Deviations on the Typical Estate Freeze

When the current generation wishes to transfer growth to the next generation to limit the exposure to taxes on death, they will almost always look at using an estate freeze. If the individuals own assets personally that are accruing value, which can occur in many cases, the assets would normally be transferred to a corporation to effect the estate freeze.

When we think about the normal estate freeze, we look at the use of a corporation to take the future growth in an asset and transfer it to the next generation. I will not go into the mechanics of the estate freeze, but suffice it to say that there is an issuance of fixed value, redeemable, retractable preferred shares to the transferors of the assets to the company, and usually the issuance of growth common shares to the next generation directly or through a family trust.

For most instances, the typical estate freeze works well but, as with all things, there are times when it does not work at all. In those cases where a different structure is necessary, a partnership could be a solution, but a partnership does not get the same treatment in the Income Tax Act as a corporation does when it comes to estate freezes. The Canada Revenue Agency has long held that an estate freeze is not possible through the use of a partnership because of specific sections in the Income Tax Act.

Up until now, there have not been many court cases that have tested Canada Revenue Agency’s position, but that is likely about to change because of a recent Tax Court of Canada and Federal Court of Appeal case. In the “Kraus v. Her Majesty the Queen” case, the Tax Court of Canada was asked to look at numerous issues regarding a reassessment of the taxpayer. In particular, one of the issues was whether the estate freeze that was done using a partnership was effective. The tax court judge reviewed the partnership agreements and had concerns with certain provisions of those agreements restricting losses and cash calls to the freeze units. There were also restrictions on the ability of the partners to redeem their units whenever they desired.

Although there were technical issues to the judgment, it would appear that the judge effectively looked at the restrictions on the partnership units and felt that the units did not mirror freeze preference shares, which would normally be redeemable at the option of the holder at any time.

The judge also felt that the fact that the freeze partnership units were the only ones to be allocated losses, and were the ones facing cash calls if the partnership needed further capital, reduced their value below the fair market value of the assets given up, thereby falling into the anti-income splitting provisions for partnerships found in the Income Tax Act. Although the taxpayer lost in this case, the tax court judge did indicate that he thought that an estate freeze was possible using a partnership if one structured the partnership units properly to mirror preference shares in a company.

The case went to the Federal Court of Appeal which reaffirmed the tax court judge’s decision against the taxpayer, but they did not express an opinion on the tax court judge’s notion that the estate freeze was possible with a partnership.

Although the Federal Court of Appeal did not specifically address the issue of the estate freeze using the partnership, the tax court judge felt that it was possible, and said so in his judgment. If you are the owner of land held for development which cannot be transferred to a corporation to affect a typical estate freeze, you may now have a better filing position and defence should Canada Revenue Agency not agree with the freeze. Again, the devil is in the details, and one would have to ensure that the freeze partnership units mirrored freeze preferred shares without the restrictions found in the Kraus case.