Principal Issues: Comparison of CRA’s response to Question 7 of the 2018 STEP CRA Roundtable (2018-074403) and examples 10 and 12 of the Guidance on the Application of the Split Income Rules for Adults.
Position: General comments provided. Answer to question 7 of the 2018 STEP Conference was based on the assumption provided in the question that the corporation was not carrying on a business while in examples 10 and 12 of the Guidance it was assumed that the corporations in both examples were carrying on a business. Under the Income Tax Act, a corporation can carry on a business the purpose of which is to derive income from property.
Reasons: According to the law and previous positions.
FINANCIAL STRATEGIES AND INSTRUMENTS ROUNDTABLE 5 OCTOBER 2018
2018 APFF CONFERENCE
Question 2
Excluded shares and tax on split income
SITUATION
At the Society of Trust and Estate Practitioners (STEP) Roundtable on May 29, 2018, the following question was put to the CRA:
“Assume that a corporation has no business income because it derives income from property (possibly rental income from real property where the activities are not sufficient to constitute business income).
In this case, can the shares of the corporation be excluded shares?”
The CRA's response was negative because the corporation had no business income.
In this regard, reference was made to paragraph (a) of the definition of excluded shares.
PARALLEL
On 13 December 2017, the CRA published a document entitled “Guidance on the application of the split income rules for adults (the “Guidance Document”).
In that document, the CRA seems to indicate the opposite in the following examples:
1)
Example 10: Dividends paid to adult shareholders
Facts
- Sibling A, Sibling B and Sibling C are over age 25 and they each acquired 10 shares of Real Estateco on incorporation for nominal consideration. All siblings are directors of Real Estateco.
- Over the years, Real Estateco has acquired several rental properties financed by arm’s length financial institutions with limited personal guarantees from each sibling.
- Third Party was engaged to manage all the aspects of Real Estateco’s rental activities.
- Real Estateco has sold one of its properties at a significant gain.
- Real Estateco uses the proceeds from such gain to pay taxable dividends to its shareholders.
CRA position
The share of Real Estateco qualify as Excluded Shares.
2)
Example 12: Retired Shareholders
Facts
- Spouse A and Spouse B own respectively 95 % and 5% of all the issued and outstanding shares of Investco.
- Spouse A is over age of 65 and Spouse B is age 60.
- Investco carried on an active business for over 25 years. Investco wound down that business many years ago and now owns a portfolio of passive investment assets that require sporadic management decisions and investment activity.
CRA Position
Spouse A owns shares that qualify as Excluded Shares.
Question to the CRA
We wish to hear the CRA's comments on these two examples.
CRA Response
The CRA's response to Question 7 of the Canadian STEP CRA Roundtable of May 29, 2018 ("Question 7") was based on the assumption made in the statement of that question that the corporation had no business income. Thus, since the condition provided in subparagraph (a)(i) (footnote 1) of the definition of "excluded shares" in subsection 120.4(1) was not satisfied, the corporation’s shares could not qualify as excluded shares. Consequently, the CRA response was dependent on the specific statement in Question 7.
The purpose of the Guidance Document is to provide, inter alia, general guidance on how the CRA intends to administer the different types of exclusions described in the definition of "excluded amount" in subsection 120.4(1).
Specifically with respect to the examples discussed above, Example 10 was intended to illustrate the exclusions with respect to reasonable return (footnote 2) and excluded shares. As for Example 12, the latter covered not only the exception for excluded shares, but also the deeming rule provided in subparagraph 120.4(1.1)(c)(i) providing relief for spouses of business owners who turned 64 before the end of the year (footnote 3).
Briefly, by virtue of this subparagraph, an amount received by a specified individual is deemed to be an excluded amount if: (1) the spouse or common law partner of the specified individual has attained the age of 64 years before the year, and (2) the amount would have been an excluded amount in respect of an individual who was the specified individual’s spouse or common-law partner, if the amount were included in computing the spouse or common-law partner’s income.
In addition, to demonstrate that the various exclusions were applicable not only to entities that earn income from an active business, such as a manufacturing corporation, but also to entities that carry on a business of earning income from property, such as a property rental business (in Example 10) or an investment management business (in Example 12), we had assumed that these corporations had a sufficient level of activity such that their income could be considered as derived from a business.
That being said, the income or loss from a business or property is computed in Subdivision b of Division B of Part I. Nevertheless, those are two separate sources of income for purposes of the Income Tax Act.
In that regard, the question of whether a particular income constitutes income from a business or income from property is a question of fact that can only be resolved following a comprehensive analysis of all the facts present with respect to a particular situation.
The term "business" is not defined in the Income Tax Act, as subsection 248(1) simply expands the concept of "business" for the purposes of the Income Tax Act by including, inter alia, an undertaking of any kind whatever.
Furthermore, the Income Tax Act contemplates that the principal purpose of a business may be to derive income from property, including interest, dividends, rents and royalties (footnote 4).
Based on the foregoing, if the assumption in Question 7 were modified so that the corporation carried on a business, the condition in subparagraph (a)(i) of the definition of “excluded shares" in subsection 120.4(1) would be satisfied.
Although it was determined - taking into account the wording of Question 7 - that the shares of the capital stock of the corporation in question could not qualify as excluded shares, an amount received from that corporation by a specified individual could nevertheless be an excluded amount.
For example, subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1) provides that, in respect of an individual who has attained the age of 17 before a particular taxation year, an amount is an excluded amount if it is not derived directly or indirectly from a related business in respect of the individual.
The expression "related business" in respect of a specified individual for a taxation year is defined in subsection 120.4(1) of the Income Tax Act and means, in respect of a corporation, (1) a business carried on by the corporation, if a source individual in respect of the specified individual (footnote 5) at any time in the year is actively engaged on a regular basis in the activities of corporation related to earning income from the business; or (2) a business of a corporation, where a source individual in respect of the specified individual owns shares of the capital stock of the corporation, or property that derives, directly or indirectly, all or part of its fair market value (“FMV”) from shares of the capital stock of the corporation, and the aggregate FMV of the foregoing shares and property is equal to or greater than 10% of the FMV of all issued and outstanding shares of the capital stock of the corporation.
Thus, if it is determined that a corporation does not carry on a business, and that that corporation pays a dividend to a specified individual, the amount of that dividend, provided it does not come directly or indirectly from a related business in respect of the specified individual (footnote 6), could be an excluded amount for the individual. Consequently, the amount of the dividend would not be included in the calculation of the split income of the specified individual and the specified individual would not be subject to split income tax in respect of the amount of that dividend.
Jean Lafrenière
(613) 670-9013
5 October 2018
2018-076579
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 That is, less than 90% of the business income of the corporation was from the provision of services.
2 In summary, the term “reasonable return” as defined in subsection 120.4(1), generally an amount derived directly or indirectly from a related business in respect of the specified individual and that is reasonable having regard to the factors - described in subparagraphs (b)(i) to (v) of that definition - relating to the relative contributions of the specified individual and of each source individual.
3 Briefly, by virtue of this subparagraph, an amount received by a specified individual is deemed to be an excluded amount if: (1) the spouse or common law partner of the specified individual has attained the age of 64 years before the year, and (2) the amount would have been an excluded amount in respect of an individual who was the specified individual’s spouse or common-law partner, if the amount were included in computing the spouse or common-law partner’s income.
4 See the definition of “specified investment business” in subsection 125(7).
5 The term "source individual" in respect of a specified individual for a taxation year is defined in subsection 120.4 (1) L.I.R. as an individual (other than a trust) who, at any time in the year, is resident in Canada and related to the specified individual.
6 Paragraph 120.4(1.1)(d) clarifies, for greater certainty, that certain amounts are included, for the purposes of section 120.4, in what constitutes an amount derived directly or indirectly from a business.