Principal Issues: M. X implements an estate freeze by exchanging his shares of the capital stock of a non-SBC pursuant to subsection 51(1). A family trust for the benefit of the spouse and the children of M. X subscribes to new common shares of the capital stock of the non-SBC for nominal consideration. Whether the CRA can confirm that the purpose test provided in subsection 74.4(2) is not met where a designated person in respect of an individual is subject to TOSI on the income distributed by the family trust and that, consequently, subsection 74.4(2) does not apply in such situation.
Position: The fact that the designated person is subject to TOSI is not relevant for the purpose test in subsection 74.4(2). However, paragraph 74.4(2)(g) may apply to the amount of any deemed interest benefit by taxable dividends received by a designated person that can reasonably be considered to be part of the benefit sought to be conferred and are included in computing the designated person’s split income.
Reasons: According to the law.
FEDERAL TAX ROUNDTABLE OCTOBER 7, 2019
2019 APFF CONFERENCE
Question 16: 16 Section 120.4 and subsection 74.4(2)
Subsection 74.4(2) provides an attribution rule where an individual transfers or loans property to a corporation if certain specified conditions are satisfied and one of the main purposes of the transfer or loan may reasonably be considered to be to reduce the income of the individual and to benefit, either directly or indirectly, by means of a trust or by any other means whatever, a person who is a designated person (i.e., the individual's spouse, a minor not dealing at arm's length with the individual or a nephew/niece of the individual). In other words, in order for subsection 74.4(2) to apply, the individual must, among other things, intend to reduce the individual’s income and benefit a designated person.
As a result of recent amendments to section 120.4, the split income rules apply much more broadly and the ability to split income has been significantly reduced.
In that context, consider the following situation:
- An individual, Mr. X, effects a freeze of his holding corporation ("Holdco"), which is not a "small business corporation" ("SBC"), in favour of a family trust ("Trust") through an exchange of his common shares for preferred shares under section 51 and through the subscription by the Trust for new common shares for a nominal amount.
- For the purposes of this example, we have assumed that Holdco has a business.
- The beneficiaries of the Trust are Mr. X, his spouse and their children.
- Mr. X's spouse and children are not actively engaged on a regular, continuous and substantial basis in the business of Holdco and no exception from the split income rules in section 120.4 applies in this case to exempt any income received by the beneficiaries of the Trust from the split income rules in section 120.4.
- The Trust Indenture does not have a clause excluding the distribution of income and capital to the spouse and children of Mr. X for the purposes of the exception provided in subsection 74.4(4).
- Consequently, any income from Holdco allocated to the beneficiaries of the Trust by the Trust constitutes "split income" for the purposes of section 120.4.
Question to the CRA
Since the transfer resulting from the implementation by Mr. X of the freeze described above cannot have the effect of reducing Mr. X's income in order to benefit a person designated by him, by reason of the application of section 120.4 to income that could be allocated by the Trust to its beneficiaries, can the CRA confirm that the condition relating to the purpose of the transfer in subsection 74.4(2) is not satisfied and that, consequently, subsection 74.4(2) does not apply in such a situation?
CRA Response
First, for the purposes of this question, we have assumed that Mr. X, his spouse and their children resided in Canada at all relevant times.
Subsection 74.4(2) is a very broad corporate attribution rule. Briefly, subsection 74.4(2) can apply to a transfer or loan of property by an individual to a corporation other than an SBC, where one of the main purposes of the transfer or loan may reasonably be considered to be to reduce the income of the individual and to benefit, either directly or indirectly, by means of a trust or by any other means whatever, a person who is a designated person in respect of the individual.
The question of whether it is reasonable to consider that one of the main purposes of the transfer of a property is to reduce the income of the individual and to benefit, either directly or indirectly, a person who is a designated person (the "Purpose Test") is a question of fact which must be resolved in the light of all the circumstances and particulars of each case.
The tax consequences to a designated person arising from a distribution from a trust received in a situation similar to that described in the statement of this question, including the fact that such distribution may constitute split income to the designated person, are not relevant for the purpose of determining whether the Purpose Test is satisfied. In fact, the part of the Purpose Test related to the designated person only turns on the question of whether it is reasonable to consider that one of the main purposes of the transfer made by the individual was to benefit, either directly or indirectly, the designated person, regardless of the tax treatment to the designated person of any income that is part of the benefit the individual was seeking to confer.
Furthermore, where the designated person is a specified individual, as defined in subsection 120.4(1), paragraph 74.4(2)(g) only mitigates the impact, resulting from the application of subsection 74.4(2), on the transferring individual by reducing the amount that the transferring individual is deemed to have received as interest. That reduction is the amount to be included in computing the designated person's income for the year as a taxable dividend that the designated person received, if it is reasonable to consider that it is part of the benefit that the taxpayer sought to confer and is included in computing the designated person’s split income for any taxation year.
Nathalie Aubin
(514) 496-5984
October 11, 2019
2019-081275