How to optimize your tax planning during an economic downturn

Many businesses are facing financial pressure as high interest rates boost borrowing costs and persuade consumers to reduce their spending — and there is considerable uncertainty about how economic conditions will continue to unfold.

A possible silver lining: an economic downturn can present an opportunity to review and refresh your tax planning. We’ve highlighted some solutions that may be available to support your business over the coming months.

Estate and succession planning

Estate freeze

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 more wealth to be transferred 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).

Alternatively, if an estate freeze was completed in the past and the value of the company is now less than the value of the outstanding preferred shares, a refreeze transaction can be completed by 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

Equity-based compensation, such as an employee stock option plan (ESOP), can help retain key employees during cashflow shortages. An ESOP also has the advantage of aligning the interests of employees and existing owners.

Provided certain conditions are met, ESOPs issued in a Canadian-Controlled Private Corporation (CCPC) can be particularly advantageous. These ESOPs may offer a significant tax deferral to the employee by only taxing the employment benefit associated with the ESOP when the employee sells the shares.

Issuing equity-based compensation when company values are depressed can minimize the value of the employment benefit and resulting taxes to the employee.

Reorganize corporate assets

Transferring assets within or out of the corporate environment can be more tax effective if there has been a reduction in the value of those assets. Some of the 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

Your company may be experiencing operating losses or declines in the value of its assets. Operating losses can be carried back to recover taxes paid in any of the three preceding tax years or be carried forward for 20 years. Capital losses may also be carried back to recover taxes paid on capital gains in any of the three preceding tax years or be carried forward indefinitely. However, timing is key to ensure you get the most out of other business tax attributes before using business losses.

General Rate Income Pool (GRIP)

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

A holding company can also be used to receive tax-free eligible dividends from an operating company to manage the impact on shareholders’ personal income taxes. 

Capital Dividend Account (CDA)

The CDA is a cumulative account balance from which tax-free capital dividends can be paid. 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 — by declaring a dividend to the extent of the company’s CDA immediately before the capital loss is realized.

Loss consolidation

One corporation in a related group may be generating losses while other corporations are profitable. Tax planning can help utilize the losses within the related corporate group. Planning ideas can include:

• 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, and the best approach will depend on your unique circumstances.

Debts or shares of insolvent companies

If you have 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 allow for a capital loss to be realized 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.