Serial Redemptions (Wasting-Away Freezes)
The serial redemption strategy, sometimes referred to as a wasting-away freeze, occurs when a company redeems a certain amount of frozen shares owned by a shareholder on a periodic basis. One of the main benefits of this approach is that it reduces, or “wastes away”, the ultimate value of the shareholder’s frozen shares. In most estate freezes, the shareholder of the frozen shares receives income through dividends. However, when a waste away freeze is used, cash flow to the shareholder is created through the redemption of shares.
From a tax perspective, the redemption gives rise to a deemed dividend and a return of paid-up capital for tax purposes. To the extent that the redemption amount exceeds the paid-up capital of the redeemed shares, there will be a deemed dividend to the shareholder. The tax rate on this deemed dividend will depend on whether the dividend paid is classified as eligible or non-eligible. The tax rate on dividends varies by province, but in Ontario the top marginal tax rate in 2014 on a non-eligible dividend is 40.13% and on an eligible dividend it is 33.82%. The paid-up capital will be received tax-free by the shareholder.
As each redemption takes place, the shareholder receives dividend income and owns fewer frozen shares with a lower fair market value. This in turn results in lower taxes payable on theat death.
By way of example, let’s assume a shareholder has undertaken an estate freeze and holds $1 million of frozen preferred shares with a 5% dividend rate. As a result, that shareholder will receive a $50,000 taxable dividend annually, and will ultimately have a $1 million capital gain on death (assuming the shares have no adjusted cost base (“ACB”)). In contrast, the serial redemption strategy would cause the corporation to redeem $50,000 of shares each year. The shareholder would still have a $50,000 of taxable dividend income each year, but after 5 years the fair market value of the remaining shares would be $750,000 and the future capital gain will have been reduced by $250,000.
When Does This Strategy Make Sense?
1. When a shareholder needs income from a corporation, but wants to reduce or eliminate the tax liability arising with respect to the shares on death and start shifting equity in the corporation to the common shareholders, typically his/her children.
2. Where it is used as a part of RDTOH (Refundable Dividend Tax on Hand) planning. RDTOH is an account of refundable tax paid by a private corporate on its investment and dividend income. This refundable tax account is repaid to the corporation when a taxable dividend is paid to a shareholder. The rate of repayment is a $1 dividend refund for every $3 taxable dividend paid out. It is common to do corporate planning so as to ensure that the RDTOH account is extinguished (or at least diminished) each year. With the higher dividend tax rates on non-eligible dividends even the use of RDTOH planning may be reduced, and result in funds being retained inside the company.
When Does This Strategy Not Make Sense?
1. This strategy may not make sense where is no RDTOH and no CDA in the company and dividends do not otherwise need to be paid out of the company, or are not otherwise required by the shareholder. This is because the waste away freeze creates a pre-payment of tax (unless the company has investment income) that would have otherwise been deferred until death and been taxed at a potentially a higher rate. Specifically, this strategy results in paying tax on a dividend at higher rate than the capital gains tax rate, which would otherwise apply when the shares are sold or deemed to be disposed at the death of the shareholder. Given that the preferred shares are fixed in value and the tax liability is frozen, an unnecessary waste-away freeze results in an acceleration of the tax liability and the loss of the time-value of that money in the family's hands. The question becomes whether there is a better and more tax-efficient means to deal with these shares, such as using life insurance proceeds to redeem the shares at death.
2. When the shareholder will have a continuing need for income from the corporation, the redemption strategy would ultimately erode the capital base of the shareholder and his/her subsequent access to dividends, unless the shareholder was included as aof the trust and can access dividends and capital through the trust.
Things To Consider
Before creating a waste-away freeze, the shareholder should consider:
- Whether he or she might have a need for the share capital in the future, and how such capital will be accessed, such as through a trust.
- Whether there is a desire to potentially start relinquishing control of the corporation (if the shares are voting shares).
- Whether there is a strategy which might allow a retention of control under these circumstances (such as issuing a separate class of voting shares).
- Whether the shareholder needs to retain some taxable income until death, in order to utilize tax credits including those related to medical expenses or charitable donations, and how such income will be realized, such as through a trust.
- Whether the use of corporate-owned life insurance as a method to defer tax (or possibly eliminate tax, depending upon the circumstances) is a better overall strategy for the family. This would include consideration of whether the shareholder is insurable.