Principal Issues: Holdco holds all of the issued and outstanding shares of the capital stock of Opco. Mr. X and his spouse, Ms. X, hold respectively 90% and 10% of the voting and participating shares of the capital stock of Holdco. Mr. X and Ms. X are both age 35. Ms. X is not involved in any manner in Opco’s business. Holdco has no source of income other than Opco. In Situation A, Opco pays dividends of $100,000 to Holdco. Then, Holdco pays dividends of $90,000 to Mr. X and $10,000 to Ms. X. In Situation B, Holdco owns passive investments which were acquired from proceeds of dividends received by Holdco on its Opco shares. Holdco has not received any dividends or any other payments from Opco in its last taxation year. In its last taxation year, Holdco earned $100,000 of income from its passive investments. Holdco pays dividends of $67,000 to Mr. X and $7,500 to Ms. X. Question 1: Whether the CRA can confirm its position as to whether shares of a holding corporation qualify as excluded shares, taking into consideration its responses to Questions 6 and 7 of the 2018 STEP CRA Roundtable (2018-074403) versus: a) examples 8 and 12 of the Guidance on the Application of the Split Income Rules for Adults; and b) the Department of Finance Technical Backgrounder on Measures to Address Income Sprinkling published in support of its December 13, 2017 press release. Question 2: In Situation A, whether the shares of the capital stock of Holdco are excluded shares of Ms. X. If not, whether this result was intended. Question 3: In Situation B, whether the shares of the capital stock of Holdco are excluded shares of Ms. X.
Position: Question 1: General comments provided. Answer to question 7 of the 2018 STEP CRA Roundtable was based on the assumption provided in the question that the corporation was not carrying on a business while in examples 8 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. Question 2: Generally no. Question 3: Yes. It can be argued that Holdco’s investment income is not derived, directly or indirectly, from one or more related businesses in respect of Ms. X. Instead, Holdco’s income is derived from its own business.
Reasons: Question 1: According to the law and previous positions. Questions 2 and 3: In accordance with the legislation and tax policy.
FEDERAL TAX ROUNDTABLE 5 OCTOBER 2018
2018 APFF CONFERENCE
Question 9
Section 120.4 - "excluded shares" and "related business"
By virtue of the new rules on tax on split income in section 120.4, income from excluded shares is an "excluded amount". The definition of "excluded shares" provides that "excluded shares" means shares:
- of a corporation that is not a professional corporation and less than 90% of the business income of its last taxation year was from the provision of services;
- which give the holders thereof 10% or more of the voting rights and have a fair market value of 10% or more of the fair market value of all the shares of the corporation; and
- of a corporation if all or substantially all of its income from its last taxation year is not derived, directly or indirectly, from a related business in respect of the individual (other than a business of the corporation).
In respect of the definition of "related business" in subsection 120.4(1), a related business includes, inter alia, the business of a corporation of which a related person owns shares or property that derives, directly or indirectly, all or part of its fair market value from shares of the capital stock of the corporation, which shares or properties have a fair market value of 10% or more of the fair market value of all the shares of the corporation.
Consequently, in order to qualify as "excluded shares", all or substantially all of the income of the issuing corporation for its last taxation year must not come directly or indirectly from one or more other related businesses in respect of the individual.
Consider the following situations:
Situation A:
- Opco is held 100% by Holdco;
- Mr. X holds 90% of the participating and voting shares of Holdco and Mrs. X, Mr. X's spouse, holds 10% of the participating and voting shares of Holdco;
- Mr. X and Mrs. X are 35 years old and Mrs. X does not participate in Opco's business in any way;
- Holdco has no other sources of income;
- Opco pays a $100,000 dividend to Holdco;
- Holdco then pays a dividend of $90,000 to Mr. X and $10,000 to Mrs. X.
Under the definitions of "excluded shares" and "related business" in subsection 120.4(1), the shares held by Mrs. X in the capital of Holdco do not appear to qualify as excluded shares because Holdco's income is derived from Opco, which has a related business in respect of Mrs. X since Mr. X holds property (that is, shares of Holdco) whose fair market value derives indirectly from shares of Opco and that represents more than 10% of Opco's value.
However, if Mrs. X held 10% of the shares of Opco directly (and not through Holdco), her shares would qualify as excluded shares.
Situation B:
- Opco is held 100% by Holdco;
- Mr. X holds 90% of the participating and voting shares of Holdco and Mrs. X, Mr. X's spouse, holds 10% of the participating and voting shares of Holdco;
- Mr. X and Ms. X are 35 years old, and Ms. X does not participate in Opco's business in any way;
- Holdco holds passive investments whose initial capital came from dividends received from Opco in previous years;
- Holdco did not receive any dividends (or other income) from Opco in its last year;
- In its last year, Holdco generated passive income on its investments of $100,000 (interest, dividends);
- Holdco pays a dividend of $67,500 to Mr. X and $7,500 to Mrs. X.
Questions to the CRA
a) In response to Questions 6 and 7 of the Society of Trust and Estate Practitioners' (STEP) Roundtable 2018, the CRA confirmed that the shares of a holding company (or a company generating no business income) cannot qualify as excluded shares, whereas (i) in examples 8 and 12 of the CRA's Guidance on the application of the split income rules for adults (" Guidance Document") and (ii) in a document titled "Technical Disclosure Document on Income Distribution Measures" issued by the Minister of Finance in support of the content of its Release of 13 December 2017, the shares of a holding company (or a company that does not generate business income) are classified as excluded shares. Can the CRA confirm its position in this regard?
b) In Situation A, are the shares held by Mrs. X in the capital stock of Holdco "excluded shares" within the meaning of that expression in subsection 120.4(1)? If not, is this incongruous result intentional?
c) In Situation B, are the shares held by Mrs. X in the capital stock of Holdco "excluded shares" within the meaning of that expression in subsection 120.4(1)?
CRA Response to Question 9(a)
The CRA's response to question #7 of the STEP Canada 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 set out in subparagraph (a)(i) (footnote 1) of the definition of "excluded shares" in subsection 120.4(1) was not satisfied, the shares of the corporation at issue could not qualify as excluding shares. As a result, 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).
With particular reference to the examples mentioned above, Example 8 was intended to illustrate the exclusion for excluded shares. As for Example 12, the latter covered not only the exception for excluded shares, but also the deeming rule 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 2).
Furthermore, to demonstrate that the various exclusions were applicable not only to entities carrying on an active business, such as a manufacturing corporation, but also to entities carrying on a business whose principal purpose is to derive income from property, including interest, dividends, rents and royalties, such as investment management corporations (in Examples 8 and 12), the CRA assumed that these corporations maintained a sufficient level of activity such that their income could be considered as derived from such 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 this regard, the question of whether particular income constitutes business income or income from property is a question of fact that can only be resolved as a result of an exhaustive analysis of all facts 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 3).
Based on the foregoing, if the assumptions 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 particular 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 (footnote 4) in respect of the specified individual 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 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 5), 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.
CRA Response to Question 9(b)
The CRA generally agrees with the stated conclusion in this question that shares of the capital stock of Holdco held by Mrs. X are not excluded shares for Mrs. X.
Shares of the capital stock of a holding corporation should generally not qualify as excluded shares of a specified individual because, in the case of a holding corporation, the total income of the corporation would come from another related business in respect of a specified individual (other than a business carried on by the holding corporation). Thus, the condition set out in paragraph (c) of the definition of "excluded shares" in subsection 120.4(1) would not be satisfied. Since shares of the capital stock of a holding corporation owned by a specified individual would not be excluded shares of the individual, the income earned, or the taxable capital gain (or profit) from the disposition of the shares would not be an "excluded amount", as that term is defined in subsection 120.4(1), and, consequently, would be split income for the specified individual unless another exclusion could apply.
Depending on the circumstances, the income earned, or the taxable capital gain (or profit) from the disposition of the shares of the capital stock of a holding corporation may not be split income if other exclusions apply. For example, where the income is from a related business that is an excluded business (footnote 6) in relation to an individual, the income is an excluded amount of the specified individual and is not subject to the tax on split income.
The various exclusions, including the exclusion of excluded shares, are not intended to apply in all circumstances. Where the exclusions do not apply in a particular situation, the underlying logic is that, in such circumstances, the most appropriate test, to determine whether the income from a related business relative to a specified individual should be excluded from the computation of split income, should be based on the general test of whether the amount constitutes a "reasonable return" given the specific criteria applicable in the circumstances, including the work performed, the assets contributed, the risks assumed, the total amounts paid or payable and any other relevant factors.
CRA Response to question 9(c)
To begin with, for the purpose of this question, we have assumed that the income earned by Holdco totalling $100,000 is derived from the carrying on of a business the purpose of which is to earn interest income and dividends. However, it must be emphasized that whether or not a corporation is carrying on a business whose purpose is to earn interest and dividend income is a question of fact that can only be resolved as a result of an exhaustive analysis of all the facts and circumstances in relation to a particular situation.
In light of the foregoing, the CRA is of the view that the condition provided in paragraph (c) of the definition of "excluded shares" in subsection 120.4(1) would be satisfied in respect of Holdco, notwithstanding the fact that the capital used in the acquisition by Holdco of the property used in carrying on its business was derived from dividends received from Opco.
In particular, at the time (the "Time") when Mrs. X received her Holdco dividend, the entire income of Holdco, for its last taxation year ending by the Time, was not derived, directly or indirectly, from one or more related businesses in respect of Mrs. X (e.g., Opco), but rather derived from the Holdco business.
Furthermore, considering that Holdco is not a professional corporation and assuming that the corporation carries on a business whose income, for its last taxation year ending by the Time, came solely from interest and dividends and not from the provision of services, the condition set out in paragraph (a) of the definition of "excluded shares" in subsection 120.4(1) is satisfied with respect to Mrs. X.
Finally, since Mrs. X held, immediately before the Time, shares of the capital stock of Holdco: (1) giving her 10% or more of the votes that could be cast at an annual general meeting of shareholders of Holdco; and (2) having a fair market value of 10% or more of the fair market value of all of the issued and outstanding shares of the capital stock of Holdco, the condition set out in paragraph (b) of the definition of "excluded shares" in subsection 120.4 is satisfied with respect to Mrs. X.
Thus, the shares of the capital stock of Holdco held by Mrs. X would be excluded shares for her at the Time. Accordingly, the $7,500 dividend received by Mrs. X for that taxation year would constitute an "excluded amount" under subparagraph (g)(i) of the definition of that term in subsection 120.4(1) and Mrs. X would not be subject to the split income tax in respect of that dividend.
In closing, if it turned out that transactions were primarily effected so that shares of the capital stock of a particular corporation could qualify as excluded shares in order to circumvent the application of section 120.4, the CRA would consider recourse to the general anti-avoidance provision in subsection 245(2) in such circumstances.
Jean Lafrenière
(613) 670-9013
5 October 2018
2018-076880
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 That is, less than 90% of the business income of the corporation must be derived from the provision of services.
2 Briefly, under this subparagraph, an amount received by a specified individual is deemed to be an excluded amount if: (1) the specified individual's spouse or common law partner has attained the age of 64 years before the year; and (2) the amount would have been an excluded amount in respect of the specified individual's spouse or common-law partner if it were included in computing the spouse or common-law partner's income.
3 See the definition of “specified investment business” in subsection 125(7).
4 The expression "source individual" in respect of a specified individual for a taxation year is defined in subsection 120.4(1) as an individual (other than a trust) who, at any time in the year, is resident in Canada and is related to the specified individual.
5 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.
6 The term "excluded business" is defined in subsection 120.4(1).