(From the October 2024 Edition of eFORUM)
By Kevin Wark
The death of an individual will generally result in the deemed disposition at fair market value of all capital property owned by that person immediately before death.[1] This will require tax reporting of any unrealized capital gains in the deceased’s final return. A notable exception is where capital property is transferred to the surviving spouse or spouse trust and such property “vests” within 36 months of the date of death.[2]
To provide some tax relief, a special rule provides that where the deceased’s graduated rate estate (GRE) realizes a capital loss in its first taxation year, it can elect that the capital loss be carried back to the deceased’s terminal return to offset capital gains realized in the year of death.[3]
This “loss carry-back rule” can be particularly helpful in tax planning for small business owners on their death, where corporate-owned life insurance is used to redeem private company shares from the deceased’s GRE. The redemption of those shares will typically result in a deemed dividend,[4] as well as a capital loss to the GRE. This capital loss (subject to the stop-loss rules discussed below) can be used to reduce capital gains arising on those shares in the year of death. In addition, a portion of the deemed dividend arising on the redemption of those shares can be received by the GRE as a tax-free capital dividend.[5]
While the loss carry-back rule is very helpful in a number of circumstances, the fact that the loss must be realized in the first year of the GRE can pose timing issues. For example, legal challenges to a will or shareholder disputes could cause delays that prevent the GRE from disposing of the relevant capital property within the required one-year timeframe.
To address these concerns, a technical tax bill released by the Department of Finance in August 2024 proposes to modify the loss carry-back rule to provide that where a GRE realizes a capital loss within the first three years of the estate, the deceased’s legal representative can elect that the loss be treated as a loss of the deceased taxpayer’s from the disposition of properties in their final tax return. This change applies to taxation years of individuals who die on or after August 12, 2024.
As noted above, there are stop-loss rules applicable to trusts that generally restrict any loss arising on the redemption of shares, where the deemed dividend arising from such redemption is received as a capital dividend. However, if the shares are acquired by a GRE as a result of the individual’s death, and the redemption takes place during the GRE’s first taxation year, the amount of the denied loss will be reduced by 50% (33 1/3% under the new capital gains rules) of the lesser of the loss otherwise determined and the capital gain from the deemed disposition of those shares on death. The technical tax bill also proposes that the reduction in the loss denial for GREs will be extended to apply to any disposition of shares that occurs during the GRE’s first three taxation years. This amendment applies to taxation years of GREs of individuals who die on or after August 12, 2024.
These are welcome changes that will create additional planning flexibility for the estates of small business owners and more generally for all individuals where there is the potential for mismatches between capital gains realized on death and capital losses realized by their GREs.
Kevin Wark, LLB, CLU, TEP, is managing partner of Integrated Estate Solutions and a tax advisor to CALU. He is the author of the popular consumer book The Essential Canadian Guide to Estate Planning (3rd Ed.), as well as tax guides on life insurance transfers, insured buy-sell agreements, and income-splitting strategies, available through Amazon.ca.
[1] Subsection 70(5) of the Income Tax Act.
[2] Subsection 70(6) of the Income Tax Act.
[3] Subsection 164(4) of the Income Tax Act, referred to as the “loss carry-back rule.”
[4] Subsection 84(3) of the Income Tax Act.
[5] Subsection 83(2) of the Income Tax Act.
