Do you have Cash trapped in your Corporation?

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Do you have Cash trapped in
your Corporation?
Unlocking Trapped Surplus…
The Corporate Estate Transfer
Insurance Concepts
This presentation is for educational or informational purposes only.
It is not intended to provide anyone with legal, taxation, accounting or
other professional advice and no one should act upon the information
provided here without a thorough review of the specific facts with the
appropriate professional advisory team.
Holding companies and Management companies often
contain cash and investment assets that are not used in
active business.
These assets, locked within the corporation can usually be
only paid out to the individual shareholders as taxable
distributions unless there is a Capital Dividend Account
(CDA)
Why use Holding Companies?
Holding Companies (Holdcos) are usually created to
protect retained earnings of an Operating Company (Opco)
from potential liabilities.
Excess funds are transferred to maintain small business
status and therefore attract a lower tax rate.
Personal tax rates apply when a dividend is taken.
Recent changes in the Income Tax legislation have
provided incentives for companies to grow retained
earnings which can be used for investment purposes.
As a result, active income can be earned by an operating
company, taxed at a low rate, and transferred to a Holdco
for investment.
By transferring assets to the Holdco, the active business
corporation can maintain it’s small business corporation
status for purposes of claiming the Capital Gains
Exemption, currently $500,000
The Income Tax Act allows tax-paid retained earnings to be
paid from an Operating Company to a Holding Company as
an intercorporate dividend – usually without attracting tax.
So a tax-free transfer can occur between corporations and no
personal tax is payable until the earnings are removed from
the Holding Company.
Not only do the Holdcos provide good wealth accumulation
vehicles, but by removing assets from the Opco, an additional
level of creditor protection is provided for the transferred
retained earnings.
Passive Investment Income - attracts tax at the top corporate rate (does not
qualify for the small business deduction)
Alberta Income
Passive
Active Business Income 000’s
($0 - 225)
Net Federal tax
28.00%
Add surtax (4)%
1.12%
Refundable tax*
6.67%
2003
($225 - $300)**
($300 - $400)
($400+)
13.12%
22.12%
24.12%
24.12%
35.79%
Alberta tax
12.50%
4.00%
4.00%
4.00%
12.50%
Total Tax
48.29%
17.12%
26.12%
28.12%
36.62%
*
Passive investment income is subject to an additional refundable
tax of 62/3 % of taxable investment income.
** The Feb/03 Federal budget proposes an increase of $25,000/yr to 2006
and a general rate decrease on all active business income above 300,000
(net 22.12%) after 2004. Alberta proposes a decrease in tax rates on all
income after April 2005 to 8% - maximum tax rate in Alberta would be 30.12%.
Corporate Income Tax
The previous table illustrates that passive investment income in a
corporation is taxed at a significantly higher rate than active business
income.
Investment Holding Companies that have passive investments will not
benefit from the lower rates on active business income, but will be
subject to the high rate of tax.
If we could shelter the the income subject to the high tax rate and receive dividends
from an Opco that paid the low tax rate, then we would achieve an optimal
advantage.
The Problem – Trapped Corporate Surplus

Funds held within Holding companies and
Management companies are taxed at the top rate,

Funds withdrawn from the Corporation are taxed as
dividend income,

Capital Gain Tax liability at the death of the
shareholder.
Dilemma………
Should the Retained Earnings be
kept in the Holdco and pay top
rates on investment income
Or
Pay out the Retained Earnings to
the shareholders who will pay
personal tax on the dividend,
thereby eliminating 24% of the
investment to dividend tax
immediately.
CORPORATION
$300,000 Trapped Surplus
DIVIDEND - $300,000
TAXABLE
DIVIDENDS
TAX @ 24% $ 72,000
NET
$228,000
SHAREHOLDER
Further, Capital Gains tax liability will exist on the death
of the shareholder who has benefited from the increased
share value of the Holding Company.
Note that the shares may be transferred on a rollover basis
to the spouse at death, but the Capital Gains tax liability
will appear on the spouse’s death – it just doesn’t go away.
Or does it?
We will see how insurance can help us…
Universal Life Insurance Policy

Shelters the growth of the assets from tax,

Provides an effective mechanism to
remove funds from Holdco,

Maximizes the estate value at death by
reducing Capital Gains exposure.
Back to the dilemma…….
Should we pay out the $300,000
accumulated funds and lose $72,000 to tax
immediately or leave it in the corporation
and pay the top tax rate?
Best of both worlds……
Don’t pay the funds out, save $72,000 in
taxes and pay no tax on the accumulating
income by tax sheltering funds in a
Universal Life policy
Elements of the Concept
 Fund a Universal Life policy as quickly as possible, by reallocating or investing a portion of the passive assets,
taking advantage of the tax sheltered growth inside the
Universal Life policy.
 Use the tax-free payout on death and minimize Capital
Gains tax.
 Take advantage of the Capital Dividend Account.
What’s The Cost?
Consider the following………
A Holdco has $300,000 of retained earnings invested in GIC’s
Interest rate is 6% per annum
Corporate tax rate 48.29%
Let’s look at investing in a Joint Last to Die Universal Life on
the shareholders:
$2,500,000 Universal Life, automatic tax sheltering optimized
Male Age 40, Non-smoker
Female Age 40, Non-smoker
Lump sum deposit $300,000
Rate of return selected for illustration purposes 5%
Insurance Cost vs GIC Tax Cost
Insurance
Charges
Annual Tax
Year 1
$2,820
$8,692
Year 5
$2,990
$9,822
Year 10
$1,671
$11,443
Year 20
$1,923
$15,533
Year 30
$4,791
$21,084
GIC’s offer the security of a guaranteed rate of return &
guaranteed principal. Taxes must be paid on an annual basis,
and the principal & interest may be subject to probate tax on
the death of the shareholder as the share price is included in
the estate.
The shareholder can also purchase GIC’s held within a
properly structured Universal Life plan. The Income Tax Act
allows these investments to grow on a tax deferred basis for as
long as those funds stay in the plan, ultimately being paid to
the heirs, tax and probate free.
Universal Life vs GIC (After Tax)
$3,000,000
$2,500,000
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
Year 1
GIC
Year 5
Year 10
Account Value
Year 20
Year 30
Estate Value
Although it is necessary to incur insurance charges, once the Universal is funded, the charges are less
expensive than the taxes that would be payable in a conventional GIC.
In addition, there is a significant enhancement to the estate.
Tax Cost vs Insurance Cost
$25,000
$20,000
$15,000
$10,000
$5,000
$0
Year 1
Year 5
Annual Tax
Year 10
Year 20
Year 30
Insurance Cost
This table shows on an annual basis, the cost of tax in relation to the cost of the insurance of a
Universal Life policy, using our case study.
Insurance Charges vs Tax Cost
$700,000
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000
$0
Year 1
Year 5
Lost to Taxes
Year 10
Year 20 Year 30 Year 40
Cumulative Insurance Charges
The chart shows the cost of tax relative to the cost of insurance in our case study, on a
cumulative basis over 40 years
Corporate Estate Transfer
Taxable
Surplus
Corporate Estate Transfer
Non-taxable
Surplus
The planning objectives of the Corporate Estate Transfer (CET) are threefold:
1.To earn a higher after-tax rate of return on the corporation’s surplus than available from
alternate investments,
2. Transform the taxable surplus into non-taxable surplus, and
3. Reduce capital gains tax on the corporate shares
Investing Trapped Surplus
WHICH IS BEST?
A
TAXABLE INVESTMENTS
Pay 48.29% Corporate Tax each
year
on growth
B
CORPORATE ESTATE
TRANSFER
Transfer to Tax Deferred Account
Pay Tax at 24% to take as dividend
income
Multiply Estate Value - insurance,
capital gains
Pay 19.5% Capital Gains Tax when
shares transferred to heirs
Tax-Free Capital Dividends
Leveraging Opportunities
So here is our choice A or B. The advantage of B is the
opportunity to transfer assets to a tax sheltered Universal Life
that will increase the estate value with tax-free capital
dividends.
A further bonus is the opportunity to access funds in the policy
by use of leveraging. In other words, the insured gets
compounded tax sheltered assets with the accessibility for
business or personal use.
The alternative of the taxable investment does not give
the opportunity to transfer corporate assets to the
estate on a tax-free basis.
Estate Benefit
INSURECO
Tax-Free Death Benefit
CDA Credit
Tax
Free
CDA
Death Benefit proceeds less Policy
ACB can be paid out as Tax-Free
Capital Dividends
What makes Life Insurance so effective?
Answer – the Capital Dividend Account
The CDA amount is the insurance proceeds that are in excess of the
Adjusted Cost Basis(ACB).
In our scenario, if the accumulated earnings that are transferred to
the policy are paid out tax-free to the estate of the deceased
shareholder using the Capital Dividend Account, then we have
achieved a Corporate Estate Transfer
The Choice is Yours….
Non-registered
Assets
Pay Tax
OR
Pay
Insurance
Conclusion
Therefore the alternatives for holding non registered assets in
the corporation that earn investment income can be included
in two pools;
a pool of investments held within an exempt life insurance
policy growing without attracting tax,
or a pool of investments that earn income on a taxable basis.
Clearly, the preferable choice is offered by insurance.
Those looking for tax shelters or deferral mechanisms may wish to explore the significant
benefits that may be derived from an ‘exempt’ life insurance policy… it is to be noted that a
substantial portion of the income from such investment accumulates free of tax, that such
income can be utilized before death, and that the proceeds are not subject to tax on death …
such policies may be a powerful tool in the tax planning arsenal.”
Excerpt from: Coopers & Lybrand,
Tax Planning Checklist, 1997-1998
Do you have Cash trapped in
your Corporation?
Thank You
For more information, please contact us at:
Tel: 239 3850 or E-mail:[email protected]

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