Principal Issues: Opco carries on a business. Sibling 3 is the general manager and works more than 20 hours per week in the business of Opco. Sibling 1 and Sibling 2 are not involved in the business of Opco. Investco carries on an investment business. The investment portfolio of Investco was acquired using historical dividends received from Opco and is managed by a third party. In 2019, all the shares of the capital stock of Opco held by Investco were redeemed and payable by the issuance of an interest-bearing promissory note. The income of Investco for the relevant years are comprised of income from its investment portfolio and interest income on the promissory note. Sibling 1, Sibling 2, Sibling 3 hold the preferred shares of the capital stock of Investco. Trust 1, Trust 2 and Trust 3 hold the common shares of the capital stock of Investco. 1) Whether dividends paid by Investco on the common shares of its capital stock to the trusts and attributed by the trusts to Sibling 1, Sibling 2 and Sibling 3 pursuant to subsection 104(19) are subject to TOSI? 2) Whether the common shares of the capital stock of Investco would qualify as excluded shares if they were held personally by Sibling 1, Sibling 2 and Sibling 3? 3) Whether dividends deemed to have been received by Sibling 1, Sibling 2 and Sibling 3 on the redemption of the preferred shares of the capital stock of Investco are subject to TOSI?
Position: General comments provided.
Reasons: According to the law and previous positions.
XXXXXXXXXX 2021-087705 Linda Do
August 5, 2022
Dear Sir,
Subject: Application of Section 120.4
This is further to your letter of December 18, 2020 requesting our opinion on the application of section 120.4 of the Income Tax Act, R.S.C. 1985, c. 1, (5th Supp.) (the "Act") to the hypothetical situation described below.
Unless otherwise indicated, all statutory references herein are to provisions of the Act.
Hypothetical Situation
M-1 is the father of C-1, C-2 and C-3. M-1, C-1, C-2 and C-3 were all over 25 years of age and resident in Canada at all relevant times.
M-1 held preferred shares of the capital stock of Investco, giving him 97% of the voting rights in Investco (the "Investco Voting Shares"). Each of C-1, C-2 and C-3 held an equal number of non-voting preferred shares of the capital stock of Investco (the "Investco Preferred Shares"). Each of C-1 Trust, C-2 Trust and C-3 Trust held an equal number of voting common shares of the capital stock of Investco having a fair market value ("FMV") equal to at least 10% of the FMV of all issued and outstanding shares of the capital stock of Investco (the "Investco Common Shares").
The trustees of C-1 Trust were C-1 and M-1 and the beneficiaries of C-1 Trust were C-1 and C-1’s spouse and children.
The trustees of Trust C-2 were C-2 and M-1 and the beneficiaries of Trust C-2 were C-2 and C-2’s spouse and children. The trustees of Trust C-3 were C-3 and M-1 and the beneficiaries of Trust C-3 included C-3 and C-3’s spouse and children.
In 2019, Opco purchased for cancellation the shares of its capital stock held by Investco in consideration for the issuance to Investco of a term note bearing interest annually and repayable over a 10-year period (the "Note").
Following the purchase for cancellation of the shares of the capital stock of Opco held by Investco, C-3 Trust held 80 non-voting common shares of the capital stock of Opco, C-3 held 80 voting preferred shares of the capital stock of Opco and Nephew Inc. held 20 voting common shares of the capital stock of Opco. All of the shares of the capital stock of Nephew Inc. were held by the child of C-1.
Opco is not a professional corporation and is not operating a services business. C-3 is the general manager of Opco and has worked more than 20 hours per week for a number of years. In this regard, we have assumed that he has done so for more than five years. C-1 and C-2 have never been involved in Opco's business.
In 2019, in addition to the deemed dividend received by Investco as a result of Opco's purchase for cancellation of the shares of its capital stock held by Investco, as applicable, substantially all of Investco's revenues were derived from interest income received from Opco on the Note. In 2020, 85% of Investco's revenues were derived from interest income received from Opco on the Note and 15% from investment income. In 2021, 75% of Investco's revenues came from interest income received from Opco on the Note and 25% from investment income.
Investco holds a portfolio of investments which had been acquired over the years from dividends received from Opco. Investco's investment portfolio is managed by an independent broker. For the purposes of the questions posed, it is assumed that Investco is carrying on a business whose principal purpose is to earn income from its investments. In addition, it is assumed that Investco is able to segregate its net investment income and pay dividends out of the cash generated from that income.
The directors of Investco are M-1 and C-1 and Investco’s business has never had any employees.
Your Questions
(1) Would the dividends received in 2020 and 2021 by Trust C-1, Trust C-2 and Trust C-3 on their Investco Common Shares and designated pursuant to subsection 104(19) by each of the trusts to their respective beneficiaries, namely, C-1, C-2 and C-3 (the "Designated Amount(s) "), be subject to the tax on split income ("TOSI")?
2) Would this answer change if, prior to the dividend payments, the Investco Common Shares held by Trust C-1, Trust C-2 and Trust C-3 were distributed by each of the trusts to their respective beneficiaries, namely C-1, C-2 and C-3, and the Investco Voting Shares held by M-1 were redeemed?
3) Would the deemed dividends resulting from the redemption of the Investco Preferred Shares held by C-1, C-2 and C-3 be subject to TOSI?
Your Comments
You are of the view that the Designated Amounts in respect of C-3 would not be subject to TOSI as C-3 works more than 20 hours per week in the business of Opco and, therefore, C-3 would qualify for the "excluded business" exclusion. You indicated that the deemed dividends received by C-3 from the redemption of the Investco Preferred Shares held by C-3 would also not be subject to TOSI.
You are of the view that the Designated Amounts in respect of C-1 and C-2 would be subject to TOSI.
You also indicated that in the event that, prior to the payment of dividends, the Investco Common Shares held by Trust C-1, Trust C-2 and Trust C-3 were distributed by each of the trusts to their beneficiary, namely C-1, C-2 and C-3 respectively, and the Voting Shares of the capital stock of Investco held by M-1 were redeemed, dividends paid out of Investco's investment income from Investco Common Shares and received by C-1 and C-2 would not be subject to TOSI, as the Investco Common Shares held by C-1 and C-2 would qualify as "excluded shares".
Our Comments
This technical interpretation provides general comments on provisions contained in the Act and other related legislation, where applicable. It is not intended to confirm the tax treatment of any particular situation involving a particular taxpayer, but rather to assist you in making that determination. Our Directorate will only confirm the tax treatment of particular transactions of a particular taxpayer in the context of a request for an advance income tax ruling as described in Information Circular 70-6R12, Advance Income Tax Rulings and Technical Interpretations.
Generally, dividends received or deemed to be received on shares of the capital stock of Investco held by C-1, C-2 and C-3 or amounts included in computing their income because of the application of inter alia subsection 104(13) in relation to C-1 Trust, C-2 Trust and C-3 Trust and designated to C-1, C-2 and C-3 pursuant to subsection 104(19) should be subject to TOSI pursuant to paragraph (a) of the definition of "split income" in subsection 120.4(1), unless each is an "excluded amount" as defined in subsection 120.4(1).
Comments respecting Question 1
Subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1) provides that an excluded amount in respect of an individual who attained 17 years of age before a particular taxation year is an amount that is not derived directly or indirectly from a related business in respect of the individual for the year.
In order to determine whether the Designated Amounts could be excluded amounts in respect of C-1, C-2 and C-3 pursuant to subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1), it would be necessary to determine, first, whether the Designated Amounts were derived directly or indirectly from Opco's business or Investco's business and, second, whether Opco's business or Investco's business was a "related business" in respect of each of C-1, C-2 and C-3 for the year.
Assuming that the dividends were paid out of Investco's investment income cash flow, we are of the view that the Designated Amounts would not be considered to be derived directly or indirectly from Opco's business, consistent with our position that "second generation" income would generally not be considered to be an amount derived directly or indirectly from the original business.
Furthermore, since Investco was carrying on a business whose principal purpose was to earn income from its investments and the dividends were paid out of Investco's investment income, the Designated Amounts would be considered to be amounts derived, directly or indirectly, from Investco's business.
Thus, the second question is whether Investco's business would be a "related business" in respect of C-1, C-2 and C-3 for the year.
The term "related business", in respect of a specified individual for a taxation year, is defined in subsection 120.4(1) and means, in respect of a corporation:
(i) a business carried on by the corporation, if a source individual in respect of the specified individual at any time in the year is actively engaged on a regular basis in the activities of the corporation related to earning of income from the business (the "Participation Test"); or
(ii) a business of a corporation in respect of which 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 FMV from shares of the capital stock of the corporation and the total of the FMV of the shares and property referred to above is equal to or greater than 10% of the FMV of all the issued and outstanding shares of the capital stock of the corporation (the "Ownership Test").
Whether an individual meets the Participation Test is a question of fact that can only be resolved following a comprehensive analysis of all the facts and circumstances present in a given situation, particularly in a context where that participation is limited to the individual's directorship. Since your letter only briefly describes a hypothetical situation, it is impossible for us to give a definitive opinion on this issue. However, we are of the view that, prima facie, the mere fact of M-1 and C-1 acting as directors of Investco would not be sufficient in itself to consider that they were actively involved, on a regular basis, in the activities of Investco's business.
Furthermore, it is possible that the Ownership Test could also be satisfied in the given hypothetical situation, depending on the FMV of the Investco Preferred Shares held by each of C-1, C-2 and C-3. In addition, given that the capital and income interests in each of C-1 Trust, C-2 Trust and C-3 Trust were property some or all of the FMV of which was derived, directly or indirectly, from shares of the capital stock of Investco, the FMV attributable to any interest held by each of C-1, C-2 and C-3 and any source individual in respect of C-1, C-2 and C-3 from Trust C-1, Trust C-2 or Trust C-3 should also be considered in the Ownership Test analysis.
That said if, first, dividends were paid out of Investco's investment income and, second, Investco's business was not a related business in respect of C-1, C-2 and C-3 for the relevant year, the Designated Amounts could be considered to be amounts not derived, directly or indirectly, from a "related business" in respect of C-1, C-2 or C-3 for the year and therefore would be excluded amounts pursuant to subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1).
Otherwise, if Investco's business were a related business in respect of C-1, C-2 and C-3 for the relevant year, the Designated Amounts would not be excluded amounts pursuant to subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1) and would be subject to TOSI, unless they are excluded amounts pursuant to another exclusion in the definition of "excluded amount" in subsection 120.4(1).
Alternatively, assuming that the dividends were paid out of cash received from the interest income on the Note from Opco, it would be necessary to determine whether Opco's business was a "related business" in respect of C-1, C-2 or C-3 for the year.
Since C-3 worked more than 20 hours per week for Opco's business for a number of years and acted as Opco's general manager, it may be reasonable to conclude that C-3, who would be a source individual with respect to each of C-1 and C-2, met the Participation Test and that, consequently, Opco would be a related business with respect to C-1 and C-2 for the years 2020 and 2021.
Regarding C-3, no source individual in respect of C-3 would meet the Participation Test. However, source individuals in respect of C-3 (e.g., his spouse and children) could meet the Ownership Test, depending on the FMV attributable to their respective interests in the capital and income of C-3 Trust. As a result, Opco could be a related business in respect of C-3 for the years 2020 and 2021 to the extent that the Ownership Test was satisfied by a source individual in respect of C-3.
Thus, if the dividends were paid out of the cash flow from the interest income received from Opco on the Note, the Designated Amounts, in respect of C-1 and C-2, would be considered to be amounts derived, directly or indirectly, from a related business in respect of C-1 and C-2 for the year and would not be excluded amounts pursuant to subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1). Consequently, those amounts would be subject to TOSI unless they were excluded amounts under another exclusion in the definition of "excluded amount" in subsection 120.4(1).
As for the Designated Amounts in respect of C-3, if Opco's business was not a related business in respect of C-3, they would be excluded amounts pursuant to subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1). Otherwise, if Opco's business was a related business in respect of C-3, the Designated Amounts in respect of C-3 could be excluded amounts under another exclusion in the definition "excluded amount" in subsection 120.4(1).
More specifically, paragraph (e)(ii) of the definition of "excluded amount" in subsection 120.4(1) provides that an excluded amount, in respect of an individual who attained 17 years of age before a particular taxation year, is an amount that is derived directly or indirectly from an "excluded business" of the individual for the year. Subsection 120.4(1) defines the term "excluded business" of a specified individual for a taxation year as a business in which the specified individual is actively engaged on a regular, continuous and substantial basis in either the taxation year or in any five prior taxation years of the specified individual.
Since C-3 worked more than 20 hours per week for Opco's business for a number of years, C-3 was deemed by paragraph 120.4(1.1)(a) to be actively engaged on a regular, continuous and substantial basis in Opco's business. Consequently, Opco's business would be an excluded business of C-3 for the years 2020 and 2021. Thus, the Designated Amounts in respect of C-3 would be considered to be amounts derived, directly or indirectly, from an excluded business in respect of C-3 for the year and would be excluded amounts pursuant to subparagraph (e)(ii) of the definition "excluded amount" in subsection 120.4(1).
Comments Respecting Question 2
In the event that the Investco Common Shares held by Trust C-1, Trust C-2 and Trust C-3 were distributed by each of the trusts to their beneficiaries, namely C-1, C-2 and C-3 respectively, and the Investco Voting Shares held by M-1 were redeemed, each of C-1, C-2 and C-3 would personally hold the Investco Common Shares (and Investco Preferred Shares) in equal shares. Thus, it is important to note that Investco's business would then qualify as a "related business" with respect to each of C-1, C-2 and C-3 since a source individual with respect to each of them would satisfy the Ownership Test.
Subparagraph (g)(i) of the definition of "excluded amount" in subsection 120.4(1) provides, in respect of an individual who has attained 24 years of age before a particular taxation year, that income from, or a taxable capital gain from the disposition of, "excluded shares" of the individual is an excluded amount.
To qualify as excluded shares, the conditions in paragraphs (a), (b) and (c) of the definition of "excluded shares" in subsection 120.4(1) must be satisfied.
First, since Investco was not a professional corporation and carried on a business whose income, for its last taxation year, was not derived from the provision of services, the condition set out in paragraph (a) of the definition of "excluded shares" in subsection 120.4(1) would be satisfied.
Second, each of C-1, C-2 and C-3 held Investco Common Shares entitling them to at least 10% of the votes that could be cast at an annual general meeting of Investco's shareholders and having a FMV of at least 10% of the FMV of all the issued and outstanding shares of the capital stock of Investco. The condition set out in paragraph (b) of the definition of "excluded shares" in subsection 120.4(1) would therefore be satisfied in respect of C-1, C-2 and C-3.
Third, paragraph (c) of the definition of "excluded shares" in subsection 120.4(1) requires that all or substantially all of the income of the corporation for its last taxation year not be derived, directly or indirectly, from a related business in respect of the specified individual (other than a business of the corporation). This condition would not be met for the 2020 year since substantially all of Investco's income for the preceding taxation year (2019) was derived, directly or indirectly, from Opco's business, a related business in respect of C-1 and C-2. This condition would also not be met for the 2021 year since 85% of Investco's income for the preceding taxation year (2020) was derived, directly or indirectly, from the business of Opco. Thus, the Investco Common Shares held personally by C-1 and C-2 would not qualify as excluded shares of them for the 2020 and 2021 years.
Regarding C-3, the condition in paragraph (c) of the definition of "excluded shares" in subsection 120.4(1) would also not be met for the years 2020 and 2021 if it were determined that Opco's business was a related business in respect of C-3. Otherwise, if it were determined that Opco's business was not a related business in respect of C-3, the Investco common shares held personally by C-3 would qualify as excluded shares of C-3 and, consequently, the dividends received by C-3 in 2020 and 2021 on those shares would be excluded amounts pursuant to subparagraph (g)(i) of the definition "excluded amount" in subsection 120.4(1).
Comments Respecting Question 3
Regarding the deemed dividends received by C-1, C-2 and C-3 pursuant to subsection 84(3) on the redemption of the Investco Preferred Shares, the same comments as in Question 1 should be considered in determining whether the amount could be an excluded amount pursuant to subparagraph (e)(i) or (e)(ii) of the definition of "excluded amount" in subsection 120.4(1).
Furthermore, since each of C-1, C-2 and C-3 held only the Investco Preferred Shares, which did not entitle the holder to at least 10% of the votes that could be cast at an annual general meeting of the corporation's shareholders, the Investco Preferred Shares could not qualify as excluded shares pursuant to subparagraph (b)(i) of the definition of "excluded shares" in subsection 120.4(1) and, therefore, a dividend received or deemed to be received on the Investco Preferred Shares held by C-1, C-2 and C-3 could not constitute an excluded amount pursuant to subparagraph (g)(i) of the definition of "excluded amount" in subsection 120.4(1).
In the situation described in Question 2, where the Investco Common Shares held by C-1 Trust, C-2 Trust and C-3 Trust were distributed by each of the trusts to their beneficiaries, namely C-1, C-2 and C-3, respectively, and the Investco Voting Shares held by M-1 were redeemed, the condition in paragraph (b) of the definition of "excluded shares" in subsection 120. 4(1) would be satisfied in respect of C-1, C-2 and C-3 since each of them would hold shares of the capital stock of Investco (the Investco Preferred Shares and the Investco Common Shares) entitling them to at least 10% of the votes that could be cast at an annual general meeting of the corporation's shareholders and having a FMV of at least 10% of the FMV of all the issued and outstanding shares of the capital stock of Investco. Thus, the Investco Preferred Shares could qualify as excluded shares of C-3 for the years 2020 and 2021 to the extent that the condition set out in paragraph (c) of the definition of "excluded shares" in subsection 120.4(1) was satisfied as discussed above.
In closing, C-1, C-2 and C-3 could also, depending on the circumstances, benefit from the general reasonable return exclusion in subparagraph g(ii) of the definition of "excluded amount" in subsection 120.4(1). The question of whether the reasonable return exclusion applies to a particular amount can only be resolved following an analysis of all the facts of a particular situation.
We hope that our comments are of assistance.
Best regards,
Jean Lafrenière LL. B, LL. M. Fisc.
For the Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch