What happens if an estate freeze undervalues the founder’s shares?

A freeze only works if the number is right. The founder’s shares are fixed at a value, and everything above that value belongs to the new shareholders, so a figure that is too low quietly hands value to them. The Income Tax Act tests the exchange against fair market value, and it has rules aimed at exactly this kind of shift.

The rules that look at the exchange

Where a shareholder swaps old shares for new ones in a reorganization of capital, section 86(2) applies if the old shares were worth more than what the founder received and it is reasonable to regard part of the excess as a benefit the founder wanted to confer on a related person. That part, the gift portion, is added to the value of anything the founder received other than new shares to set the founder’s deemed proceeds, which cannot exceed the fair market value of the old shares, and any capital loss on the old shares is treated as nil. Section 85(1)(e.2) does the same job for a section 85 transfer, which is made by joint election on CRA form T2057, by raising the elected amount.

The shareholder-benefit rule

Section 15(1) is a separate rule. When a corporation confers a benefit on a shareholder, the value of that benefit is included in the shareholder’s income for the year, subject to listed exceptions. Whether a particular shift of value is such a benefit is a question for the founder’s advisers, and the rule can land on the person who received the value rather than on the founder.

A deemed gain is still a share gain

A larger deemed gain is still a gain on shares. If those shares are qualified small business corporation shares, the CRA lists dispositions of such shares among the gains eligible for the capital gains deduction, so the final result turns on whether those tests are met. For the other side of the same structure, see how a freeze can help with planning for beneficiaries.