INCOME ATTRIBUTION RULES AND GIFTING - PLANNING CONSIDERATIONS

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1 INCOME ATTRIBUTION RULES AND GIFTING - PLANNING CONSIDERATIONS This issue of the Legal Business Report provides current information to the clients of Alpert Law Firm on estate planning, including the income attribution rules, gifting and sales of assets to a spouse or a child. Alpert Law Firm is experienced in providing legal services to its clients relating to estate planning, including the preparation of wills, deeds of gift, trust documents and all documentation necessary in connection with estate freezes and other tax, corporate and estate planning matters. I. INCOME ATTRIBUTION RULES A. TRANSFERS AND LOANS TO A SPOUSE OR A COMMON-LAW PARTNER The attribution rules under the Income Tax Act (the Act ) deem any income from property loaned or transferred directly or indirectly by means of a trust or by any means whatsoever to or for the benefit of a spouse to be income of the transferor and not of the spouse. Notwithstanding the provisions of the Act, the income is the property of the spouse and not the transferor. The rules apply to a person who is an individual s spouse or to a person who became the individual s spouse after the loan or transfer of property was made to that person. Pursuant to the Act, a spouse of an individual is defined as another individual who is a party to a voidable marriage with the particular individual. The term "commonlaw partner" became applicable to the Act in 2001 and all provisions in the Act referring to spouses and marriage now also refer to common-law partners and common-law partnerships. As a result, common-law partners are entitled to the same tax benefits, and subject to the same obligations, as married couples. A common-law partner can be a same-sex or opposite-sex partner. The Act defines a common-law partner of a taxpayer as a person who cohabits in a conjugal relationship with the taxpayer, provided that either i) they have so cohabited throughout a continuous one-year period before that time, or ii) they are both parents of the same child. A child includes a natural or adopted child and also includes a person who is wholly dependent on the taxpayer for support and of whom the taxpayer has in law or in fact custody and control. Where the taxpayer and the other individual cohabit in a conjugal relationship, they are deemed to be cohabiting in a conjugal relationship at any time after that, unless LEGAL BUSINESS REPORT / JUNE

2 they have not cohabited for a period of at least 90 days due to a breakdown of their conjugal relationship. As soon as a common-law partnership commences, it is deemed to continue until there is a breakdown of the conjugal relationship as evidenced by a separation of at least 90 days. Commencing at the beginning of that 90 day period they are no longer deemed to be living as spouses and the attribution rules will not apply. In this issue of the Legal Business Report any reference to a spouse should also be read as a reference to a common-law partner. Where property is loaned or transferred to a spouse, any taxable capital gain realized by the spouse is deemed to be the taxable capital gain of the transferor. In addition, where capital property that has been transferred between spouses is subsequently disposed of and new property is acquired with the proceeds of disposition, any income or losses arising from the spouse s ownership of the substituted property and any taxable capital gains or allowable capital losses on the disposition of the substituted property will be attributed back to the transferor spouse. Notwithstanding the provisions of the Act any capital gain is the property of the spouse and not the transferor. There are additional rules where an individual has transferred or loaned property to a trust in which his spouse is beneficially interested. The income or loss that a spouse actually receives from the trust in respect of such property or substituted property is deemed to be received by the individual who made the transfer or loan. In addition, capital gains and capital losses that a spouse receives or is deemed to receive from the trust in respect of such property or substituted property are also deemed to be received by the individual who made the transfer or loan. The attribution of income, losses, capital gains and capital losses will only apply if the spouse has received or is deemed to receive such income, loss, capital gains and capital losses from the trust for tax purposes. Therefore, income, losses, capital gains and capital losses which are accumulated in the trust and on which the trust would be taxable are generally not subject to the attribution rules. If the consideration to be received by the transferor includes indebtedness, then a minimum interest rate must be charged on the indebtedness at a rate at least equal to the lesser of the prescribed rate under the Act existing at the time the indebtedness was incurred and the rate that would have been agreed upon at such time between arm s length parties. Interest on any indebtedness must be paid not later than 30 days after the end of the relevant year and not later than 30 days after the end of each previous year. The interest must actually be paid each year in order to avoid the effect of the attribution rules for the particular year. LEGAL BUSINESS REPORT / JUNE

3 These same requirements dealing with the interest rate and the payment of interest also apply to a loan made to a spouse or a trust in order to avoid the attribution rules. It is not possible to avoid the attribution rules by making a non-interest bearing demand loan. The attribution rules also apply in cases where back-to-back loans are used by spouses or where third parties or institutions are utilized by the spouses to make loans. In the event that an individual guarantees a loan, then that loan will be deemed to be a direct loan from the guaranteeing spouse and as a result the income generated from that loan will be attributed to the guaranteeing spouse. Where property is transferred to a spouse, there is an additional requirement in order to avoid the attribution rules that the transferor must elect in his tax return for the taxation year in which the property was transferred that the tax-free rollover provisions of the Act do not apply. The exclusion from the attribution rules will only apply if all of the requirements are met at the time of the loan or transfer. The provisions do not provide for a partial exemption, for example, if interest is charged at a rate lower than the prescribed rate or if interest is not paid when required in the year or in any previous year. In addition the attribution rules are applicable only to income from property. Therefore, in the event that business assets are transferred or loaned to a spouse, the income from such assets is not attributed back to the other spouse. B. TRANSFERS AND LOANS TO A MINOR Note that income which is taxed under the Split Income Tax (discussed below) is not subject to these attribution rules. The attribution rules deem any income from property loaned or transferred directly or indirectly by means of a trust or by any means whatsoever to or for the benefit of a minor to be income of the transferor and not of the minor. A minor means the transferor s child, grandchild, niece or nephew, who is under 18 years of age. However there is no attribution in respect of capital gains which are realized from assets which are transferred or loaned to a minor. LEGAL BUSINESS REPORT / JUNE

4 There are additional rules where an individual has transferred or loaned property to a trust in which a non-arm s-length person under the age of 18 years, or the individual s nephew or niece under the age of 18 years is beneficially interested. The income or loss that a minor actually receives from the trust in respect of such property or substituted property is deemed to be received by the individual who made the transfer or loan. The attribution of income or losses will only apply if the minor has received or is deemed to receive such income or loss from the trust for tax purposes. Therefore, income or losses which are accumulated in the trust and on which the trust would be taxable are generally not subject to the attribution rules. The attribution rules only apply if the loan or transfer is made to a person who is a spouse or minor. In addition, these provisions only apply if the individual who loans or transfers property is a Canadian resident. Therefore, income splitting may be possible in respect of transfers and loans to children 18 years of age or older as well as parents and other adult relatives, or if the transferor is not a Canadian resident. An exception to the attribution rules is provided for transfers and loans to a minor if certain conditions are met. A transfer of property will not be subject to the attribution rules if the consideration received by the transferor at the time of the transfer is at least equal to the fair market value of the transferred property. Written appraisals to determine fair market value are advisable and a price adjustment clause should be included in the transfer documents in order to retroactively re-adjust the consideration to fair market value in the event that the CRA successfully contests the amount of such consideration. It is usually necessary to create a trust for the benefit of the minor in connection with the transfer of property to the minor. In addition, if the consideration to be received by the transferor is to include indebtedness, then a minimum interest rate must be charged on the indebtedness at a rate at least equal to the lesser of the prescribed rate under the Act existing at the time the indebtedness was incurred and the rate that would have been agreed upon at such time between arm s length parties. Interest on any indebtedness must be paid not later than 30 days after the end of the relevant year and not later than 30 days after the end of each previous year. These same requirements dealing with the interest rate and the payment of interest also apply to a loan made to a minor or a trust in order to avoid the attribution rules. It is not possible to avoid the attribution rules by making a non-interest bearing demand loan. LEGAL BUSINESS REPORT / JUNE

5 The exclusion from the attribution rules will only apply if all of the requirements are met at the time of the loan or transfer. The provisions do not provide for a partial exemption, for example, if interest is charged at a rate lower than the prescribed rate or if interest is not paid when required in the year or in any previous year. C. TRANSFERS AND LOANS TO A CORPORATION Where an individual transfers or loans property to a corporation, the individual is deemed to receive an amount in the year as interest where one of the main purposes of the transaction may reasonably be considered to be to reduce the income of the individual and to benefit directly or indirectly, by any means, a person who is (i) the spouse of the individual; (ii) the common-law partner of the individual as defined above; or (iii) a minor as defined above. In the case of a spouse, this provision does not apply if the corporation to which the transfer or loan is made is a small business corporation. Therefore a spouse can make an interest-free loan to a small business corporation or alternatively, can purchase non-participating shares in a small business corporation without invoking the deemed interest provisions where the other spouse owns equity shares in the corporation. Likewise, if the spouses are living separate and apart by reason of the breakdown of their marriage, no income is attributed back to the transferor spouse. These rules do not apply to income attributed to the transferor where an adult child is a shareholder of a corporation regardless of whether the corporation is or is not a small business corporation. However subsection 56(4.1) of the Act may be applicable to attribute income in the case where a person loans property, directly or indirectly, and the primary reason for the loan is to reduce or avoid tax. Where a loan is made for the purpose of purchasing shares in a corporation and income-splitting is one of the main reasons behind the loan, then, pursuant to subsection 56(4.1) of the Act, any income from the property, or a substituted property, that relates to a period in a taxation year throughout which the maker of the loan is resident in Canada, will be attributed to that individual. Regard should be had to the provisions of the Neuman decision (discussed below) which still may be applicable to permit income splitting with a spouse or adult children. However there will be no income attribution in the event that interest is in fact charged and paid on such loan at a rate at least equal to the lesser of (i) the prescribed rate in effect at the time the loan is made, and (ii) the rate which would be negotiated in the circumstances by parties dealing with each other at arm s length. In addition, LEGAL BUSINESS REPORT / JUNE

6 interest on any loan must be paid not later than 30 days after the end of the relevant year and not later than 30 days after the end of each previous year. The amount of the deemed receipt of interest in the year is equal to the prescribed rate of interest multiplied by the outstanding amount (usually the fair market value of the property at the time of transfer), less any interest received in the year by the individual in respect of the transfer or loan and less 5/4 of all taxable dividends received by the individual in the year on any shares that were received from the corporation as consideration for the transfer. D. M.N.R. v MELVILLE NEUMAN (1998 S.C.J. No. 37) In the recent Supreme Court of Canada decision, M.N.R. v Melville Neuman 1998 S.C.J. No. 37, the taxpayer and some other members of his law firm owned common shares in the law firm s management company ( Newmac ). Newmac owned some commercial property including the property occupied by the taxpayer s law firm. The taxpayer incorporated Melru Ventures Inc. ( Melru ) as an income splitting and estate freezing vehicle. The taxpayer sold his common shares of Newmac to Melru in return for Class G shares of the latter. One common voting share of Melru was issued to the taxpayer. Later on the same day Class F shares of Melru were issued to the taxpayer s wife. At the annual meeting of shareholders of Melru the taxpayer s wife was elected as the sole director and subsequently at a director s meeting she passed a resolution to declare taxable dividends of $5,000 on its Class G shares, and of $14,800 on its Class F shares. Immediately afterwards she lent the taxpayer $14,800 on the strength of a noninterest bearing demand promissory note. The wife s actions as a director were ratified at the next annual meeting of Melru s shareholders. Relying on the indirect payment provisions of subsection 56(2) of the Act, the Minister included in the taxpayer s income the $14,800 dividend paid to his wife. The taxpayer s appeal to the Tax Court of Canada was allowed, and the Crown s appeal to the Federal Court-Trial Division was dismissed. However, the Crown s appeal was allowed by the Federal Court of Appeal, which found that the Trial Judge failed to consider all of the evidence concerning the taxpayer s ratification of the dividends which had been declared at Melru s director s meeting. The Federal Court of Appeal followed Fraser Companies Limited v. M.N.R., where the Federal Court-Trial Division laid down four conditions for the application of LEGAL BUSINESS REPORT / JUNE

7 subsection 56(2) of the Act: a transfer of property (1) must have been made to a person other than the taxpayer; (2) at the direction of, or with the concurrence of the taxpayer; (3) for the taxpayer s own benefit or for the benefit of some other person whom the taxpayer desired to benefit; and (4) such transfer of property would have to have been included in the taxpayer s income if received by him. It was held that these four elements were present in this case. The Federal Court of Appeal held, moreover, that the taxpayer and his wife, as related persons, were not at arm s length; and as the sole shareholders of Melru, neither was dealing with it at arm s length. Confronted with these undisputed facts the Federal Court of Appeal considered the final paragraph of the reasons of the Supreme Court of Canada in M.N.R. v. McClurg (1990) 3 S.C.R There the Supreme Court of Canada drew an obiter distinction between (a) non-arm s length shareholders receiving dividends where they have made no contribution to the company (in which case subsection 56(2) of the Act could be applicable), and (b) the same shareholders receiving dividends where they have made a legitimate contribution to the company, which was found by the Supreme Court of Canada to be the situation in the McClurg case. Paying heed to the decision in the McClurg case, the Federal Court of Appeal held that subsection 56(2) of the Act did apply to the wife s $14,800 dividend in the circumstances of this case, and the Minister was entitled to include such dividend in the taxpayer s income. The taxpayer s appeal to the Supreme Court of Canada was successful. The appeal was confined to the issue of the interpretation and application of subsection 56(2) of the Act and was not based on the general anti-avoidance rule contained in section 245 of the Act, which came into force on September 13, The Supreme Court considered the McClurg case which had determined that, as a general rule, subsection 56(2) of the Act does not apply to dividend income because, until a dividend is declared, the profits belong to the corporation as retained earnings. Therefore the declaration of a dividend cannot be considered to be a diversion of a benefit which the taxpayer would have otherwise received. Therefore the reassessed taxpayer, in the capacity as either a director or a shareholder of the corporation, has no entitlement to the money. In addition, the Supreme Court of Canada, in the McClurg case, held that the dividend received by the taxpayer s wife did not constitute a benefit under subsection 56(2), since her contributions to the corporate enterprise could be considered as a legitimate quid pro quo, and not simply as an attempt to avoid tax. The Supreme Court of Canada found that the approach in the McClurg case ignores the fundamental nature of dividends, i.e., a payment which is related by way of entitlement to one s capital or share interest in LEGAL BUSINESS REPORT / JUNE

8 the corporation, and not to any other consideration, such as the shareholder s level of contribution to the corporation, or the existence of a non-arm s length transaction. Therefore, unless a reassessed taxpayer had a pre-existing entitlement to the dividend income, subsection 56(2) of the Act cannot operate to attribute the dividend income to the taxpayer for tax purposes. For all of these reasons, the dividend paid to the wife was not required to be included in the taxpayer s income. Therefore dividend sprinkling can be utilized for income-splitting between spouses where the transaction is properly documented. However, this is not the case where minor children are concerned due to the imposition of the new Split Income Tax. E. SPLIT INCOME TAX Over the years, numerous tax planning techniques have evolved in order to avoid the attribution rules and to take advantage of the fact that the attribution rules generally do not apply to business income. These tax planning schemes included structuring the ownership of private corporations to include family trusts that would receive dividends from the corporations. Then, the trusts would allocate the dividend income to minor beneficiaries who would pay little or no income tax on the income. Another tax planning technique required the establishment of a partnership which would provide services to a related entity at a profit. Family trusts, which would own the partnership interests, would allocate the income to minor beneficiaries who would pay significantly less income tax compared to a high-income taxpayer. In response to the Neuman decision, the Department of Finance introduced a special tax designed to discourage income splitting with minor children. In particular, commencing in the year 2000, this special tax, previously dubbed the Kiddie Tax and now known as the Split Income Tax was imposed on the following types of income of individuals aged 17 or under: (a) (b) taxable dividends and other shareholder benefits on unlisted shares of Canadian and foreign corporations (received directly or through a trust or partnership); and income from a partnership or trust where the income is derived by the partnership or trust from the business of providing goods or services to a business carried on by a relative of the child or in which the relative participates. However there possibly may be an exception where a trust LEGAL BUSINESS REPORT / JUNE

9 provides services directly to customers of the business rather than merely providing services to the business itself. The Split Income Tax replaces the regular income tax and is computed at the top marginal rate of tax. The minor taxpayer is not entitled to personal tax credits, or any other deductions in computing the special tax, with the exception of dividend tax credits or foreign tax credits, where applicable. The minor taxpayer is not entitled to the benefit of the graduated rate of tax. Note that income which is taxed under the Split Income Tax is not subject to the attribution rules. The Split Income Tax does not apply to dividends from public corporations. Therefore, subject to the application of the attribution rules, the shares of publicly listed corporations can be gifted to minor children either directly or by means of a trust. Any dividends received by the minor taxpayer from private corporations will be subject to the special tax regardless of whether the corporation earned business income or investment income. In addition, this provision is applicable in the case of taxable dividends earned by a minor from a private corporation, whether or not a relative of the minor is involved with the private corporation. The Split Income Tax also applies to dividends from a non-resident corporation in spite of the fact that such dividends do not receive dividend tax credit treatment. The Split Income Tax is applicable to taxable dividends, shareholder benefits under Section 15 of the Act and related business income. However, the Split Income Tax does not apply to income generated from interest, rent, royalties or capital gains. As a result, estate planning may still be done to enable a child that owns the shares of a qualified small business corporation to receive the benefit of the $750,000 lifetime capital gains exemption. The Split Income Tax will not apply (a) if no parent is a resident of Canada at any time in the year; (b) to income from property inherited from a parent; or (c) to income from property inherited from any other person, if the child is in full-time attendance at a post-secondary educational institution, or is disabled (and is eligible to claim the disability tax credit). Therefore, if a child, who is not disabled, inherits shares from a person other than a parent (ie. an uncle or grandparent) and dividends received on those shares will be subject to the Split Income Tax. Alternatively, if the child inherits bonds from an uncle LEGAL BUSINESS REPORT / JUNE

10 or grandparent, the interest income will be taxed at the regular marginal rate of tax of the child. The Split Income Tax applies to business income received by a self-employed minor, whereas income from general employment is taxed at regular rates. A parent of an individual liable for the Split Income Tax will be jointly and severally liable for that tax if the parent was actively involved in the business from which the income was derived. Note that the Split Income Tax applies to the 2000 and subsequent taxation years, with no exceptions for pre-existing arrangements. However, this measure does not affect income splitting arrangements involving children age 18 or over, spouses or the attribution of capital gains. F. REVERSION OF TRUST PROPERTY TO TRANSFEROR Pursuant to the provisions of subsection 75(2) of the Act, where, by a trust created in any manner whatever, property is held on condition that it or any property substituted therefore may (i) revert to the person from whom the property or substituted property was directly or indirectly received; (ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust; or (iii) not be disposed of during the lifetime of the person except with the person's consent or in accordance with the person's direction, any income or loss from the property and any taxable capital gain or allowable capital loss from the disposition of the property, shall, during the lifetime of the person, while the person is resident in Canada, be deemed to be the income or loss or taxable capital gain or allowable capital loss, as the case may be, of the person. Where the provisions of subsection 75(2) of the Act apply or have applied, a rollout to beneficiaries of capital property of a trust is not permitted pursuant to subsection 107(4.1) of the Act. In paragraph 1 of Interpretation Bulletin IT-369R, the CRA states that "A genuine loan to a trust would not by itself be considered to result in property being held by the trust under one or more of these conditions (i.e., would not by itself result in the application of subsection 75(2), if the loan is outside and independent of the terms of the trust. LEGAL BUSINESS REPORT / JUNE

11 II. GIFTING Gifting may be utilized to effect an alternative type of estate freeze. An individual may choose to give assets which are expected to appreciate in value to his child by way of a deed of gift. Such a gift will not trigger the application of the Split Income Tax rules, provided that the child is an adult child (ie. the child has attained the age of at least 18 years previous to the year in which the gift is made). Where gifts are made to minor children, the Split Income Tax rules outlined above must be considered. Where an asset is transferred by way of gift, the transferor will be deemed to have disposed of the asset so gifted at its fair market value. This deemed disposition at fair market value may result in immediate tax consequences by triggering a taxable capital gain to the transferor depending upon the transferor s adjusted cost base of this asset. However, where the gifted assets consist of qualifying shares of a small business corporation, the enhanced lifetime capital gains exemption of $750,000 may be available to the transferor, thereby reducing the impact of a deemed taxable capital gain. III. SALE OF ASSETS TO CHILD As an alternative to gifting, an individual may choose to sell an asset to his child at its fair market value. This disposition of an asset at its fair market value may result in immediate tax consequences by triggering a taxable capital gain to the transferor depending upon the transferor s adjusted cost base of this asset. Again however, where the assets sold to the child consist of qualifying shares of a small business corporation, the transferor may be able to claim the enhanced lifetime capital gains exemption of $750,000. Where some portion of the sale proceeds for the asset is not due until after the year of the sale, then the transferor may be able to obtain a limited deferral of tax on a capital gain arising from such a sale by claiming a reserve based on a proportion of the sale proceeds not yet due. The maximum available reserve is five years. Therefore, in each year, a minimum of one-fifth of the gain on the sale of such assets must be reported as a capital gain on the transferor s tax return regardless of whether or not any of the sale proceeds are actually received in that particular year. LEGAL BUSINESS REPORT / JUNE

12 IV. IN-TRUST ACCOUNTS FOR MINOR CHILDREN The CRA has provided its views on in-trust accounts for minor children in various technical interpretations as follows: (i) (ii) (iii) The existence of a trust is determined by the relationship between the settlor, the trustees and the beneficiaries. The relationship may or may not be defined by a formal written document but is codified by any applicable trust legislation and common law. It is accepted at law that a trust cannot be established unless three certainties are present. That is, the attempt to establish a trust will fail unless it is certain that the settlor intended to bring a trust relationship into existence and both the property and the beneficiaries or other objects of the trust are described with sufficient certainty. Whether the three certainties are present or not is a question of fact and particular to the circumstances of each case. A written trust document would serve as the best evidence of their existence and would resolve any ambiguities which may otherwise arise. The certainty of intention is established where it is clear that a gift of property was intended or that a trust relationship was intended (as opposed to an agency or transferor-transferee relationship). The property, or property substituted therefore, must be clearly identifiable in order for that certainty to exist. Lastly, in creating a valid trust, the beneficiaries must be identifiable. Where an in-trust account is opened by a parent for his or her children, in absence of a formal trust document, the certainty of intention to set up a trust arrangement would be a difficult one to prove. As the children involved are most likely minors, often the arrangement is designed to accommodate the fact that minors do not have the legal capacity to enter into legally binding contracts and hence purchase financial instruments in their own name. Thus, the arrangement may be one akin to agency as opposed to a trust. In a technical interpretation, the CRA stated that the social insurance number should be reported on information slips with respect to in-trust accounts. Pursuant to paragraph 2 of Information Circular IC-82-2R2, the social insurance number (SIN) of the child is not required if the child s income is anticipated to be $2,500 or less. Paragraph 8 of the Information Circular provides if there are no trust deeds and if the depositors can withdraw the funds at any time, information slip preparers have to report the children s SINs unless these children are under 18 years old and are expected to have an annual income of $2,500 or less. LEGAL BUSINESS REPORT / JUNE

13 It is the CRA s position that the particular social insurance number to be recorded on the information slip for an in-trust account depends on whether the attribution rules apply. In the event that the child tax benefit is transferred to an in-trust account, the income earned on the account is not attributed back to the parent. Consequently, the social insurance number of the child would be reported on the information slip for income earned on the account unless the child is under 18 and the child s income is $2,500 or less. However, where funds other than the child tax benefit are deposited in the account (including situations where other funds are commingled with the child tax benefit) the attribution rules would apply to income from the account. In this event, the social insurance number of the parent, but not the child, is required to be reported on the information slip. This issue of the Legal Business Report is designed to provide information of a general nature only and is not intended to provide professional legal advice. The information contained in this Legal Business Report should not be acted upon without further consultation with professional advisers. If you require assistance with estate planning or need other tax, corporate and estate planning advice, please contact Howard Alpert directly at (416) No part of this publication may be reproduced by any means without the prior written permission of Alpert Law Firm Alpert Law Firm. All rights reserved. LEGAL BUSINESS REPORT / JUNE