Recently, the Canada Revenue Agency (“CRA”) was asked to comment on the tax consequences that may result from implementing an estate planning or income splitting arrangement which involves the issuance of shares that entitled the holder to discretionary dividends, for nominal consideration.
The CRA was presented with a hypothetical small business corporation (“Opco”) with voting common and non-voting preference shares, both having the right to discretionary dividends to the exclusion of the other. The preference shares could be redeemed for the fair market value determined when issued and have 1st right to assets upon liquidation.
The taxpayer (“Mrs. A”) owned 1 common share in the capital stock of Opco, which is 100% of the issued and outstanding shares of Opco. The common share has a fair market value of $1 million. Opco has $500,000 of retained earnings. Opco intends on issuing 1 Class B preferred share to Mrs. A’s spouse (“Mr. A”) for nominal consideration. Subsequent to the issuance of the Class B preferred share to Mr. A, Opco may immediately declare and pay out a $100,000 dividend on the Class B preferred share, which would have the effect of reducing the FMV of Opco and the 1 Class A common share by the same amount or Opco may declare and pay out a $100,000 dividend on the Class B preferred share only after it earns an additional $100,000 of income subsequent to the issuance of the Class B preferred share to Mr. A and only to the extent that the FMV of Opco after such dividend is not less than $1,000,000.
The CRA was to comment on the tax consequences for Opco and the shareholders of Opco that may arise on the issuance of the 1 Class B preferred share to Mr. A for nominal consideration and the payment of any discretionary dividends on the Class B preferred share.
In its commentary, the CRA referenced the various sections of the Income Tax Act related to the attribution rules (dividend is taxed back in the hands of Mrs. A, regardless of whether or not the spousal rollover rules were invoked), shareholder benefit conferred (Mr. A is deemed to have received a taxable benefit equal to the value of the shares when issued) and the general anti-avoidance rules that may apply to such arrangements.
In the CRA’s general view, the application of these rules really narrows down to one issue or fact: whether the nominal consideration paid by Mrs. A for the 1 Class B preferred share would be considered fair market value paid for such share at the time of issuance.
The CRA notes that whether an amount paid for a share which carries an entitlement to discretionary dividends would be considered fair market value is a question of fact. The tax consequences of the subscription of the Class B preferred share by Mr. A would depend, among other things, on the fair market value of such shares upon subscription.
If you are about to enter into such arrangements, it is prudent to seek independent valuation advice and have the support for the basis of consideration received for the issuance of the preference share in your file for when and if the taxman cometh!
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