Toronto Young Practitioners Group

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2 Family Transactions Biggest issue for young practitioners is communication explaining difficult concepts in meaningful terms. 3 Robin MacKnight Family Transactions Biggest issues in estate planning: Expectations of the parent planners Expectations of the family members Clearing the air to reduce frustrated expectations 4 Robin MacKnight

3 Your Biggest Challenge Family Transactions Simple Questions Can I deduct interest expense? Can I claim a loss on a loan to family member? No simple answers Maybe can you show an income earning purpose? Maybe can you demonstrate a business purpose? Can I claim a capital gain exemption? What can I do with recreational property? Can I give away my estate or should I sell it to my kids? Maybe refer to Rachel s presentation Inside/outside Canada? Be creative What s your real intent? Dramatically different results. 6 Robin MacKnight

4 Family Transactions Is interest expense on family transactions deductible? How do you demonstrate a purpose of earning, gaining or producing income? Why do we care? Deductible expense to payor? ABIL to lender? Attribution rules? Other consequences s. 80? 7 Robin MacKnight Family Transactions Swirsky v. The Queen 2013 TCC 73 (under appeal) Issue was whether interest expense was deductible by borrower Wife borrowed money from institutional lender to purchase shares of family opco from Husband Husband used sale proceeds to repay shareholder advances which would otherwise have been included in his income. No history of dividend payments from family opco. Husband claimed loss (interest expense) under attribution rules 8 Robin MacKnight

5 Swirsky Family Transactions Husband Advances Repayment Opco Purchase Price Wife Sale of Shares Loan Institutional Lender Interest/Loss 9 Robin MacKnight Family Transactions CRA disallowed losses deducted by Husband on the basis no losses were realized by Wife, so there was nothing to attribute back to him No issue about first two conditions for interest deduction legal obligation to pay and reasonable rate were established. However, CRA claimed Wife had no expectation of income, so the purpose of earning income test was not satisfied No reference to the accumulation of capital argument to support interest deduction 10 Robin MacKnight

6 The Conflict Family Transactions CRA has clearly (and frequently) enunciated conflicting policies on interest expense where borrowed funds are used to acquire non-income producing assets. Supporting Swirsky see documents , , , and 2002 Conference Report Supporting deduction for purchase of common shares IT-533 Lipson GAAR applied 11 Robin MacKnight ABILs Family Transactions Parents want to assist children in their business venture. How should they proceed to claim ABIL on failure? Funding agreement in writing Set out anticipated terms of repayment Set out maturity date for repayment Report interest income Follow terms of the agreement 12 Robin MacKnight

7 Wife financed husband s Opco Family Transactions Elliott 2005 DTC 149 Wife borrowed from Bank 2 to pay off high interest debt from Bank 1 Opco agreed to repay this debt and interest Opco ceased operations, debt unpaid No ABIL on loan since made for family reasons However, Wife assumed position of Bank 1 on refinancing, and was entitled to interest so ABIL in respect of amount paid to Bank 1 13 Robin MacKnight Family Transactions Share Conditions ITA contains many special rules for various types of ugly preferred shares Consequences range from special taxes (Part IV.1 and VI.1) to disallowed capital gains exemption ( prescribed shares ) Policy behind these shares is generally based on loss trading, income deferral and conversion of income to capital gain Plain vanilla common shares can become ugly preferred shares as a result of shareholder agreements or financing agreements (VCs) Look for the safe havens in the pref share rules 14 Robin MacKnight

8 Family Transactions Recreational Properties Be creative in dealing with legacy or multigeneration recreational properties Consider property held by trust with long term beneficiaries. Original owners (grandparents) want to ensure property stays in the family for use by future generations. How do you ensure continuing control, but future use? 15 Robin MacKnight Family Transactions One solution could be to transfer property to second generation but that would be a taxable event and would not ensure control. If property is held in a trust, consider whether the property could be transferred into a limited partnership trustees would control GP, beneficiaries become LPs all on tax deferred basis (except for LTT). But is there a business to support a LP? Could you set up a club or association? Have trust lease property on long term basis to club, distribute encumbered real estate at reduced value to beneficiaries. 16 Robin MacKnight

9 Family Transactions Selling or Gifting Assets Gift disposition and acquisition at FMV under section 69. But if no consideration is paid, does recipient really value the gift? Alternative may be to sell asset to children on preferred terms long term note, no interest, with debt forgiven on death of vendor. Disposition at FMV by vendor (whether price reflects that or not) But what are consequences on death is the note a commercial debt obligation so that cost to child is reduced when debt is forgiven? 17 Robin MacKnight

10 Tax for the Owner/Manager A Mr. Bryant is just starting out and has incorporated a company. Mr. Bryant Common shares Opco 2

11 Tax for the Owner/Manager A Mr. Bryant has purchased real estate to operate his business out of and has introduced a holding company into his corporate structure. Why? Drop Down Mr. Bryant Split Up Mr. Bryant Holdco Holdco Realco Opco Opco Realco 3 Tax for the Owner/Manager A The two holding company structure is a better structure for Mr. Bryant. This enables him to sell Holdco#1 with Opco and still realize his lifetime capital gains exemption. Also allowing the sale of Opco if the purchaser does not want the real estate. Mr. Bryant Holdco#1 Holdco#2 Opco Realco 4

12 Tax for the Owner/Manager A Mr. Bryant has: - Introduced family members into the ownership Beneficiaries of the family trust include: a) Children of Mr. Bryant b) Grandchildren of Mr. Bryant c) Mr. and Mrs. Bryant d) Any corporations Bryant Family Trust (owns common shares) Mr. Bryant (Owns preferred shares) controlled by them. Holdco # 2 Holdco #1 Preferred shares Preferred shares RealCo. Opco 5 Tax for the Owner/Manager A Common areas of consideration: Section 75(2) of the Income Tax Act ( Canada ) ( ITA ) The attribution rules found under section 75(2) will apply if any one of the following conditions are met: The trust property may revert back to the person from whom the property was directly or indirectly received. (Section 75(2)(a)(i)). The trust property is held on the condition that it may pass to persons to be determined by the settlor of the trust. (Section 75(2)(a)(ii)). The trust property cannot be disposed off by the trust without the consent of the settlor. (Section 75(2)(b)). 6

13 Tax for the Owner/Manager A Common areas of consideration: Section 75(2) of the Income Tax Act ( Canada ) ( ITA ) The implication of section 75(2) applying is that any income or loss from the trust property contributed by the settlor is attributed back to the settlor. The above includes any taxable capital gains or allowable capital losses resulting from the disposition of the trust property. In addition to the adverse consequences of section 75(2) of the ITA also section 107(4.1) of the ITA could apply. 7 Tax for the Owner/Manager A Common areas of consideration: Section 107(4.1) of the Income Tax Act ( Canada ) ( ITA ) The application of section 107(4.1) of the ITA causes the distribution of the property from the trust to adhere to section 107(2.1) and therefore: The rollover provisions found in section 107(2) of the ITA will cease to apply. The trust is deemed to have received proceeds of disposition equal to the fair market value of the property distributed. The beneficiary will be deemed to have disposed of their capital interest in the trust at FMV of the property received (net of any capital gain realized by the trust). 8

14 Tax for the Owner/Manager A Common areas of consideration: Section 107(4.1) of the Income Tax Act ( Canada ) ( ITA ) The pre-conditions of the application of section 107(4.1) to apply are as follows: The distribution from the trust is in satisfaction of the beneficiaries' capital interest in the trust. Subsection 75(2) was applicable at any time to the particular trust. The beneficiary is not the person or the spouse or common law partner from whom the trust received the property. The settlor was in existence at the time of the distribution. 9 Tax for the Owner/Manager A Common areas of consideration: Section 107(4.1) and Section 75(2) of the Income Tax Act ( Canada ) ( ITA ) To counteract the implication of section 107(4.1) and section 75(2) the following should be considered: The freezor should not be the settlor of the trust and a capital beneficiary, instead a third party should settle and fund the trust so that it may subscribe to the common shares of the private corporation. or; The subscription price of the common shares should be funded by an interest bearing loan to the trust. 10

15 Tax for the Owner/Manager A Common areas of consideration: Section 107(4.1) and Section 75(2) of the Income Tax Act ( Canada ) ( ITA ) Should section 75(2) of the ITA apply in the case of Mr. Bryant the following would occur: All income earned by the trust and subsequent capital gains on the sale of Opco or Realco attribute back to Mr. Bryant. The beneficiaries will be deemed to have acquired the property at a cost equal to the fair market value. No roll-out of shares under 107(4.1) at or before 21 year anniversary. 11 Tax for the Owner/Manager A Family Law considerations in the context of an estate freeze In the event of a marital breakdown each spouse is required to calculate his or her Net Family Property ( NFP ). The NFP is the change in the net value of a spouse s assets between the date of marriage and date of separation. Gifts and Inheritances gained after marriage are excluded from the NFP calculation. 12

16 Tax for the Owner/Manager A Family Law considerations in the context of an estate freeze The following procedures should be implemented to ensure that the growth shares received by the next generation are indeed a gift as opposed to a purchase: The freezer of the shares gifts a nominal sum by cheque to the subscriber of the common shares. This gift is documented in a deed or declaration of gift. The subscriber subscribes to the common shares of the company. or; After the freeze shares have been issued, the original shareholder will subscribe to new common shares for a nominal value and then gift those shares. This gift is again evidenced by a deed or declaration of a gift. 13 Tax for the Owner/Manager A Family Law considerations in the context of an estate freeze In either case the person gifting the shares should not be a beneficiary of the family trust otherwise 75(2) considerations. As a result of the gift the 24 month holding period test for the shareholder to utilize the lifetime capital gains exemption will be reset. Alternative steps-mr. Bryant receives common and preferred shres on freeze and gifts the common shares to trust. 14

17 Common areas of consideration: Section 74.4(2) of the Income Tax Act ( Canada ) ( ITA ) Corporate Attribution Tax for the Owner/Manager A Applies where property is transferred or loaned to a corporation (either directly or indirectly) and, it is considered that one of the main purposes of the transfer of the property was to reduce the income of the transferor as well as to confer a benefit to a designated person. This section deems interest to be computed at the prescribed rate and included in the transferor s income for every taxation year that the designated person benefited from the transfer of the property. 15 Tax for the Owner/Manager A Common areas of consideration: Section 74.4(2) of the Income Tax Act ( Canada ) ( ITA ) Corporate Attribution A designated person is defined under section 74.5(5) of the ITA as: A spouse or common law partner of the transferor. A child under the age of 18 of the transferor. A niece or nephew under the age of 18 of the transferor. Or any other individual under the age of 18 that does not deal at arm s length with the individual. 16

18 Common areas of consideration: Section 74.4(2) of the Income Tax Act ( Canada ) ( ITA ) Corporate Attribution Tax for the Owner/Manager A In order for section 74.4(2) of the ITA to apply all of the following conditions have to be met: The transferor of the property was a resident of Canada for the period when the attribution applied. The corporation was not a small business corporation as defined under section 248(1) of the ITA. The designated person is a specified shareholder as defined under section 248(1) of the ITA. 17 Tax for the Owner/Manager A Corporate attribution in the context of an estate freeze In an estate freeze generally there is a reduction of the future capital gains tax on death; and it can be reasonable to consider that the transaction was implemented to reduce the income upon death of the transferor. Usually in an estate freeze there is a conferral of a benefit to a designated person by the issuance of the future growth shares of the corporation either directly or indirectly to this individual. 18

19 Tax for the Owner/Manager A Exception to the corporate attribution rules in section 74.4(2) of the ITA Section 74.4(2) of the ITA states that for the purposes of the corporate attribution rules the transfer shall not be considered to be a benefit to a designated person if: The designated person s only interest in the corporation is a beneficial interest in a trust that owns the shares of that corporation. The terms of the trust prevent the designated person the ability to use the income or capital of the trust while they are a designated person. While the person is a designated person under the provisions of 74.5(5) of the ITA, that person has not obtained the use of any income or capital of the trust and the trust has not deducted any amount paid or made payable to the designated person. 19 Tax for the Owner/Manager A Upgraded Share Exchange/Freeze 20

20 Tax for the Owner/Manager A Upgraded Share Exchange/Freeze Structure allows Holdco to remain pure for future QSBC without payment of personal taxes on any distributions Benco must be connected to Holdco Preferred shares of Holdco must be prescribed shares No transfer of property by Mr. Bryant to Benco appears FT#2 terms do not need to restrict designated persons entitlements Minor children non issue, due to kiddie tax Spouse allows for income splitting from Benco income Watch any future transfer of property to Benco by Mr. Bryant Must meet 2 year holding period test 21 Tax for the Owner/Manager A The benefits of having a corporate beneficiary Provides the ability for the trust to pay a connected dividend that is deductible under section 112(1) of the ITA. The trust can roll out at cost under section 107(2) to a corporate beneficiary despite the controller of the corporation being a non-resident for tax purposes. Provides the trustee of the trust the flexibility to roll out the shares to a corporate beneficiary rather than any other individual beneficiary of the trust. 22

21 Rachel Gervais, CPA, CA Partner The Sale of a Business Capital Gains Deduction Deduction from capital gains on disposition of a share of a qualified small business corporation (QSBC) Limits of deduction lesser of: 1/ 2014 taxation year - $400,000 ($800,000 X 50%) minus previous claims. (2013 taxation year $375,000 ($750,000 x 50%) minus previous claims) 2/ Annual gains limit 3/ Cumulative gains limit 2

22 The Sale of a Business Capital Gains Deduction The following three tests must be met for QSBC status: Determination Time Test 90% Rule 24 Month Ownership Test Holding Period Assets Test 50% Rule 3 The Sale of a Business Determination Time Test Company must be a SBC at time of sale or realization of gain What is an SBC? CCPC At the determination time all or substantially all of the FMV of the assets are attributable to assets that are: used principally in an active business carried on primarily in Canada by the corporation/related corporation shares of the capital stock or indebtedness of one or more connected small business corporations, or a combination of the above All or substantially all = 90% or more 4

23 The Sale of a Business Determination Time Test Qualifying Assets: Assets used principally (greater than 50%) in an active business carried on primarily (greater than 50%) in Canada by a particular corporation or a related corporation 5 The Sale of a Business Determination Time Test Which of the company s assets are used in an active business? Consider: Significant cash Vacant land (inventory or capital) Marketable securities Trade accounts receivable from related corporations Partnership interests Investments in shares or debt of a connected SBC Unrecorded assets such as corporately owned Goodwill FMV of assets vs. cost of assets wording of SBC definition in 248(1) 6

24 The Sale of a Business 24-Month Ownership Test Throughout the 24 months immediately preceding the determination time, the shares must not have been owned by anyone other than the individual or a person or partnership related to the individual 7 The Sale of a Business 24-Month Ownership Test Newly Issued Shares: The Act deems them to have been owned immediately before their issue by a person who was not related to the particular person Exceptions provided Issued in exchange for other shares Issued in exchange for assets of a business Issued in exchange for a partnership interest Issued as a stock dividend 8

25 The Sale of a Business Holding Period Asset Test Throughout the holding period leading up to the sale or realization of the gain, the shares must be shares of a CCPC and, at least 50% of the assets of the CCPC must be active business assets 9 The Sale of a Business Holding Period Asset Test Anti-Stacking Rule Prevents using layers of corporations to circumvent 50% rule Three general scenarios that will meet the test: At least 50% of assets are active business (no connected corporations) 90% of assets are active business (including connected corporations which meet the 50% test) At least 50% of assets are active business (includes connected corporations which must meet a 90% test in place of the 50% test) 10

26 The Sale of a Business Holding Period Asset Test Does the Anti-Stacking Rule Apply? 1) Determine if more than 50% of the FMV of the assets of the corporation includes assets that the corporation or a related corporation use in an active business, other than shares or indebtedness of connected corporations. If so, then the holding period test is met. 2) If the corporation does not have more than 50% of the FMV of its assets representing assets that the corporation or a related corporation uses in an active business (other than shares or indebtedness of connected corporations), but these assets, together with shares or indebtedness of connected corporations, make up at least 90% of the FMV of its assets, then it potentially meets the holding period test. However, it is still necessary to check the FMV of assets of all of the connected corporations to ensure they are comprised of more than 50% of active business assets. 11 The Sale of a Business Holding Period Asset Test Does the Anti-Stacking Rule Apply? (cont.) 3) If the FMV of the corporation s business assets (other than shares or indebtedness) and shares and indebtedness of connected corporations together total over 50% of the FMV of all its assets, but less than 90%, then it is necessary to ensure that all of the connected corporations meet the 90% test. 4) If the FMV of the corporation s business assets (other than shares or indebtedness) and shares and indebtedness of connected corporations together total 50% or less of the total asset value, then it does not meet the holding period test. 12

27 The Sale of a Business Purification Process where non-qualifying assets are generally removed from a corporation, in order for corporation to obtain SBC status so that the CGE may be used immediately May also involve removing non-qualifying assets to put company onside of the holding period asset test; however access to the CGE will be delayed for another 24 months Purification may be necessary on a more continuous basis to avoid corporation attribution where a company is prone to accumulate passive assets 13 The Sale of a Business Purification Methods Non-taxable methods Pay liabilities Pay shareholder loans Pay capital dividends Pay RDTOH dividends Invest in business expansion 14

28 The Sale of a Business Purification Methods Taxable methods Pay salaries or dividends Pay passive assets as dividend in kind Sell passive assets and pay down debt/invest in active assets 15 The Sale of a Business Purifications Ongoing methods Holding company dividends can be paid on a regular basis as earnings (or passive assets) arise Trust with corporate beneficiary dividends again paid as passive assets accumulate, can be received by corporate beneficiary on a tax-free basis Watch out for 55(2) ensure dividends are not part of a series that includes a sale or that adequate safe income exists. 16

29 The Sale of a Business Crystallizations Process whereby capital gain is triggered and sheltered by CGE thus increasing ACB of shares and crystallizing the use of the CGE Reasons to crystallize: Changes in QSBC status Lock in high ACB when value of business is high Avoid AMT if can crystallize over 2 or 3 years Avoid last minute purifications, and series of transaction problems 17 The Sale of a Business Crystallization Techniques: Sale or gift to related individual or trust Transfer shares of Opco to Holdco Consider application of S on non-arm s length sale no non-share consideration Share exchange Internal S.85 exchange No non-share consideration S could apply 18

30 The Sale of a Business Barriers to Capital Gains Exemption CNIL balance CNIL is essentially the amount (if any) by which an individual's "investment expenses" after 1987 exceeds the "investment income" for the same period. AMT Where an individual recognizes a capital gain on the disposition of QSBC shares and shelters it by claiming the capital gains deduction, minimum tax may apply Previous ABIL claims Other anti-avoidance rules. Insufficient dividends - subsection 110.6(8) Transfers for inadequate consideration - paragraph 110.6(7)(b) 19 The Sale of a Business Asset Sales Considerations: Characterization and allocation of purchase price Timing CCA and recapture Replacement property rules ECP - 14(1.01) election 20