Principal Issues: Mr. X and Mrs. X each own 50% of the common shares of the capital stock of a corporation that is not a small business corporation. Mr. X and Mrs. X exchange their common shares of the capital stock of the corporation in consideration for preferred shares of the capital stock of the corporation pursuant to subsection 51(1). Two discretionary family trusts (Trust Mr. X and Trust Mrs. X) then each subscribe for an equal number of new common shares of the capital stock of the corporation for nominal consideration. Mr. X and Mrs. X are both beneficiaries of Trust Mr. X and Trust Mrs. X. Whether subsection 74.4(2) applies in the situation described.
Position: The fact that Trust Mr. X and Trust Mrs. X would each own 50% of the new common shares of the capital stock of the corporation would not, in and by itself, prevent the application of subsection 74.4(2). Since Mr. X and Mrs. X would presumably be entitled to receive more than 50% of the income of the corporation because of their respective interest in both Trust Mr. X and Trust Mrs. X, subsection 74.4(2) could apply if one of the main purposes of the transfer may reasonably be considered to be to reduce the income of Mr. X or Mrs. X and to benefit the other spouse.
Reasons: According to the law and previous positions.
FEDERAL TAX ROUNDTABLE OCTOBER 7, 2020
APFF CONFERENCE 2020
15. Section 74.4 and estate freeze by spouses
Mr. X and Mrs. X each own 50% of the common shares of the capital stock of a corporation (the "Corporation") and the Corporation is not a small business corporation. Mr. X and Mrs. X decide to effect an estate freeze of the Corporation by exchanging their respective common shares in consideration for the issuance of freeze preferred shares having a value equal to the FMV of the exchanged common shares, all pursuant to section 51.
Concurrently with the share exchange, a trust created for each of Mr. X and Mrs. X (the "Mr. X Trust" and the "Mrs. X Trust", respectively) subscribes for 50% of the new common shares of the Corporation for a nominal amount. In addition, each spouse is a beneficiary of the income and capital of the trust created by the other spouse, so that Mr. X is a beneficiary of the Mrs. X Trust, and vice versa.
Questions to the CRA
a) Does the attribution rule in subsection 74.4(2) apply if the trust deeds do not include a clause that prohibits the allocation of income and capital to the spouse as described in subsection 74.4(4)?
(b) Would the equal holding of the common shares by Mr. X and Mrs. X immediately before the freeze, and the equal holding of the common shares by Mr. X Trust and Mrs. X Trust after the freeze, result in the intent test in subsection 74.4(2) not being satisfied?
CRA Response
First, for the purposes of this question, we have assumed that Mr. X and Mrs. X are resident in Canada at all relevant times. We also have assumed that Mr. X Trust and Mrs. X Trust are discretionary trusts.
Subsection 74.4(2) is a corporate attribution rule of very broad application. Briefly, subsection 74.4(2) may apply to a transfer or loan of property by an individual to a corporation where it can reasonably be considered that one of the main purposes of the transfer or loan is to reduce the income of the individual and to benefit, either directly or indirectly, by means of a trust or otherwise, a designated person in respect of that individual.
Paragraph 51(1)(c) provides that an exchange described in section 51 is deemed, for the purposes of sections 74.4 and 74.5, to be a transfer of the property exchanged by the taxpayer to the corporation. Thus, the exchanges of shares of the capital stock of the Corporation described in the statement of this question would constitute transfers to the Corporation by Mr. X and Mrs. X for the purposes of section 74.4.
Furthermore, the term "designated person" is defined in subsection 74.5(5) and includes, in respect of an individual, a person who is the spouse or common-law partner of the individual. Thus, Mrs. X is a designated person in respect of Mr. X and vice versa.
Finally, whether it is reasonable to consider that one of the main purposes of the transfer of property is to reduce the individual's income and directly or indirectly benefit a designated person (the "Purpose Test") is a question of fact that must be resolved in light of all the circumstances and particularities of each case. While it is not possible to reach a definitive conclusion on this issue, it is our view that the holding of the new common shares of the capital stock of the Corporation equally between Mr. X Trust and Mrs. X Trust after the estate freeze would not, in and of itself, prevent the application of subsection 74.4(2) in respect of either Mr. X or Mrs. X.
For example, assuming that Mr. X Trust and Mrs. X Trust are discretionary trusts, one of the spouses could potentially be entitled to more than 50% of the income of the Corporation because of his or her beneficial interest in both trusts. Accordingly, an estate freeze by Mr. X and Mrs. X in favour of Mr. X Trust and Mrs. X Trust could have the effect of reducing Mr. X's or Mrs. X's income from the Corporation benefiting their spouse. Subsection 74.4(2) could therefore apply to the transfers of property made by Mr. X and Mrs. X if the Purpose Test were satisfied.
Nancy Charlebois
(514) 496-8591
October 7, 2020
2020-085227