality” within the meaning of
that Act. It is a rather tricky and dangerous sport and will be dealt
with later in this article.
The three steps of the holding company reorganization are simple
and the results rewarding. However, as in all else, there is a right
–
and a wrong way. As one of the key players on
way to do things –
the estate planning team, the lawyer should make sure the right way
is chosen. There exist several obstacles (more or less hidden) which
could destroy the usefulness of the holding company. They will now
be reviewed as they appear at each step of the way.
STEP 1
The choice of a federal or provincial charter. The right to vote
cannot be completely removed from preferred shares of a federal
company (a usual provision is that preferred shares acquire voting
rights if dividends thereon are not paid for two consecutive years).
It can in the case of Quebec companies. Accordingly, if non-voting
preferred shares are contemplated for the reasons outlined below, a
Quebec charter should be chosen.
The preferred shares. The conditions attached to the preferred
shares should clearly limit the holders’ participation, to a fixed
dividend rate and to return of capital only. They should have no
further rights to participate in profits and assets of the company. If
no such limitation exists, the preferred stock will share the growth
of the company with the common and will not have frozen values.
Furthermore, it has been recently held that a controlling “preferred”
shareholder whose “preferred” shares entitled him to quasi-unlimited
dividends was competent to dispose of the assets of the company
within the meaning of the Estate Tax Act and that his estate was
liable for death duties on those assets. 7 Although the circumstances
of that case are rather unique, it has caused some commotion and a
7 Barber V. M.N.R. [1966] D.T.C. 315.
McGILL LAW JOURNAL
[Vol. 13
short review of it appears justified. The facts are that in 1946, Mr.
Barber incorporated a holding company with an authorized capital
of $50,000 divided into 500 Class “A” shares and 4,500 Class “B”
shares of the par value of $10 each. The conditions attached to the
Class “A” and Class “B” shares can be summarized as follows:
–
–
The Class “A” shares were entitled to a fixed, cumulative,
preferential dividend of 5% per annum and, on liquidation,
to the balance of the company’s assets after distribution to the
Class “B” shareholders.
The Class “B” shareholders were entitled to all the net earnings,
profits or income of the company declared as dividends after
the payment of the 5% dividend on the Class “A” and, on
liquidation, were entitled to receive the par value of their
shares and no more.
– Both classes were entitled to one vote per share.
Between the date of incorporation and Barber’s death, Barber
transferred securities to the company in exchange for Class “A” and
Class “B” shares of its capital stock. At the date of death, the net
asset value of the company was $146,654, and its shares were owned
as follows:
1 Class “A”
– Mrs. Barber:
– Mr. Barber: 4,497 Class “B”
The three other “B” shares beneficially owned by Barber were
registered in the names of the directors for qualifying purposes.
Barber’s executors included the Class “B” shares in his estate at
their par value of $45,000. The Minister of National Revenue in-
creased the taxable estate by $101,610, being the surplus in the
company after allowing $10 for the one outstanding Class “A” share.
He alleged that the additional amount was taxable because Barber
was competent to dispose of it immediately before death.8
The assessment was objected to but the Tax Appeal Board ruled
in favour of the Minister. The reasons given were:
– Barber controlled the company and could have withdrawn the
–
entire surplus by way of dividends on the Class “B” shares;
he was free to change any of the provisions governing the
capital stock;
s “There shall be included in computing the aggregate net value of the property
(a) all property of which the deceased was, immediately before his death,
passing on death…
competent to dispose…”
(Estate Tax Act, 3(1) (a)).
No. 1]
THE CORPORATE FREEZE
– his competency to dispose of the company’s assets was accent-
uated by the fact that he and his wife were its two beneficial
shareholders.
It is the writer’s view that Mr. Barber’s Class “B” shares as a
block were worth $146,610, because they controlled the company and
had the right to quasi full participation in the company’s profits.
The interesting feature of the case is the Minister’s approach. The
judgment would have attracted very little attention if the increased
tax had been levied on the basis of the real value of the shares.
Instead, the Minister chose to look upon the assets of the company as
property which the deceased could freely dispose of. One has to agree
that the share conditions gave Mr. Barber the right to freely withdraw
the company’s surplus. On the other hand, the judgment does not
provide authority for the proposition that the controlling shareholder
of a company has the power to dispose of the company’s assets. He
must respect the rights of minority shareholders. It is an accepted
principle that majority shareholders cannot take unfair advantage
of the minority, whose rights in such instances are protected by the
courts. It is not within the power of the majority to sacrifice the
interests of the minority to serve its own selfish ends. This principle
requiring fair if not equality of treatment has been applied in distri-
bution of company property among shareholders where there has
been an attempt on the part of one group to benefit themselves at
the expense of others and to use their majority powers for that pur-
pose. Wegenast states at page 321 of his treatise on company law:
It is not open to the majority to divide the assets of a company among
themselves to the exclusion of minority or to make presents to themselves
of company property.9
Admittedly, these principles do not apply in Barber’s case since
the “B” shares clearly gave their holders the right to participate in
surplus. The exercise of that right cannot be considered as legally
unjust to shareholders of another class who are presumably aware
of it when they acquire their shares. This is not a question of the
majority sacrificing the interests of the minority for selfish purposes
such as acquiring a corporate asset for less than its real value. It
is merely a question of the majority exercising its rights in accordance
with the conditions of its shares. The fact that the only other share-
holder involved in Barber was Mrs. Barber, who held one out of
5,000 shares, pushes minority rights further into the background.
Indeed, this might very well be what the assistant chairman of the
Tax Appeal Board had in mind when he said: “If there had been
D Wegenast, Canadian Companies, p. 321. See also p. 315 et seq. Also Fraser &
Stewart, Company Law of Canada, 5th ed., p. 717 et seq.
McGILL LAW JOURNAL
[Vol. 13
other shareholders for value, with consequent vested interests, such
as strangers, for instance, additional factors might have called for
consideration, but this was not the factual position.”
Of greater interest is the Board’s second reason that Mr. Barber
was free to change any of the provisions governing the capital stock.
This should not have been a consideration. Mr. Barber did not have
to change anything on his shares. He had quasi full participation any-
way, which is what made his shares valuable. If preferred shares
provide for a fixed rate of dividends and limited participation in the
corporate assets on distribution, an increase in either reduces the
value of the junior or common shareholders’ equity rights. It is a
recognized rule of law that any change in shareholders’ rights must
have the approval of the shareholders affected.’ 0 The required ap-
proval, in the case of federal and Quebec companies, will be either
unanimity, three-quarters or two-thirds of the shares affected, de-
pending upon the change sought and the provisions of the company’s
charter and by-laws. Indeed, the company might very well have to go
through the procedure of arrangements and compromises with share-
holders as set out in the relevant statutes.” This procedure, in addition
to requiring shareholder approval, necessitates the sanction of a
judge prior to an application for supplementary letters patent. Ac-
cordingly, one should not conclude from the Barber case that a con-
trolling shareholder can change the conditions of his shares as he so
wishes. He cannot disregard the rights of other shareholders.
The conditions attached to the Class “A” and Class “B” preferred
shares of Holdings Inc., as indicated above, are clearly distinguishable
from those of the late Mr. Barber’s company. Hence the Barber
decision should not apply.
The preferred shares are divided into two classes (voting and non-
voting)
to permit reduction of the estate without affecting the
planner’s voting percentage. As explained in D,12 he can do this by
giving away the non-voting preferred. If it is felt that the non-voting
stock will be put into a trust for the benefit of a particular beneficiary,
as explained in E, the dividend on the voting preferred should rank
after the dividend on the non-voting. An alternative is to have a small
number of voting preferred shares at the outset, so that the servicing
of their dividend will not be too onerous on the company. This alter-
native is not to be recommended. A small number of voting preferred
shares with very little equity participation can nevertheless be very
1o Fraser & Stewart, Company Law of Canada, p. 328 ot seq.
11 Section 46, Companies Act; Section 126, Canada Corporations Act.
12 See page 4.
No. 1]
THE CORPORATE FREEZE
valuable if they control a prospering business. The Tax Department
will certainly-attempt to assess those shares at a value much higher
than par. It is therefore advisable for the controlling preferred shares
to represent a reasonable portion of the company’s equity.
The dividend rate on the preferred stock should be reasonable in
the light of current interest and dividend rates. Rates varying between
6% and 10% have been acceptable to the Department of National
Revenue. The non-voting stock should carry a slightly higher rate
than the voting.
STEP 2
(Section 23(2). The big obstacle here is Section 23(2) of the
Quebec Succession Duties Act.13 The section taxes any property trans-
ferred to a company in exchange for securities of the latter if the
transfer is outside the ordinary course of business and has resulted
in the avoidance or decrease of succession duties. The property so
transferred is taxed on its value at the date of death less the value
at the same date of the securities received in exchange.
The key move around this obstacle is to include all of the common
shares of Holdings Inc. in the consideration paid to Mr. B. The last
paragraph of Section 23 (2) provides that the real value of the pro-
perty to be taxed as at the date of death is that which exceeds the
real value as at the same date of what Mr. B received in exchange
for the shares transferred to the holding company. Accordingly, if he
received the common shares, their value at death must be deducted
from the taxable amount. The computation in Mr. B’s case would be
as follows:
Add property deemed transmitted on death
Real value of shares of Growth
Enterprises at date of death ……….
Deduct value at same date of property
… …
.
$1,300,000
received in exchange
Class “A” preferred shares
of Holdings Inc.
Class “B” preferred shares
of Holdings Inc.
Common shares of Holdings Inc.
$300,000
199,000
801,000
Taxable am ount …………………………………………………………….
$1,300,000
.. N il
13 “Whenever a person domiciled in the Province at the time of his death, which
occurred after the 1st of January 1950, has assigned or transferred to a partner-
ship, company or corporation any property in consideration of or in exchange for
capital shares, bonds, debentures, notes or other securities of such partnership,
McGILL LAW JOURNAL
EVol. 13
On the other hand, if the common shareholders had directly sub-
scribed for their shares and the company issued preferred shares only
to Mr. B as consideration, the computation would be as follows:
Add property deemed transmitted on death
Real value of shares of Growth
Enterprises at date of death ……………………………………
$1,300,000
Deduct value at same date of property
received in exchange
Class “A” preferred shares
of Holdings Inc.
Class “B” preferred shares
of Holdings Inc.
$300,000
199,000
Taxable am ount …………………………………………………………….
499,000
$ 801,000
It is obviously important for all of the documents to clearly in-
dicate that each link of the chain has been solidly welded. Not only
should the contract of sale clearly stipulate that the common shares
are part of the consideration paid to Mr. B, but the minute book of
Holdings Inc. should show their issuance to Mr. B, as should its stock
ledger and share certificates. The minutes should then indicate a
subsequent transfer to his family, as should both the ledger and the
endorsements on the certificates. A short cut there could be deadly.
Gift tax. The other obstacle to watch for is gift tax. If this tax
is to be avoided, proper values must be used on the sale of Growth
Enterprises’ stock to Holdings Inc. The shares must be sold for their
real value, neither more nor less. If they are sold for more than their
company or corporation, or for revenues, emoluments, benefits, payments or other
advantages, and such assignment or transfer was made otherwise than in the
ordinary course of business and has resulted in the avoidance or decrease of the
duties which would otherwise have been payable under this act, had such transfer
or assignment not been made and such property had formed part of his estate,
at the time of his death, the ownership, enjoyment or usufruct of such property
shall be deemed, for the purposes of this act, to have been transmitted owing
to the death of the assignor or transferor and shall be included in his estate.
Every person benefiting therefrom, directly or indirectly, whether in consequence
of the said assignment or transfer or of contemporaneous or subsequent deeds
or instruments executed by the deceased, shall pay, in proportion to the benefit
derived by him, the same duties in respect of the property deemed to have been
transmitted owing to the death, as would have been payable, had the ownership,
enjoyment or usufruct of the property assigned or transferred been transmitted
to him owing to the death of the assignor or transferor.
The real value of the said property, as at the date of the death, shall be
determined by the collector having jurisdiction, who shall, however, deduct there-
from, for succession duty purposes, the real value, as at the same date, of the
property received in exchange.” (Quebec Succession Duties Act, 23(2)).
No. 1]
THE CORPORATE FREEZE
worth, the excess can be considered as a benefit from a company
(Holdings Inc.) to a shareholder (Mr. B). These benefits are taxable
under the Income Tax Act.14 If they are sold for less, then the diffe-
rence between the price and the value is reflected in the common
shares. If the difference exceeds Mr. B’s gift tax exemption, gift tax
will be due on the transfer of common shares to members of his
family. Assume, for example, that the real value of the Growth
Enterprises stock is $600,000 instead of $500,000. If Mr. B receives
$499,000 in preferred shares and $1,000 in common stock as consi-
deration, it follows that the 1,000 common are worth the difference
between $499,000 (the value of the preferred) and $600,000, namely,
$101,000. If the common are subsequently sold for $1,000, there is a
gift of $100,000 which is subject to gift tax.
The real or fair market value of private company shares is not
easy to determine. Fair market value has been defined as the price
that an item can fetch when sold by a vendor who is not forced to
sell to a purchaser who is not forced to buy, both of whom are com-
pletely familiar with the item sold and the circumstances affecting
it. In other words, it is the price paid by a willing buyer to a willing
seller. The problem is accentuated in the case of a private company
because there is no public market for its shares. If they were listed
on the stock exchange, then their value would be their closing price
as at the date of the transaction. 15 There is no such luxury in valuing
14″Where, in a taxation year,
(a) a payment has been made by a corporation to a shareholder otherwise
than pursuant to a bona fide business transaction,
(b) funds or property of a corporation have been appropriated in any manner
whatsoever to, or for the benefit of, a shareholder, or
(c) a benefit or advantage has been conferred on a shareholder by a corpo-
ration,
otherwise than
(i) on the reduction of capital, the redemption of shares or the winding-
up, discontinuance or reorganization of its business,
(ii) by payment of a stock dividend, or
(iii) by conferring on all holders of common shares in the capital of
the corporation a right to buy additional common shares therein,
the amount or value thereof shall be included in computing the income of the
shareholder for the year.” (Income Tax Act, 8(1)).
15 ,…
the value of any security that is listed on a stock exchange, or, in the
case of any security not so listed, on which a price or quotation is obtainable
from a recognized financial journal or financial report or from a registered
broker, shall be deemed to be the closing price or quotation of that security on
the day as of which such value is required to be computed, or, if there was no
closing price or quotation on that day, on the last preceding day on which there
was a closing price or quotation.” (Estate Taxc Act, 27(1)).
McGILL LAW JOURNAL
[Vol. 13
private company shares., One must assume a market and estimate a
value on that basis. Our courts have long recognized the complexity
and elusiveness of determining the proper value of a certain asset
at a given time. It has been said that:
Value is a general and indefinite term, and is as variable as the opinions
or humours of men. It may be nothing or something very great in the same
object, at the same time, in the eyes of different men. 16
Although the shareholder himself (Mr. B) and his auditor will
normally determine the value of the shares, the lawyer involved in
estate planning should at least have a general notion of how values
can be determined. That subject in itself justifies a thick book. The
following are the two basic methods:
1. Book value:- This is simply the result obtained by deducting
the company’s liabilities from its assets. It is the company’s net worth,
its shareholders’ equity. If the company has only one class of stock,
i.e. common, then all of that equity belongs to the common share-
holders and is the book value of their shares. If the company has
preferred stock, its value must be deducted from the overall book value
to determine the value of the common. Take the following balance
sheet as an example:
Assets:
$780,000
Liabilities:
$250,000
Shareholders’ Equity
2,000 pref. at $1
1,000 common at $1
Surplus
$200,000
1,000
329,000
$780,000
$780,000
The book value of the company is $530,000 (the difference between
$780,000 and $250,000) and the book value of the common is $330,000,
the result obtained by deducting the 2,000 preferred shares from
$530,000.
2. Earnings value:- This value is established by capitalizing
average past earnings of a company at a given rate. The past earnings
considered should cover a period which is representative of the com-
pany’s profit history. The capitalization ratio should be chosen in the
light of the price earnings ratio of companies in similar businesses
whose shares are traded on stock exchanges. Say, for example, that
the average net after-tax earnings of Growth Enterprises for the
last five years have been $55,000. The price earnings ratio of listed
companies in similar businesses is 12, in other words, shares of
16 Hickey v. Stalker [1924] 1 D.L.R. 440.
No. 1]
THE CORPORATE FREEZE
similar companies on the public market are selling at 12 times
earnings. A substantial discount (say, 25%) can be justified for a
private company whose shares are not listed on the public market.
This gives a capitalization rate of 9 and a value of $495,000 for the
stock of Growth Enterprises on an earnings basis ($55,000 x 9).
Book value does not reflect intangibles such as goodwill. Hence it
is often unrealistic and if used must be adjusted to reflect various
items. For estate planning purposes, it will normally be accepted
by the Department of National Revenue if it exceeds the value based
on earnings. If the eanings value is considerably lower than book, it
may be possible to have the Tax Department accept a discounted
book or “break-up” value. This is predicated on the premise that the
value of assets is measured by their production. If they do not produce,
they should be disposed of. Break-up value is the amount realized
upon the disposal of a “broken” business’ assets. It will often be
less than book value.
If the earnings value exceeds book, the estate planner will attempt
to discount it and arrive at a figure somewhere between the two. The
arguments in favour of a discount will be more or less reasonable,
depending upon the circumstances in each case. Some of the factors
which may be used are:
( i) The one-man business argument, i.e. Growth Enterprises
may be worth so much with Mr. B at the helm but would suffer a
heavy drop in profits following his death;
(ii) The earnings for a part of the period examined were extra-
ordinarily high;
(iii) Much heavier competition is expected in the near future;
(iv) A good deal or all of the company’s profits depend upon
licenses or franchises which can be revoked on short notice.
When all of the appropriate factors have been considered, a figure
must be chosen. Quite frankly, at this stage the choice is often a
guess –
the determination of real value is arbitrary. However, if it
has been “arbitrarily” chosen after all the above factors and financial
data have been considered and examined, it will be very close to what
the Tax Department would consider as real value. The planner should
then submit his value for approval by the Department of National
Revenue. This is done by writing the Department, setting out the
details of the reorganization, a short outline of the company’s ope-
rations and financial data in support of the valuation sought. Finan-
cial statements covering the periods mentioned in the letter should
accompany it. The Tax Department can be slow in processing sub-
missions for valuations. Indeed, some district offices (Montreal,
among others) have suspended valuations for estate planning pur-
McGILL LAW JOURNAL
[Vol. 13
poses until further notice because of Section 138A of the Income
Tax Act.17 The estate planner need not be delayed for those reasons.
He should complete his reorganization by selling his shares to the
holding company for a price subject to adjustment in the light of
the Tax Department’s valuation. The contract of sale between Mr. B
and Holdings Inc. can provide that additional preferred shares and/or
promissory notes will be issued to Mr. B by the purchasing company
to take up the difference, if any, between the value of the shares sold
(the shares of Growth Enterprises Inc.) as used in the contract and
such higher value as may be determined by the Tax Department and
accepted by the parties. This permits the taxpayer to freeze as at a
given date regardless of how long it then takes the tax officials to
value the shares. Whenever they do get around to valuing them, even
if it’s only at his death, they must value them as at the date of the
transaction, regardless of what has transpired afterwards from the
point of view of the company’s operations. This formula of an “esca-
lation clause” is acceptable to the tax officials. It is suggested, how-
ever, that if used, a copy of the contract be sent to the Department
with the submission. A client’s first reaction to this type of contract
may very well be that he is handing the tax collector the butt of a
loaded shotgun. However, that is not so. If the Department comes
back with a considerably higher value which is not acceptable to the
taxpayer, the latter need not accept it. He will then be assessed for
gift tax, can object to the assessment and let real value be determined
by the courts. Hence the valuation is not up to the Tax Department.
It is also felt that the longer the Tax Department’s delay the better
for the planner. If a reasonable value is used and submitted to the tax
officials with all required data and justifications, it would be awk-
ward for the Department to change that value several years after-
wards after having refused to value at the time of the transaction.
This is not to say that the Department cannot do it, but it would
be difficult. In practice, most valuations seem to be satisfactorily
settled for all concerned.
As an added measure of certainty, the taxpayer may, if he so
wishes, have the shares valued by an independent expert appraiser,
whose valuation isn’t as likely to be considered biased. The Depart-
ment will hesitate to take issue with such an appraisal –
especially
if the appraiser’s services are sometimes sought by the Department
itself in valuing shares. The advice of a real estate appraiser should
definitely be sought if the company owns substantial real estate.
Finally, if the planner insists upon a Department valuation before
going ahead, there exists a slow but rather sure way to finesse the
17 See page 18.
No. 1]
THE CORPORATE FREEZE
Department into making a valuation. The taxpayer should simply
give away a few shares of his company and declare it for gift tax
purposes. The Department will then have to value the shares given to
assess the gift tax. Once this is done, the taxpayer can use the same
basis of valuation for the reorganization.
STEP S
Time lapse. There should be the smallest possible time lapse
between Steps 2 and 3 in order to avoid an increase in the value of
the common stock. Ideally, Step 3 should be completed the day fol-
lowing Step 2.
Sale or gift. Mr. B can dispose of the shares by way of gift or
sale. If proper values have been used, as indicated above, the common
shares will be worth only $1,000, which should be easy to finance. A
sale is preferable because it immediately extracts the growth from
Mr. B’s estate. If the shares are given, their value at the date of death
will be included in Mr. B’s estate for Quebec succession duty purposes
if he dies within 5 years of the gift. The same applies for federal
estate tax if he dies within 3 years. If the sale is impossible (such as
to Mr. B’s wife or to his minor children without a tutor duly author-
ized by the courts) ,18 then Mr. B must give. It is suggested, however,
that in certain circumstances the estate planner can disregard the
civil restrictions on sales to minors. This applies when the minor
involved is 17 years of age or over. The reasoning here is that the
nullity of a sale to a minor is not absolute but relative. It can be
claimed only by the minor or his tutor and only in the case of lesion. 19
It cannot be claimed by the Tax Department. Furthermore, the
transaction can no longer be voided if it is ratified by the minor
18 “Without the authorization of the judge, or prothonotary, granted on the
advice of a family council, the tutor is not allowed to borrow for the minor, nor
to alienate or hypothecate his immoveable property; nor is he allowed to make
over or transfer any capital sums belonging to the minor, or his shares and interest
in any financial, commercial or manufacturing joint-stock company.” (Art. 297
C.C.).
“Such authorization can only be granted in cases of necessity or for an evident
advantage.
In the case of necessity, the judge or prothonotary grants his authorization
only when it is established by a summary account submitted by the tutor, that
the moneys, moveable effects and revenues of the minor are insufficient.
In all cases, the authorization indicates what property is to be sold or hypothe-
cated, and any conditions deemed expedient.” (Art. 298 C.C.).
19 Articles 987 and 1002 C.C. Trudel, Trait de Droit Civil, Tome 2, pp. 291-314,
Tome 7, pp. 81 and 233.
McGILL LAW JOURNAL
[Vol. 13
upon his attaining the age of majority. Accordingly, if Mr. B gives to
his child of, say, 18 years old, he will have to wait until the child is
23 before the shares are completely exluded from his estate for death
duty purposes. On the other hand, if the shares were sold, the child
could ratify on attaining 21 and Mr. B would have gained 2 years, If
he were to die before his child attains 21, the relative nullity rule
makes it highly unlikely that the Tax Department could be successful
in an attempt to void the sale. If the child is 16 or under, Mr. B
should give. Here, the 5-year maximum limitation will either coincide
with (or be less than) the years it will take to reach 21 and ratify.
Furthermore, if a sale is made to a child of a young age, the nullity
might very well be absolute for lack of legal onsent.
Form of gift. The gift should be in notarial form. There are
several strong arguments against the gift of private company shares
being a “don manuel”. The requirement of having the transfer ap-
proved by the Board of Directors is the main one. Physical delivery
of the share certificate endorsed for transfer cannot be said to com-
plete the gift if a corporate resolution is also required to transfer
title.20
Acceptance…..It is unnecessary to appoint a tutor to accept a gift
to a minor. It can be done by a child’s parent or a grandparent.21
Indeed, the writer feels that a tutor should be avoided if at all possible.
The reasoning here is Section 27 of the Quebec Succession Duties Act.
That section makes it quite clear that the donee must have complete
administration of the asset given to the exclusion of one and all. 22
20 “Deeds containing gifts inter vivos must under pain of nullity be executed
in notarial form and the original thereof be kept of record. The acceptance must
be made in the same form.
Gifts of moveable property, accompanied by delivery may however be made
and accepted by private writings, or verbal agreemnts.” (Art. 776 C.C.).
Se also The Object of the Don Manuel by Watt, 16, Revue du Droit, p. 160.
21 “Gifts made to a minor may be accepted by his tutor, or a tutor ad hoc, or
by his father, mother, or other ascendants; such acceptance being valid without
the advice of any family council.” (Art. 303 C.C.).
22 “For the purposes of this act, the ownership, usufruct or enjoyment of any
property shall be deemed to be transmitted owing to death, whenever the deceased
has disposed of same by gratuitous title, in any manner whatsoever, by a dis-
position which has taken effect more than five years prior to the date of death,
unless the’ ownership, possession, usufruct, .enjoyment, administration of and the
revenue from or the income on the said property has actually been assumed and
thenceforward retained by the real beneficiary, to the exclusion of the donor or
of any other person.” (Quebec Succession Duties Act, 27).
No. 1]
THE CORPORATE FREEZE
The main function of the tutor is to administer the minor’s assets.2 3
Hence, the minor does not have the complete administration required
by Section 27. It should be mentioned that the writer’s view here is a
minority one (at least among the confreres with whom I discussed
it). The big argument against this view is that civilly speaking, the
tutor is the minor. He is a continuation of his ward’s personality.
However, estate planning is preventive law and discretion is the
better part of valour if it means avoiding death duties on the common
shares given to minors. Adcordingly, it is suggested that tutors be
avoided in the case of giving common shares of holding companies
to minors.
Income Tax
Mr. B’s reorganization as constituted will not produce immediate
income tax benefits. This results from the holding company’s cha-
racter as a personal corporation and the deemed distribution of the
latter’s income to its shareholders for income tax purposes.2 4 Holdings
Inc. will be a personal corporation for each of its taxation years
23 “A tutor has the care of the person of his pupil, and represents him in all
civil acts.
He is bound to manage his property like a prudent administrator, and is liable
for the damages which may result from bad management.
He can neither buy the property of his pupil, nor take it on lease, nor accept
the transfer of any right or any debt against his pupil.” (Art. 290 C.C.).
24 “The income of a personal corporation whether actually distributed or not
shall be deemed to have been distributed to, and received by, the shareholders
as a dividend on the last day of each taxation year of the corporation.” (Income
Tax Act, 67(1)).
“In this Act, a “personal corporation” means a corporation that, during the
whole of the taxation year in respect of which the expression is being applied,
(a) was controlled, whether through holding a majority of the shares
of the corporation or in any other manner whatsoever, by an individual
resident in Canada, by such an individual and one or more members
of his family who were resident in Canada or by any other person on
his or their behalf;
(b) derived at least one-quarter of its income from
(i) ownership of or trading or dealing in bonds, shares, debentures,
mortgages, hypothecs, bills, notes or other similar property or an
interest therein,
(ii) lending money with or without securities,
(iii) rents, hire of chattels, charterparty fees or remunerations, annui-
ties, royalties, interest or dividends, or
(iv) estates or trusts; and
(c) did not carry on an active financial, commercial or industrial business.
For the purpose of paragraph (a) of subsection (1), the members of an
individual’s family are his spouse, sons and daughters whether or not they live
together.” (Income Tax Act, 68(1) (2)).
McGILL LAW JOURNAL
[Vol. 13
throughout which it will be controlled by Mr. B and will not carry
on an active commercial, financial or industrial business. Consequent-
ly, so long as both those conditions exist, any dividends the company
might receive from its subsidiary, Growth Enterprises, while not
taxable in its hands will be taxable to Mr. B whether or not he has
actually received them. Until June 13, 1963 and the advent of Section
138A of the Income Tax Act, many estate planners used the holding
company technique to minimize income tax in addition to its death
duty advantages. They would do so by “depersonalizing” their holding
company. This automatically wiped out the deemed distribution of the
holding company’s income, which was then paid out to the planner
tax-free through redemption of the holding company’s preferred
shares. Depersonalization was achieved by either having the holding
company carry on an active business or by allotting less than 51%
of its voting shares to the planner and members of his family. For
the purpose of a personal corporation, the members of an individual’s
family are his spouse, sons and daughters, whether or not they live
together. Hence, for example, Mr. B could depersonalize Holdings Inc.
by transferring 100,000 Class “A” preferred shares to his brother.
The only tax liability attracted by such an arrangement was the
taxation of dividends received by the holding company to the extent
that they were paid out of the subsidiary’s “designated surplus”, i.e.
its surplus as at the end of its last complete taxation year before
its control was acquired.25 Dividends paid out of the subsidiary’s
25 “Where a corporation in a taxation year received a dividend from a corpora-
tion that
(a) was resident in Canada in the year and was not, by virtue of a statutory
provision, exempt from tax under this Part for the year,…
an amount equal to the dividend minus any amount deducted under subsection (2)
of section 11 in computing the receiving corporation’s income may be deducted
from the income of that corporation for the year for the purpose of determining
its taxable income.
Notwithstanding subsection (1), where
(a) a dividend was paid by a corporation that was resident in Canada and
was controlled by the receiving corporation, and
(b) the payer corporation had undistributed income on hand at the end of
its last complete taxation year before the control was acquired (which
undistributed income is hereinafter referred to as the “designated sur-
plus”),
if the dividend was paid out of designated surplus, no amount is deductible
under subsection (1) …
For the purpose of subsection (2), one corporation is controlled by another
corporation if more than 50% of its issued share capital (having full voting
rights under all circumstances) belongs to the other corporation or to the other
corporation and persons with whom the other corporation does not deal at arm’s
length.” (Income Tax Act, 28(1) (2) (3)).
No. 1]
THE CORPORATE FREEZE
earnings from the commencement of its taxation year in which control
was acquired are free of tax.
Although there has been no change in the various sections of the
Income Tax Act as to the qualifications of a personal corporation or
the tax treatment of intercorporate dividends and the redemption of
preferred shares, Section 138A of the Income Tax Act has deterred
the estate planner from seeking income tax advantages from his
holding company reorganization. The section gives the Minister of
National Revenue the right to assess as taxable any amount received
as consideration for, among other things, the sale or redemption of
shares if in his opinion the transactions were for the purpose of
substantially reducing the assets of a company in a way that tax has
been or will be avoided on what would otherwise have been a taxable
distribution.26 The purpose of the section was to put an end to surplus
stripping operations. Its generality and wide discretionary powers
have led to threats by Department of National Revenue officials that
it would be used in the case of estate plan holding companies. Their
reasoning, in effect, is that the income tax immunity of the subsi-
26,,Where a taxpayer has received an amount in a taxation year,
(a) as consideration for the sale or other disposition of any shares of a
corporation or of any interest in such shares,
(b) In consequence of a corporation having
(i) redeemed or acquired any of its shares or reduced its capital stock, or
(ii) converted any of its shares into shares of another class or into an
obligation of the corporation, or
(c) otherwise, as a payment that would, but for this section, be exempt
income,
which amount was received by the taxpayer as part of a transaction effected or
to be effected after June 13, 1963 or as part of a series of transactions each of
which was or is to be effected after that day, one of the purposes of which, in
the opinion of the Minister, was or is to effet a substantial reduction of, or
disappearance of, the assets of a corporation in such a manner that the whole or
any part of any tax that might otherwise have been or become payable under
this Act in consequence of any distribution of income of a corporation has been
or will be avoided, the amount so received by the taxpayer or such part thereof
as may be specified by the Minister shall, if the Minister so directs,
(d) be included in computing the income of the taxpayer for that taxation
year, and
(e) in the case of a taxpayer who is an individual, be deemed to have been
received by him as a dividend described in paragraph (a) of subsec-
tion (1) of section 38.”
(Income Tax Act, 138A(1)).
McGILL LAW JOURNAL
[Vol. 13
diary’s dividends as they move into the holding company and through
it to the planner’s pocket by preferred share redemptions or other
payments constitutes the distribution of assets which would otherwise
be taxable. Such amount 27 having been received on the sale of the
subsidiary’s shares or the redemption of preferred stock gives the tax
officials what they need to threaten the use of 138A. Although there
are several arguments which could be used against its application,
such as the fact that a “substantial” reduction of assets at the time
of the transaction would require a taxable dividend out of designated
surplus, the ministerial discretion looms large and its application
should not be invited if at all possible. It is felt that such an invitation
does not exist so-long as the holding company remains a personal
corporation.
27 ” ‘Amount’ means money, rights or things expressed in terms of the amount
of money or the value in terms of money of the right or thing.” (Income Tax
Act, 139(1) (a)).
