Principal Issues: A family Trust (“Trust”) has sold its shares of the capital stock of a corporation (“Opco”) and has allocated the taxable portion of the resulting capital gain to Mr. X, Ms. X (Mr. X’s spouse) and their children (“Child X” and “Child Y”). The shares of the capital stock of Opco held by Trust qualified as small business corporation shares as defined in subsection 110.6(1) and the beneficiaries claimed the capital gains exemption with respect to the taxable capital gain allocated by Trust. Child X and Child Y are age 15 and 22, respectively. A holding company (“Holdco”) was incorporated and Trust, Mr. X, Ms. X, Child X and Child Y subscribed to, respectively, 50%, 20%, 20% 5% and 5% of the shares of the capital stock of Holdco with the proceeds of disposition received from the sale of the Opco shares. Ms. X, Child X and Child Y were not involved in Opco’s business. Holdco used the proceeds received from the issuance of its shares to purchase portfolio investments. The following year, Holdco earned $150,000 of passive income from its portfolio investments. Holdco intends to pay dividends to its shareholders ($50,000 to Trust, $20,000 to each of Mr. X and Ms. X, and $5,000 to each of Child X and Child Y). Trust intends to allocate the dividends received from Holdco to Ms. X, Child X and Child Y. A) Whether the dividends paid by Holdco to Mr. X, Ms. X’ Child X and, Child Y are subject to TOSI. B) Whether the allocation of the dividends by Trust is subject to TOSI.
Position: The taxable capital gains distributed by Trust would be excluded amounts for Mr. X, Ms. X, Child X and Child Y under paragraph (d) of the definition of the expression “excluded amount”. A) Because Child X is minor, dividends paid by Holdco would be added to his split income and he would be subject to TOSI. If Holdco does not carry on a business, the dividend received by Mr. X, Ms. X and Child Y would not be derived, directly or indirectly, from a related business and would be an excluded amount for these three individuals. If Holdco carries on a business, Holdco would be a related business in respect of Mr. X, Ms. X and Child Y as Mr. X and Ms. X would both meet the ownership test in respect of Holdco for the purposes of the definition “excluded shares”. Consequently, dividends paid by Holdco would be excluded amounts for Mr. X and Ms. X as their shares held in the capital stock of Holdco would qualify as excluded shares. The dividends paid by Holdco could be an excluded amount for Child Y to the extent it does not exceed the safe harbour capital return exclusion. B) Because Child X is minor, the Trust’s distribution received would be added to his split income and he would be subject to TOSI. If Holdco does not carry on a business, the Trust’s distribution received by Ms. X and Child Y would not be derived, directly or indirectly, from a related business and would be an excluded amount for these two individuals. If Holdco carries on a business, the Trust’s distribution could be an excluded amount in respect of Ms. X if it is a reasonable return in respect of her. The distribution could be an excluded amount in respect of Child Y to the extent it does not exceed the safe harbour capital return exclusion.
Reasons: In accordance with the legislation.
FEDERAL TAX ROUNDTABLE 5 OCTOBER 2018
2018 APFF CONFERENCE
Question 13
Section 120.4 - Distribution reinvested in a company
As part of the announcement of legislative proposals to amend section 120.4, the Minister of Finance clarified, in a document entitled " Technical Backgrounder on Measures to Address Income Sprinkling” which supplemented its December 13, 2017 News Release, that the legislative proposals would not target “compound income (i.e., income earned from the investment of an initial amount of income that is subject to the TOSI or attribution rules).”
In that context, consider the following situation:
- A family trust ("Trust") sold the shares it held in the capital stock of a corporation ("Opco") and distributed the taxable portion of the resulting capital gain to its beneficiaries, X, his spouse Mrs. X and their children, Child X and Child Y;
- Trust retained the non-taxable portion of the capital gain;
- The shares of the capital stock of Opco constituted qualified small business corporation shares for the purposes of section 110.6 and the beneficiaries of the trust claimed the capital gains deduction against the taxable gain received;
- Child X and Child Y are aged 15 and 22 years respectively;
- A holding company ("Holdco") was incorporated and Mr. X, Mrs. X, Child X and Child Y and Trust subscribed for shares of the capital stock of Holdco in consideration for the payment of the amount received on the sale of the shares of the capital stock of Opco;
- As a result of such subscriptions, the participating and voting shares of the capital stock of Holdco are held 50% by Trust, 20% by Mr. X, 20% by Mrs. X, 5% by Child X and 5% by Child Y;
- Neither Mrs. X nor the children, Child X and Child Y, were involved in Opco's business;
- Holdco invested the amounts received in stock market investments;
- The following year, Holdco generated $150,000 in passive income;
- Holdco wishes to pay a $50,000 dividend to Trust, $20,000 to each of the parents, Mr. X and Ms. X, and $5,000 to each of the children, Child X and Child Y;
Trust wishes to allocate the $50,000 dividend received from Holdco to Mrs. X, Child X and Child Y.
CRA Response
Preliminary comments
To begin with, it appears from the question as stated that, pursuant to subsection 104(21.2), Trust has distributed to its beneficiaries, Mr. X, Mrs. X, Child X and Child Y, in respect of its eligible capital gains, amounts determined under subparagraph 104(21.2)(b)(i) and clause 104(21.2)(b)(ii)(B) in respect of shares of the capital stock of Opco, which qualified as qualified small business corporation shares. Accordingly, each of the beneficiaries of Trust is deemed, by virtue of paragraph 104(21.2)(b), to have disposed of shares of the capital stock of Opco and to have had a taxable capital gain from the disposition of those shares.
Such taxable capital gain should be an excluded amount for Mr. X, Mrs. X, Child X and Child Y under paragraph (d) of the definition of "excluded amount" in subsection 120.4(1).
Dividend paid by Holdco
With respect to the dividend paid by Holdco to Child X (footnote 1), it will be added to the child’s split income under paragraph (a) of the definition of "split income" in subsection 120.4(1). Child X did not attain the age of 17 before the year in which the child received the dividend from Holdco and it appears that none of the exclusions in the definition of "excluded amount" in subsection 120.4(1) is applicable to the dividend.
With respect to Mr. X, Mrs. X and Child Y (footnote 2), it must first be determined whether or not Holdco carries on a business whose primary purpose is to earn income from its stock market investments.
If it were determined that Holdco does not carry on a business, then the dividends received from Holdco would be excluded amounts for Mr. X, Mrs. X and Child Y by virtue of subparagraph (e)(i) in the definition of that term in subsection 120.4(1) since in order for Holdco's business to qualify as a related business in respect of Mr. X, Mrs. X and Child Y, it must, inter alia, carry on a business.
On the other hand, if it turns out that Holdco is carrying on a business, the Holdco business will be a related business with respect to Mr. X, Mrs. X and Child Y.
Mr. X and Mrs. X are connected by marriage or common-law partnership. Child Y is connected by blood relationship with Mr. X and Mrs. X. Consequently, these three persons are related persons by virtue of paragraph 251(2)(a). Mr. X, Mrs. X and Child Y are therefore source individuals in relation to each other within the meaning of the definition of "source individual" in subsection 120.4(1).
Since Mr. X and Mrs. X each hold 20% of the voting and participating shares in the capital stock of Holdco, they both satisfy the ownership condition of the definition of "related business" in subsection 120.4(1).
Consequently, Holdco's business is a related business with respect to each of Mr. X, Mrs. X and Child Y.
Mr. X and Mrs. X could benefit from the exclusion for excluded shares provided in subparagraph (g)(i) of the definition of "excluded amount" in subsection 120.4(1).
First, under the assumptions that Holdco is not a professional corporation and that it is carrying on a business whose income for its most recent taxation year was derived solely from stock market investments and not from providing services, the condition set out in paragraph (a) of the definition of "excluded shares" in subsection 120.4(1) is satisfied with respect to Mr. X and Mrs. X.
Second, Mr. X and Mrs. X each hold shares of the capital stock of Holdco: (1) giving them 10% or more of the votes that could be cast at an annual meeting of the shareholders of Holdco; and 2) having a FMV of 10% or more of the fair market value of all 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(1) is therefore satisfied with respect to Mr. X and Mrs. X.
Third, all of Holdco's income is not derived, directly or indirectly, from one or more related businesses in respect of Mr. X and Mrs. X, but rather is derived from Holdco's business. The condition set out in paragraph (c) of the definition of "excluded shares" in subsection 120.4(1) is therefore satisfied with respect to Mr. X and Mrs. X.
As for Child Y, since that child is 22 years old and holds only 5% of the voting and participating shares of the capital stock of Holdco, that child is not able to benefit from the exclusion for excluded shares.
Child Y also cannot benefit from the exclusion for arm’s length capital contributions provided in subparagraph (f)(ii) of the definition of "excluded amount" in subsection 120.4(1). The expression "arm’s length capital" in respect of a specified individual is defined in subsection 120.4(1) as the property of the individual - the shares of the capital stock of Holdco held by Child Y - or a property for which the individual’s property is a substitute - the amount of money distributed by Trust to Child Y as a result of the disposition, by Trust, of shares of the capital stock of Opco.
Since that amount of money was acquired by Child Y as a taxable capital gain from the disposition of another property - the shares of the capital stock of Opco - which directly or indirectly came from a related business - Opco - in respect of Child Y(footnote 3), the condition set out in paragraph (a) of the definition of "arm’s length capital" in subsection 120.4(1) is not satisfied, thus preventing Child Y from benefiting from that exclusion.
On the other hand, Child Y could benefit from the exclusion for a safe harbour capital return of a specified individual provided in subparagraph (f)(i) of the definition of "excluded amount" in subsection 120.4(1). The term "safe harbour capital return" of a specified individual is defined in subsection 120.4(1) and is the amount which does not exceed the product of the highest prescribed rate of interest in effect for a quarter in the taxation year in question, and the fair market value of property contributed by the specified individual determined in respect of a related business. With respect to Child Y, this safe harbour capital return is calculated based on the amount the child subscribed for the issuance of shares of the capital stock of Holdco.
Trust Distribution
With respect to Mrs. X, Child X and Child Y, the distribution received from Trust (the "Distribution"), which was derived from the $50,000 dividend from Holdco, could constitute split income, unless it qualifies as an excluded amount.
With regard to Child X, considering that that child did not attain the age of 17 before the year in which the child received the Distribution, it appears that none of the exclusions in the definition of "excluded amount" in subsection 120.4(1) is applicable to that child. As a result, Child X is subject to the tax on split income with respect to the Distribution.
With respect to Mrs. X and Child Y, if it turns out that Holdco was not carrying on a business, then Holdco would not be a related business for each of those specified individuals.
Thus, the Distribution would be an excluded amount for Mrs. X and Child Y under subparagraph (e)(i) of the definition of that term in subsection 120.4(1) since it did not come, directly or indirectly, from a related business in respect of Mrs. X and Child Y.
On the other hand, if it turns out that Holdco is carrying on a business, then the Distribution would come, directly or indirectly, from a related business with respect to Mrs. X and Child Y, as explained above.
Mrs. X could benefit from the reasonable return exclusion provided for in subparagraph (g)(ii) of the definition of "excluded amount" in subsection 120.4.
The term "reasonable return" in respect of a specified individual is defined in subsection 120.4(1). It is an amount derived directly or indirectly from a related business in respect of the individual that, inter alia, must be reasonable having regard to the factors described in subparagraphs (b)(i) to (v) of that term relating to the relative contributions of the specified individual and each source individual to the related business.
Given that, on the one hand, the statement of this question only briefly describes a hypothetical particular situation and, on the other hand, the amount of the Distribution that is distributed to Mrs. X is unknown, it is impossible for us to determine whether Mrs. X could benefit from the reasonable return exclusion.
Finally, Child Y could benefit from the exclusion for a safe harbour capital return of a specified individual provided in subparagraph (f)(i) of the definition of "excluded amount" in subsection 120.4(1) with respect to the Distribution, as discussed above.
Jean Lafrenière
(613) 670-9013
5 October 2018
2018-077866
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 We have assumed that Child X, as well as his parents, Mr. X and Mrs. X, were resident in Canada at all relevant times. Child X, Mr. X and Mrs. X are therefore specified individuals as defined in subsection 120.4(1).
2 We have also assumed that Child Y was resident in Canada at all relevant times. Therefore, Child Y is a specified individual as defined in subsection 120.4(1).
3 The statement in this question states that none of Mrs. X, Child X, and Child Y participated in Opco's business. Accordingly, it is our assumption that Mr. X participated in Opco's business and, as such, satisfied the participation test in the definition of "related business" in subsection 120.4(1).