How to optimize your tax planning during an economic downturn

Businesses across Canada are facing financial pressure as high interest rates boost borrowing costs and persuade consumers to reduce their spending. While the economy has been resilient so far, considerable uncertainty remains about how economic conditions will continue to unfold.

Still, there’s a possible silver lining: economic uncertainty can present an opportunity to review and refresh your tax planning. Consider these solutions that may be available to support your business over the coming months.

Estate and succession planning

Now may be an excellent time for an estate freeze. This process?freezes?the current value of an individual’s shares into fixed-value preferred shares and allows new shareholders to acquire common shares at a nominal value.

Growth of the company attributes directly to the new common shareholders going forward — typically family members or a family trust. Freezing an estate when share values are depressed will allow for more wealth to transfer to the next generation when the business bounces back. It’s possible to transfer future growth through this method without necessarily transferring control of the company.

An estate freeze can also:

• Help business owners manage income taxes payable on death
• Offer options to split income with family members (subject to the Tax on Split Income, or TOSI rules), and
• Help utilize the Lifetime Capital Gains Exemption (LCGE).

You can also complete a re-freeze transaction if you previously completed an estate freeze and the value of the company is now less than the value of the outstanding preferred shares. This would involve replacing the preferred shares from the original estate freeze with new preferred shares equal to the reduced value of the company.

To support the value of the company used in any tax planning, we recommend obtaining a formal business valuation — especially when the value of the company includes goodwill.?

Equity-based compensation

Employee stock option plans (ESOP) and other equity-based compensation can help retain key employees during cashflow shortages. An ESOP also has the advantage of aligning the interests of employees and existing owners.

ESOPs issued in a Canadian-Controlled Private Corporation (CCPC) may — under certain conditions — offer a significant tax deferral advantage to the employee. In these cases, the deferral would only tax the employment benefit associated with the ESOP when the employee sells the shares.

Moreover, issuing equity-based compensation when company values are depressed can minimize the cost of the employment benefit to the company and resulting taxes to the employee.

Reorganize corporate assets

Has there been a reduction in corporate asset values? This may be a tax-effective time to transfer those assets within or out of the corporate environment. Three reasons you may wish to transfer assets include:

• Removal of passive assets from an operating company to maintain eligibility for the LCGE on an eventual sale.
• Separating assets from operations or different businesses, either for asset protection or in preparation for an eventual sale.
• Removing company assets which are primarily for personal use.

Loss utilization

Businesses may carry operating losses forward for 20 years — or back to recover taxes paid in any of the three (3) preceding tax years. You may also carry capital losses back to recover taxes paid on capital gains in any of the three (3) preceding tax years or carry them forward indefinitely.

However, timing is key to ensure you get the most out of other business tax attributes before using business losses.

Other loss utilization strategies include:

General Rate Income Pool (GRIP)

Eligible dividends should be paid from a GRIP annually prior to a year where a loss is incurred, and a loss carryback is requested.

Another option is to establish a holding company to receive tax-free eligible dividends from an operating company. This will help to manage the impact on shareholders’ personal income taxes.?

Capital Dividend Account (CDA)

The CDA is a cumulative account balance that allows for the payment of tax-free capital dividends. The CDA is calculated at the point in time a dividend is paid from the account.

There may be a cumulative balance a shareholder can access in the CDA account prior to realizing a capital loss in their company. To make this available requires declaring a dividend to the extent of the company’s CDA immediately before the capital loss is realized.

Loss consolidation

Is one corporation in a related group may be generating losses while other corporations are profitable? Proper tax planning can help utilize the losses within the related corporate group, including via:

• A corporate merger, such as an amalgamation or wind-up, of entities in a corporate group.
• Transfer of profitable business asset(s) to a corporation with accumulated losses. The loss corporation could lease the property back to generate income to utilize losses.
• Use of a partnership structure to allow losses of one business to offset income of another.

A range of other basic and more sophisticated solutions are available. The best approach will depend on your unique circumstances.

Debts or shares of insolvent companies

Invested in debt or shares of another company that is now insolvent, or unable to repay its debt? A special election may be available to realize a capital loss without an actual disposition of the debt or shares.

In some cases, the capital loss might qualify for a deduction from all types of income — not just capital gains.

Take the next steps

While you may be focusing on operational issues and controlling costs to pre-empt the impacts of a downturn, proper tax planning is also an important part of this equation.

The above are just a handful the tax strategies that may be available to you. A qualified tax advisor can help you determine which options will be most efficient and effective to navigate the path forward.

Contact MNP here to learn more.