Freezes and Refreezes: Opportunities and Risks in the Era of Self-Isolation

The economic havoc wreaked by COVID-19 is self-evident. With the chaos, however, comes opportunity. Those looking to minimize future income tax may consider "freezing" the value of their investments now, at depressed values. Similarly, those who previously undertook an estate freeze may consider "refreezing" their equity interests. This article explores the mechanics, principal benefits, and risks of each such strategy.

In general, a freeze transaction aims to fix—or "freeze"—the freezor's value in a subject asset. All growth in value of the frozen asset thereafter accrues to other persons, typically the freezor's family members (or a personal trust created for their benefit). A freeze may also indirectly result in other benefits—for example, multiplication of the capital gains deduction for qualifying shares of certain active business corporations.

Freeze transactions typically involve a tax-deferred reorganization through an underlying corporation (Freezeco). Myriad methods of implementing a freeze exist. If the freezor already owns growth shares in Freezeco, an "internal freeze" can be undertaken, whereby the freezor exchanges such shares for fixed-value preferred shares with specific share rights and restrictions. Interests in personally owned assets—such as real estate held as capital property—may also be frozen by transferring such assets to Freezeco in return for preferred shares (with an election under section 85 typically being filed). The freezor may take back non-share consideration (for example, a promissory note) equal to the cost amount of the subject asset without necessarily impairing the tax-deferred nature of the transaction.

In either case, the freezor's family members, or a trust settled for their benefit, then subscribe for the Freezeco common shares. The freezor may wish (or be advised for post mortem "bump" planning reasons) to retain voting control over Freezeco. Preferred shares received are then frequently transferred to a life-interest trust—for example, an alter ego, spousal, or joint partner trust—for other estate-planning reasons.

Significantly, estate freezes are driven in large part by administrative concession. The CRA's view that fixed-value preferred shares can have an FMV equal to that of the frozen asset is critical to the effectiveness of an estate freeze. Therefore, any preferred shares issued should have rights and restrictions that comply with longstanding CRA policy—namely, that such preferred shares (1) are redeemable at the holder's option (that is, retractable); (2) carry voting rights in respect of matters pertaining to the relevant class of shares; (3) have first preference on any distribution arising from the underlying corporation's liquidation, winding up, or dissolution; (4) have no restriction on transferability (other than as mandated by governing corporate law); and (5) are issued by a corporation that is restricted from paying dividends on any other class of shares if doing so would impair the corporation's ability to pay the full redemption amount of the preferred shares.

Valuation is also always a critical consideration. Undervaluing the preferred shares received on a freeze transaction risks benefit conferral, attribution, and double taxation. Prudence thus dictates that a price adjustment clause (PAC) always be used where possible and, to ensure that the CRA will respect such a PAC, bona fide steps should be taken to determine the FMV of the frozen asset when setting the redemption value of the preferred shares.

Here is where COVID-19 presents the clearest opportunities. Public securities trading at historically low values (as determined by true market forces) are ripe for an estate freeze before markets recover. Commercial real estate, especially in the urban centres most directly affected by the pandemic, is similarly well positioned. Private company shares may also be ideal candidates for an estate freeze given widespread cash flow and revenue losses (though if such losses are temporary only, caution suggests that declines in value may not be as acute as instinctively perceived).

Similar considerations apply for taxpayers who have already undertaken a freeze transaction. If COVID-19 has resulted in the value of the underlying corporation decreasing since the time of an earlier freeze, a "refreeze" transaction may be an equally attractive planning opportunity.

Refreeze transactions generally involve a taxpayer exchanging preferred shares received on an earlier freeze for newly issued preferred shares with a redemption amount equal to the current (lower) equity value of the underlying corporation. The preferred share redemption amount is thus "reset" at present values. Naturally, a refreeze is only prudent where the aggregate redemption amount of the existing preferred shares exceeds the current net equity value of the corporation (such that the common shares effectively have nil value).

The CRA has commented favourably on the viability of refreezes (see, among others, CRA document no. 9607635, May 28, 1997). In particular, the CRA has confirmed that no benefit is conferred on a corporation's common shareholders where the post-freeze decline in value was not caused by intentionally stripping the corporation's assets (see, for example, CRA document no. 2010-0362321C6, June 8, 2010).

Refreezes are subject to the same considerations that apply to freeze transactions. In particular, CRA administrative positions—including those regarding the necessary share rights and restrictions—should be complied with, and a PAC should be used when possible. Particular scrutiny should be given to the value of the underlying corporation and whether the existing common shareholders have indirectly received a benefit from the refreeze. Practitioners should be mindful of the basis for the post-freeze decline in value, especially if it is significant, and whether the CRA could challenge the decline as having been "manufactured" to justify the refreeze. External valuations and third-party appraisals may be particularly advisable when considering a refreeze transaction.

The corporate attribution rule is particularly relevant in the context of a refreeze. As background, that rule may apply if an individual transfers property to a corporation and one of the main purposes of the transfer is to reduce the individual's income and benefit a "designated person" (as defined in subsection 74.5(5)) in respect of the individual. If the rule is applicable, the individual may be subject to an annual deemed interest benefit. There are various exceptions and caveats to that rule, a full discussion of which is beyond the scope of this article. However, in the context of refreezes, the corporate attribution rule may result in unforeseen, and seemingly unintended, consequences.

In particular, an individual freezor subject to the corporate attribution rule—knowingly or otherwise—who undertakes a refreeze transaction may continue to be subject to a deemed interest benefit calculated by reference to the value of the assets transferred to the corporation on the initial freeze. The preferred shares received on the refreeze do not appear to reduce the "outstanding amount" of the transferred property (as determined under subsection 74.4(3)). Thus, it appears that the amount on which the deemed interest benefit is computed will not be reduced, notwithstanding that the underlying transferred property has presumably declined in value. Further, if the refrozen preferred shares are redeemed, the "outstanding amount" will apparently be reduced only to the extent of the value of the refrozen shares. Thus, the freezor may technically be deemed to continue receiving "phantom" interest income, even after all outstanding preferred shares are redeemed. For more detail, see Manu Kakkar, Alex Ghani, and Boris Volfovsky, "Corporate Attribution: Refreeze May Cause Unsolvable Corporate Attribution Problem," Tax for the Owner-Manager, Vol. 18, No. 3 (July 2018).

In conclusion, alongside the extreme difficulties brought by COVID-19 come planning opportunities. Freeze or refreeze transactions may be particularly advantageous given the present circumstances. However, the benefits, considerations, and risks outlined above should be kept directly in mind.

Alexander Demner
Thorsteinssons LLP Tax Lawyers, Vancouver

Nicholas McIsaac
Thorsteinssons LLP Tax Lawyers, Toronto

COVID-19 and Canadian Tax
A special joint issue of Canadian Tax Focus and Tax for the Owner-Manager
July 2020
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