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 2003 Passive Active Business Income 000’s ($ ) ($225 - $300)** ($300 - $400) ($400+) Net Federal tax 28.00% 13.12% 22.12% 24.12% 24.12% Add surtax (4)% 1.12% Refundable tax* 6.67% 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 6 2/3 % 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 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.

DIVIDEND - $300,000 24% $ 72,000 NET $228,000 TAXABLEDIVIDENDS SHAREHOLDER CORPORATION $300,000 Trapped Surplus

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… 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…… no tax 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 re- allocating 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 $21,084$4,791 Year 30 $15,533$1,923 Year 20 $11,443$1,671 Year 10 $9,822$2,990 Year 5 $8,692$2,820 Year 1 Annual TaxInsurance Charges

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) 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 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 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 Non-taxable Surplus 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 Corporate Estate Transfer

Investing Trapped Surplus WHICH IS BEST? A B TAXABLE INVESTMENTSCORPORATE ESTATE TRANSFER  Pay 48.29% Corporate Tax each year on growth  Pay Tax at 24% to take as dividend income  Pay 19.5% Capital Gains Tax when shares transferred to heirs  Transfer to Tax Deferred Account  Multiply Estate Value - insurance, capital gains  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 Pay Insurance OR

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,

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