As the calendar rolls into March and tax slips arrive in the mail, I thought that I would remind blog readers about a provision in the Income Tax Act (the “ITA”) that I think is one of the more insidious ones, namely the so-called “corporate attribution rule” in subsection 74.4 of the ITA.
The corporate attribution rule is unlike most other attribution rules in the ITA in that it does not simply “redirect” the tax consequences associated with the actual receipt of income by one person to another person – rather the corporate attribution, if it applies, results in phantom income being taxable. Thus the “insidious” reference.
A number of conditions have to be met in order for the provision to apply. Firstly, there has to be a transfer or loan of property to a corporation – so, the good news is that if there is no corporation involved in your planning, you need not read any further. Secondly, there is a purpose test that must be met, in that one of the main purposes of the transfer/loan must be reasonably considered to be to reduce the income of the transferor/lender and to benefit (directly or indirectly) a person who is a “designated person” in respect of the transferor/lender. So…. who is a designated person? A designated person is the spouse or common law partner of the transferor/lender or a person under the age of 18 who either (i) does not deal at arm’s length with (i.e., children or grandchildren) or (ii) is the niece or nephew of the transferor/lender. One important implication to appreciate from this definition is that status can change – the rule will not apply once minors are no longer minors.
You might be musing, “why do I care about this rule?” This is the answer – subject to certain exceptions, if the rule applies then the transferor/lender will be deemed to have realized interest income equal to the fair market value of the property transferred to the corporation (or the amount lent) times the prescribed rate under Reg 4301(c), less actual interest or dividends received by the transferor/lender and amounts that are included in an individual’s income under the “tax on split income” rules. In other words, if the rule applies, it results in tax being payable on phantom income. To make matters worse, the amount that is taxed to the transferor/lender is not deductible by the corporation. The application of this rule is a “point in time” test. If an exception is not available for a period of time in the year, the imputed income is calculated for that period of time.
What are these exceptions? The rule does not apply unless the transferor/lender is resident in Canada. The rule also does not apply unless the designated person is a “specified shareholder” of the corporation under modified rules (generally the person and non- arm’s length persons own 10% or more of any class of shares of the corporation). Finally, the rule does not apply if the corporation is a small business corporation for purposes of the ITA.
There is also a “safe harbour” exception in the ITA that often gets relied upon in order to avoid the application of the rule (recall the “main purposes” requirement outlined above). In particular, the ITA provides that one of the main purposes of the transaction will not be considered to be to benefit a designated person if certain requirements are met – the designated person must own their interest in the corporation through a trust, the terms of the trust must provide that the person is not entitled to receive any income or capital from the trust while a designated person, and they must not have actually received any such income or capital. So, if one can meet these requirements, then you don’t need to worry about an exception, because the rule won’t apply in the first place for having failed the “purpose” test.
Seems like an easy planning fix, then…. just make sure there is a trust and that the “no designated person” language is in the trust. How could one possibly go wrong by putting that language in every trust?
The answer is demonstrated by this fairly common example – founder has a new business, and hopes to eventually multiply access to the capital gains exemption. Growth shares are owned by a trust of which the spouse and minor children are beneficiaries, but the trust has “no designated person” provisions in it (because the drafter of the trust knew about the statutory “out” from the rules, which means one doesn’t have to even concern themselves with them). Five years later, the business is sold. By virtue of the terms of the trust, no capital gains exemption can be flowed through to the spouse or any minor children. The planning has completely and utterly failed.
What this example demonstrates (yet again) is that there is no “one size fits all” solution to planning, and the objectives need to be carefully considered in documenting transactions.
I hope you have found this “Tax Talk” useful.