What is Estate Planning:
The general purpose of an estate plan is to organize your personal affairs so as to preserve your wealth. An estate plan typically involves structuring your will so that, when you die, your assets will pass in the most advantageous manner possible to those whom you have chosen to be the beneficiaries of your estate. An estate plan may also involve splitting income with other family members while you are alive so as to reduce your family’s overall tax bill (see audio/visual “Estate Planning for Freeholders”).
Who Needs an Estate Plan:
Our eventual demise is certain and, because conversations from the grave are so difficult, we all need an estate plan. The timing of our death is not certain, therefore the time to consider estate planning is now.
For More Information View our Estate Planning Video.
To view the video full screen, click on the button at the bottom of the video player. To exit full screen, hit the Escape button on your keyboard.
Setting Your Objectives:
As we make our way through life, our circumstances change. At different times we may have a dependent spouse, dependent children, dependent parents or others who rely on us for financial support. Typically, during our earning years our dependents become more self-sufficient and our ability to accumulate wealth increases. Who we want to inherit our wealth may also change as circumstances change. That is why it is so important to have an up-to-date will. There may also come a time when we have accumulated more wealth than is necessary for our individual future needs, and structuring an estate plan to distribute excess wealth to our beneficiaries during our lifetimes may be something worth considering.
Even the simplest will can involve complex legal and tax matters. When your assets include mineral rights, further complexities arise. People are unique and so are their estate planning objectives. The Freehold Owners Association strongly recommends that all of its members retain competent professionals to assist them in structuring an estate plan. The following comments are intended to assist you in recognizing the merits of estate planning and are no substitute for professional advice.
Relevant Factors in Estate Planning for Freehold Minerals:
Under the Canadian Income Tax Act, gifting of property, cessation of Canadian residency or death gives rise to a deemed disposition. In the case of capital property (ie shares of a company, real estate other than an individual’s principle residence, etc.) the deemed disposition which occurs on the death of an individual gives rise to a capital gain and the individual’s estate is subject to tax based on 50% of the difference between the fair market value of the capital property at the date of the individual’s death and the adjusted cost base of the property. However, freehold mineral rights are not capital property – they are Canadian Resource Property. When an individual owning freehold mineral rights dies, the deemed disposition of his mineral rights gives rise to income in his estate equal to the difference between the fair market value of the mineral rights at the time of his death and the adjusted cost base of the mineral rights. As many current freehold owners acquired their mineral rights from their parents at no cost, the tax implications can be very substantial in the case of producing properties.
One of the most important goals of estate planning for freehold mineral rights owners is to minimize the extent of this tax.
Fractionation of Interests:
Historically, freehold mineral interests have typically been transferred from one generation to the next equally amongst the heirs. In situations where succeeding generations have large families, the freehold mineral interests rapidly become fractionated. Excess fractionation may effectively destroy the value of your freehold mineral interests.
The problem relates, in part, to today’s mobile society in which family members often become dispersed around the world. Energy companies typically retain land agents to negotiate freehold lease agreements. In situations where a single freehold property is held by a large number of individuals living in different areas, the oil company may spend more in land agent fees than on actual lease bonus payments. Clearly, the less an oil company pays in land agent fees, the more money the company has available to pay the freeholder for a lease.
Fractionation of freehold mineral interests also gives rise to other practical problems for an energy company. In order to conduct oilfield operations on freehold mineral interests, an energy company must secure lease rights from all owners of the property or face lengthy and costly hearings under the forced pooling provisions of regulatory authorities. As the number of individuals on title increases, the chance that all family members will agree to the same lease terms decreases. Nine signed leases on a property with ten freehold owners is the type of problem most oil companies would prefer to avoid. Some companies have policies which prohibit their staff from dealing with freehold mineral interests where there are more than a certain number of titleholders.
Land Titles Acts:
In addition to the practical problems presented by the fractionation of freehold mineral interests, under the Alberta Land Titles Act, the Registrar may refuse to register a transfer which gives rise to an undivided fractional interest in minerals which is less than an undivided 1/20th of the whole interest. Most of the freehold owners in Alberta are the descendants of settlers who acquired their mineral interests at the turn of the last century as part of their homestead lands. In many cases, these mineral interests have now passed through three or four generations. Members of the current generation will increasingly be forced to address the issue of legal registration of title. In Saskatchewan, at one time the problem was more severe because the Saskatchewan Land Titles Act authorized the Registrar to refuse to register any instrument that disposes of an undivided fractional interest that is less than 1/4th of the whole. Recently the Information Services Corporation of Saskatchewan has adopted Alberta’s position.
Although having a large number of individuals on title to the same freehold property is generally not a good idea because it may reduce your leasing opportunities, there is merit to having more than one owner. More than one owner may allow your family to engage in ‘good cop - bad cop’ negotiating strategies with land agents.
Under the Income Tax Act, individuals and corporations may be subject to significantly different income tax levies on the same amount of income (see below).
Freehold mineral tax should also be considered in estate planning. In Alberta, an exemption of up to $3,200 per year in freehold mineral tax may be available to each title owner. Transferring freehold mineral interests to a single legal entity, such as a corporation, rather than to individual beneficiaries may result in an effective increase in future liabilities for freehold mineral tax. There are also GST issues to consider.
Options to Consider:
A great many factors must be considered in structuring an estate plan involving freehold mineral interests. There are no simple answers and the use of qualified tax and legal experts is highly recommended.
Transfer to a Corporation:
One of the most commonly applied strategies that may be used by individual freehold owners to resolve the issues of title fractionation and excessive taxation on death is to incorporate a company and transfer the freehold mineral interests to the corporation. Such a transfer can usually be accomplished on a tax-free roll-over basis under the provisions of section 85 of the Income Tax Act. Upon such a transfer, the corporation acquires legal ownership of the freehold mineral interests and title is registered in the name of the corporation in the land titles registry.
It is then the shares of the corporation which you leave to your beneficiaries, not partial interests in your freehold minerals. This has two advantages. Firstly, further fractionation of title is prevented and oil companies interested in the mineral interests can deal with a single entity - the corporation. Secondly, the shares of the corporation which pass to the freehold owner’s beneficiaries are capital property and receive capital gains treatment.
Transferring your mineral interest to a corporation may have the disadvantage of creating additional income tax liabilities. Income received from freehold mineral interests does not qualify as ‘active business income’ and, in most cases, the corporation will not qualify for the reduced tax rate applicable to the first $750,000 of active business income. Depending on your own marginal tax rate and the marginal tax rates of the other shareholders in the corporation, the same freehold mineral income may give rise to a significantly greater income tax liability at the corporate level than would otherwise have been payable.
Transferring your mineral interests to a corporation also has the disadvantage of minimizing the Alberta freehold mineral tax exemption.
There are also costs involved in creating and running an corporation. In addition to incorporation costs, there are annual filing fees and the costs of preparing financial statements and filing corporate income tax returns.
Creating a company to own your freehold mineral interests and then leaving shares in that company to our children may either cause or prevent future conflicts among your children. Had you left fractional interests in the freehold minerals directly to your children, they would each be free to deal with their individual interests in the minerals as they saw fit. However in leasing negotiations some land agents take advantage of multiple owners by leasing from the most vulnerable owner and then playing the ‘aunt Matilda needs the money for a hip replacement’ song to secure leases from the other family members. In other situations, the ‘black sheep’ of the family may refuse to lease under reasonable terms thereby potentially denying the rest of the family the right to lease. The corporate structure requires a uniform approach to matters such as leasing. If you transfer your freehold minerals to a corporation, it is recommended that a unanimous shareholder agreement be executed. This type of agreement provides a mechanism for the reasonable resolution of disputes amongst shareholders and can be structured to prevent the shares of the corporation from moving outside the family blood line through such matters as divorce of one of the family members or creditor claims.
One of the more significant advantages of transferring freehold mineral interests to a corporation is the opportunity to ‘freeze’ the value of the freeholder’s interest in the property and allow future growth to accrue to other shareholders in the corporation.
In its simplest form, an estate freeze may be accomplished by having a parent transfer his (or her) freehold mineral interests into a corporation and taking back preferred shares with a value equal to the fair market value of the freehold minerals. Common shares in the corporation are issued to the owner’s children and/or grandchildren.
Future royalties which accrue to the corporation may then be used to redeem the preferred shares providing the parent with a revenue stream during his or her lifetime which is taxed at rates preferable to royalty income. Any increase in the fair market value of the freehold mineral interest will accrue to the common shares.
This not only has the effect of spreading the tax liability associated with the preferred shares over a number of years, it minimizes the tax impact in the parent’s estate. Instead of being taxed on the deemed disposition of the freehold mineral interests at fair market value immediately before the parent’s death, tax is calculated on the value of the parent’s preferred shares which have not been redeemed.
Caution must be exercised in structuring an estate freeze in order to ensure that the attribution and benefit provisions of the Income Tax Act do not apply. Professional assistance is essential.
Transfer to a Trust:
In simple terms, a trust is created when there is a legal obligation placed on a person (the ‘Trustee’) to control and deal with certain property (the ‘Trust Property’) for the benefit of a person or persons (the ‘Beneficiaries’). The Trustee must act according to the terms and conditions specified by the person who set up the trust (the ‘Settlor’).
In the case of freehold minerals, ‘family trusts’ may be used to split income from mineral rights amongst family members. The concept is to transfer income from one family member to other members of the family thereby reducing the overall income tax paid. The Settlor is typically the parent who owns the mineral interests which become the Trust Property. The Beneficiaries are usually the owner, his spouse and children or grandchildren. A family member, a professional trustee, a legal firm, or an accounting firm may be chosen to be Trustee.
Setting up a family trust to hold freehold minerals is typically more expensive than setting up a corporation. In addition, the transfer into the trust of the freehold minerals gives rise to a disposition in the freehold owner’s hands in an amount equal to the fair market value of the minerals. It is also essential that a professional evaluation of fair market value be obtained.
Once structured, a family trust holding freehold minerals provides considerable flexibility in allocating income from the mineral interests in a tax advantageous manner.
A trust may also be utilized in combination with a transfer to a corporation to accomplish both an estate freeze and income splitting.
A number of complex income tax rules, including the ‘21-year rule’, which essentially deems a trust to have disposed of its property every twenty-one years, must be addressed in structuring a trust to hold freehold mineral interests. Once the trust is structured, it is necessary to maintain records, and file trust tax returns and beneficiary elections. Professional tax and legal advice is essential.
Transfer to Children:
If fractionation of title is not an issue, a strategy which may be implemented by a parent is to transfer ownership of the freehold mineral interest to his or her children during the parent’s lifetime. The transaction will give rise to a disposition and the parent will be subject to income tax on the fair market value of the freehold mineral interest at the time of the transfer. This works best if the mineral interests have nominal value because they are not leased or, if leased, not producing. If the freehold minerals are leased and developed in the future, the children will benefit from the increased value and taxes in the parent’s estate associated with deemed disposition of the mineral interests will be eliminated.
The foregoing information on estate planning for freehold mineral interests is not meant to be exhaustive. There are many additional factors which should be examined in structuring an estate plan involving your freehold minerals. Issues such as the clawback of Old Age Security benefits, the application of GST and alternative minimum tax may all have an impact on your decisions.
The information provided should not be considered to be legal or accounting advice. Everyone’s situation is different and the information provided should only be used in conjunction with the advice of legal and accounting professionals.
Please log in or become a member.