How Ontario Surtax Impacts Estate Plans

How Ontario Surtax Impacts Estate Plans

A “wasting freeze” is a common estate planning strategy to deal with an individual’s eventual tax liability upon death. In a typical estate freeze transaction, an individual may transfer assets to a corporation on a tax-deferred basis and receive shares of the corporation that have a fixed redemption value. Alternatively, where the individual already owns a corporation, he or she may exchange the existing Common shares for new shares that are fixed in value. The redemption of these fixed-value shares will typically result in a deemed dividend taxable in the hands of the individual. However, these share redemptions can result in overall tax savings under certain circumstances, including where the corporation has a balance of “refundable dividend tax on hand” (RDTOH).

RDTOH is a notional account that tracks the refundable portion of tax paid by corporations earning investment income. RDTOH can be recovered by the corporation at a rate of $1 for every $3 of dividends paid by the corporation (limited to the corporation’s RDTOH balance). To the extent the individual’s marginal personal tax rate is less than the corporation’s dividend refund rate of 33 1/3%, overall tax savings will result. At the same time, the individual will have eliminated tax that would otherwise have been payable upon death.

Prior to the 2012 Ontario budget, the highest marginal tax rate applicable to dividends received by Ontario residents was 32.57%. In the case of a share redemption resulting in deemed dividends of $100,000, an Ontario resident would have incurred personal tax at a maximum of $32,570 (or less, if not in the top personal tax bracket). Meanwhile, the corporation may have received a refund of its RDTOH balance of $33,333, resulting in immediate tax savings. To the extent the individual was not already in the top tax bracket, the current tax savings would be even greater. In addition to these immediate tax savings, the individual would have avoided over $23,000 of tax that would otherwise have been payable upon death.

The 2012 Ontario budget has created a new personal tax bracket applicable to taxable income in excess of $500,000. At this new tax bracket, dividend income will be subject to a tax rate of 34.52% in 2012 and 36.47% in 2013. Since this new top marginal tax rate will exceed the corporate dividend refund rate of 33 1/3%, the use of a corporation’s RDTOH balance will no longer provide an efficient method of redeeming shares under a wasting freeze strategy to the extent the share redemption increases an individual’s taxable income over $500,000. This will also hold true for “eligible dividends” taxed at this top tax bracket beginning in 2013. The wasting freeze will still remain an integral estate planning strategy even with the introduction of these new tax rates. However, these new tax rates may extend the period over which freeze shares may be redeemed efficiently, particularly in the case of larger estate freezes. Individuals who have implemented wasting freeze strategies should consider whether these new tax rates will have an impact on their plans. Those who have put off such planning should consider implementing the strategy sooner than later, given the possibly extended redemption schedule.

For more information, please contact Zoran Vranjkovic at 613-236-9191 or by zvranjkovic@welchllp.com.