All About Estates

Capital Gains Exemption Purification before a Share Sale: Be Careful about Timing

Assume a family trust (“Trust”) which has a December year end owns 100% of an operating company (“opco”). A separate corporation (“holdco”), owned by the founders of opco, is a corporate beneficiary of the Trust. Opco is up for sale. Opco has excess funds which may affect the Trust’s and its beneficiaries’ ability to claim the capital gains exemption.

A common technique to purify opco for capital gains exemption purposes prior to the sale of opco is to pay dividends to the Trust which would then designate the dividend to holdco, being a beneficiary of the Trust.  This step can usually can be completed without incurring taxes on the dividends because the holdco and opco are “connected” for tax purposes. However, the timing of the dividend prior to sale must be carefully planned as can be seen further here.

So assume a dividend to purify opco is paid to the Trust in June, which is in turn paid to the corporate beneficiary in the same month, and opco is sold three months later to a 3rd party, say September by the Trust.

In a Technical Interpretation released a couple of years ago, the Canada Revenue Agency concluded that under these circumstances, the dividend would be subject to tax (known as Part IV tax).

In its interpretation of the relevant sections of the Income Tax Act, the CRA stated that an amount received by a beneficiary of a trust cannot be deemed a dividend received by the beneficiary until the trust’s year-end — that is, on December 31. The CRA further stated that the relevant time for determining whether a dividend was received by a corporate beneficiary from a “connected” corporation is not at the time the dividend is paid (June in our case) but rather at the time the dividend is deemed to be received by the corporate beneficiary, which would be at December 31 (the trust’s year-end). Therefore, the CRA concluded that Holdco would be deemed to receive the dividend as of December 31, when Opco and Holdco would no longer be “connected” corporations as a result of the sale of Opco to a third-party (in September). Accordingly, the CRA held that Holdco would be liable to pay Part IV tax on the dividend attributed to it.

Thanks to the folks at Fogler Rubinoff for prompting us planners in particular about this potential trap in a recent blog of their own.

Happy Reading.

About Steven Frye
Baker Tilly WM LLP is a leading, independent audit, tax, and business advisory firm based in Vancouver and Toronto, serving clients across Canada. Drawing on well-trained teams across a variety of disciplines, we ensure the alignment of our professional’s skills and experience with client requirements, resulting in exceptional service and business outcomes.

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