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Principal Issues: 1. Whether a capital dividend paid by a corporation to a trust and allocated to a child over 17 years old but under 24 years old qualifies as arm’s length capital of the child. 2. Mr. X and his spouse Mrs. Y hold respectively 95% and 5% of the shares of Investco . Investco holds all of the shares of Opco. The only other assets held by Investco is a cash amount of $100,000 which came from a dividend paid by Opco. Mr. X is actively engaged on a regular, continuous and substantial basis in the business of Opco. Mrs. Y is not involved in the business of Opco. In 20X1, the business carried by Opco is sold to a third party. Following the sale, Opco does not hold any assets or liabilities and is wound up into Investco. Question A : In 20X2, Investco pays a dividend of $9,500 to Mr. X and $500 to Mrs. Y. Whether the dividend received by Mrs. Y is not derived directly or indirectly from a related business in respect of Mrs. Y. Question B : In 20X3, Investco uses its remaining $90,000 to invest in the shares of ABC Inc. generating an investment income of $500 which is reinvested in others shares of ABC Inc. It is assumed that Investco carries an investment business and that Mr. X is actively engaged on a regular, continuous and substantial basis in the business of Investco but not Mrs. Y. In 20X3, Investco sells shares of ABC Inc. for a proceed equal to its adjusted cost base of $10,000. Investco pays a dividend of $9,500 to Mr. X and $500 to Mrs. Y. Whether the dividend received by Mrs. Y is not derived directly or indirectly from a related business in respect of Mrs. Y.
Position: 1. No in the circumstances as the CDA dividend does not qualify as arm’s length capital 2. a) Yes b) Generally no.
Reasons: According to the law and previous positions.
FEDERAL TAX ROUNDTABLE, OCTOBER 7, 2021
APFF CONFERENCE 2021
Question 17
Tax on split income tax and excluded amount
SITUATION A
Mr. X held all of the preferred shares of the capital stock of Opco Inc. including, in particular, voting shares giving him control of Opco Inc. with more than 50% of the voting rights. The common shares of the capital stock of Opco were held by a discretionary family trust (the "Trust") whose beneficiaries were Mr. X's three children, namely Child A, Child B and Child C. Child A is 20 years old. The trustees of the Trust were Mr. X and Mr. Y, a friend of Mr. X who was not a settlor or beneficiary of the Trust.
During the year, Opco paid a dividend of $10,000 out of its capital dividend account on the common shares of its capital stock. The Trust distributed the entire dividend received to Child A. With the funds received from the Trust, Child A subscribed for preferred shares in the capital stock of Opco.
Question to the CRA
Is Child A's subscription for shares of the capital stock of Opco considered to be a contribution of arm’s length capital within the meaning of subparagraph (f)(ii) of the definition of "excluded amount" in subsection 120.4(1)?
SITUATION B
The only class of shares of Investco was owned 95% by Mr. X and 5% by his spouse, Ms. Y. Investco wholly owned all of the issued shares of the capital stock of Opco. The only other asset of Investco was $100,000 held in a non-income producing bank account, which was derived from a dividend received from Opco out of the profits generated by Opco in the operation of its business. Mr. X has always been actively engaged on a regular, continuous and substantial basis in the activities of Opco, but Ms. Y has never been involved in the business carried on by Opco.
In the fiscal year ending December 31, 20X1, the business carried on by Opco was disposed of to a third party. Mr. X retained no connection with the business following the disposition. After the sale of the business and the repayment of debts, Opco had no assets or liabilities. Opco was wound up into Investco on December 31, 20X1.
Investco's taxation year end is also December 31.
Questions to the CRA
a) In 20X2, Investco paid a dividend in the amount of $10,000 on the only class of issued shares of its capital stock, namely $9,500 to Mr. X and $500 to Ms. Y. Given that no source individual in respect of Ms. Y was engaged in the operation of the business sold by Investco during 20X2, does the dividend received by Ms. Y qualify as an excluded amount under subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1)?
b) In 20X3, Investco invested $90,000 in ABC Inc., a U.S. corporation. For purposes of simplicity, we have assumed that Investco carries on an investment business and that Mr. X is actively involved in that business. Ms. Y is not involved in any way in the business carried on by Investco.
Investco received a $500 dividend on the shares of the capital stock of ABC Inc. during the year and reinvested the entire amount by purchasing new shares of the capital stock of ABC Inc. The $500 dividend was Investco's only income for the year 20X3 and it had no expenses for that year.
Before the end of 20X3, Investco sold shares of ABC Inc. for their average ACB (so that no gain or loss was realized) for $10,000 and paid a dividend of $10,000 on the only class of issued shares of its capital stock, i.e. $9,500 to Mr. X and $500 to Ms. Y. Does the dividend received by Ms. Y qualify as an excluded amount under subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1)?
CRA response to the Situation A question
Generally, an amount that is a reasonable return in respect of the independent capital contributions of an individual who has attained the age of 17 years but not the age of 24 years, is an excluded amount under subparagraph (f)(ii) of the definition of "excluded amount" in subsection 120.4(1) and is therefore not subject to TOSI.
The term "reasonable return" as defined in subsection 120.4(1) generally means the amount that is derived directly or indirectly from a related business, taking into account the relative contributions made to the business by the specified individual and each source individual. However, for the purposes of subparagraph (f)(ii) of the definition of "excluded amount" in subsection 120.4(1), only the specified individual's arm’s length capital contributions are taken into account in determining whether an amount constitutes a reasonable return.
The term "independent capital" is defined in subsection 120.4(1) as follows:
“arm’s length capital, of a specified individual, means property of the individual if the property, or property for which it is a substitute, was not
(a) acquired as income from, or a taxable capital gain or profit from the disposition of, another property that was derived directly or indirectly from a related business in respect of the specified individual;
(b) borrowed by the specified individual under a loan or other indebtedness; or
(c) transferred, directly or indirectly by any means whatever, to the specified individual from a person who was related to the specified individual (other than as a consequence of the death of a person).”
Thus, for a property to qualify as "arm’s length capital" of a specified individual, that property, or property for which the particular property is a substitute, must not have been acquired by the specified individual in any of the ways described in paragraphs (a) to (c) of the definition of "arm’s length capital" in subsection 120.4(1).
The CRA is of the view that the $10,000 received by Child A as a capital dividend is not arm’s length capital of Child A since it is property transferred indirectly by Opco (i.e., through the Trust), a person related to Child A. Since Mr. X controls Opco, Opco is related to Mr. X by virtue of subparagraph 251(2)(b)(i). Furthermore, Mr. X and Child A are related to each other by blood relationship and are related persons by virtue of paragraphs 251(2)(a) and 251(6)(a). Consequently, Opco and Child A are related persons by virtue of subparagraph 251(2)(b)(iii).
Thus, Child A's subscription for shares of the capital stock of Opco with the proceeds of the capital dividend received from Opco (through the Trust) would not be considered an arm’s length capital contribution within the meaning of subparagraph (f)(ii) of the definition of "excluded amount" in subsection 120.4(1).
Depending on the circumstances, however, Child A may be able to benefit from the specified individual's exempt return exclusion in subparagraph (f)(i) of the definition of "excluded amount" in subsection 120.4(1). The term "safe harbour capital return" of a specified individual is defined in subsection 120.4(1) as the return, not exceeding the product of multiplying the highest prescribed rate for a quarter of the relevant taxation year by the FMV of property contributed by the specified individual in support of a related business. In the case of Child A, that safe harvour capital return would be calculated by reference to the amount of the subscription to the shares of the capital stock of Opco and the appropriate prescribed rate.
CRA's response to question (a) of Situation B
Subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1) provides that an excluded amount in respect of an individual for a taxation year would be an amount that is the individual's income for the year from, or the individual’s taxable capital gain or profit for the year from the disposition of, a property and that, if the individual has attained 17 years of age before the year, is not derived, directly or indirectly, from a related business in respect of the individual for the year.
For the purposes of this question, we have assumed that Investco does not carry on a business in the year 20X2.
The dividend received by Ms. Y would be considered to arise directly or indirectly from a related business (the former Opco business) in respect of Ms. Y notwithstanding that the dividend was paid in a year subsequent to the year in which the Opco business was disposed of. However, the dividend would not be considered to arise, directly or indirectly, from a related business in respect of Ms. Y for the year 20X2 since the former Opco business was not carried on in that year, in accordance with the CRA's position issued in response to Question 9 of the 2018 Canadian Tax Foundation Annual Conference Round Table. Consequently, the dividend received by Ms. Y qualifies as an excluded amount by virtue of subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1).
CRA's response to question (b) of Situation B
In the present issue, since the former business of Opco is not carried on in the 20X3 taxation year, it is not a related business in respect of Ms. Y for that year, as appears from the CRA's position noted above.
As stated in this question, Investco carries on an investment business in 20X3 and Mr. X is actively involved in that business. Thus, Investco's business is a related business in respect of Ms. Y for the 20X3 taxation year.
As noted above, Investco has invested $90,000 in its business. Thus, when Investco sells a portion of the property used in the operation of that business in order to pay the dividend declared to its shareholders, it is the CRA's view that the dividend must be considered to have arisen, directly or indirectly, from Investco's business.
Consequently, the dividend received by Ms. Y would be considered to have arisen directly or indirectly from the business of Investco, a related corporation in respect of Ms. Y. Thus, the dividend received by Ms. Y cannot qualify as an excluded amount by virtue of subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1).
On the other hand, if it were shown that Investco does not carry on a business, the dividend received by Ms. Y from Investco would not be considered to be derived directly or indirectly from a related business in respect of Ms. Y and could qualify as an excluded amount by virtue of subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1).
Whether a taxpayer's activities are sufficient to constitute a business remains a question of fact that, in each particular situation, can only be resolved after an examination of all relevant facts and circumstances.
In closing, the various exclusions, including the one in subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1), are not intended to apply in all circumstances. Where the exclusions do not apply in a particular situation, the general logic is that, in such circumstances, the most appropriate test for determining whether income from a related business in respect of a particular individual should be excluded from the split income calculation should be based on the general test of whether the amount is a "reasonable return" having regard to the specific criteria applicable in the circumstances, including the work performed, the property contributed, the risks assumed, the total amounts paid or payable, and any other relevant factors.
Linda Do
(438) 341-5473
October 7, 2021
2021-090107
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 CANADA REVENUE AGENCY, Technical Interpretation 2018-0779981C6, November 27, 2018.
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