Introduction - Specialized Tax Attribution Rules
In another article, we focused on the basic tax-attribution rules and their exceptions. For an explanation of the on the basic tax-attribution rules and their exceptions, see here.
This article describes more specialized tax-attribution rules in the Canadian tax system—specifically, those applying to diverted payments, income-splitting with minors, holding corporations, and revocable trusts.
Indirect Payments and Transfers: Subsection 56(2)
A taxpayer may seek to reduce his or her taxable income by diverting payments to a third party, For example, an employee directs her employer to pay a part of her salary to her creditor. Or a creditor directs a debtor to make interest payments to the creditor’s mother.
Subsection 56(2) of the Income Tax Act includes the diverted payment into the taxpayer’s income if the payment:
- was made to a person other than the taxpayer,
- was made under the taxpayer’s direction or concurrence,
- was made for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person, and
- would have been included in the taxpayer's income if it had been made to the taxpayer.
The Supreme Court of Canada restricted the application of subsection 56(2) in the context of private corporations (see: R v McClurg; Neuman v R).
Kiddie Tax: Section 120.4
The declining number of two-spouse/one-income families caused a new trend in income splitting. Where both spouses earn similar income, there’s little scope for income splitting between them. Diverting income to minor children therefore becomes an attractive alternative.
In response, Parliament enacted section 120.4—also known as the “kiddie tax.” Simply put, a minor child draws top-rate tax on his or her “split income.”
In sum, a minor child’s split income captures five planning arrangements:
- A trust established for a minor child’s benefit owns shares of a private corporation paying dividends. The grossed-up private corporation dividends are split income.
- A trust established for a minor child’s benefit owns an interest in a partnership earning business income by providing property or services to an entity related to the minor child. For example, a lawyer sets up a trust benefitting her child. The trust is a partner in a limited partnership providing management services to the parent’s law firm. The law firm pays the partnership a management fee, which the partnership allocates to the trust. The trust, in turn, pays this amount to the child. The child’s income is split income.
- A trust established for a minor child’s benefit operates a business that earned income from property or services provided to an entity related to the minor child. The income paid or payable to the child is split income.
- The minor child (or trust established for his or her benefit) owns shares of a private corporation, and the minor child receives a shareholder’s loan, which triggers a taxable benefit under subsection 15(2). The subsection 15(2) benefit is split income.
- The minor child (or a trust established for his or her benefit) owns shares of a private corporation and the minor child sells the shares to a non-arm’s length person. The full capital gain is deemed to be a dividend from the private corporation to the child, which is grossed up and taxed to the child at full rate as split income.
The kiddie tax only applies to the income earned in these five arrangements. It doesn’t apply to:
- dividend income earned on shares of a public corporation, interest income, employment or self-employment income, or capital gains (other than those covered under 120.4);
- income from property inherited from a deceased parent;
- income from property inherited from a non-parent when the minor is either a full-time student at a post-secondary institution or eligible for the disability tax credit; or
- trust or partnership income where the trust or partnership earns business income from services provided to an unrelated entity.
Further, the kiddie tax doesn’t applies if neither of the minor’s parents is a Canadian resident at any time during the year.
Finally, the kiddie tax ousts any otherwise applicable attribution rule. In other words, income that’s subject to the kiddie tax won’t be subject to an attribution rule under sections 74.1 or 74.2.
At the end of 2017, Parliament proposed various amendments to section 120.4 of the Income Tax Act that broadly expanded the rules beyond minors. Parliament also proposed that these amendments would apply to the 2018 and subsequent tax years. For more on the new tax on split income (TOSI) rules, see here.
Corporate Attribution Rules - Transfers to Non-Small-Business Corporations: Section 74.4
Section 74.4 of Canada’s Income Tax Act is an anti-avoidance rule designed to deter taxpayers from splitting income by transferring or loaning property to a corporation in which a spouse or related minor has at least a 10% interest.
Section 74.4 applies if :
- an individual transferred or loaned property to a corporation that isn’t a “small business corporation,”
- one of the main reasons for the transfer or loan is to both reduce the individual’s income and benefit the individual’s spouse or a related minor, and
- the individual’s spouse or related minor owns at least 10% of the corporation’s shares either directly or indirectly.
If section 74.4 applies, the rule attributes to the transferor’s income a prescribed interest rate based on the FMV of the property transferred or loaned. This amount is attributed to the transferor regardless of whether the transferee corporation pays a dividend to the spouse or related minor.
Section 74.4 may lead to double tax since (i) the transfer results in the attribution of a prescribed rate of income to the transferor, (ii) the spouse or minor must report any dividend received from the corporation as income, and (iii) the dividend may stem from the property that the corporation received from the transferor.
Revocable Trusts: Subsection 75(2)
Trust income may be attributed to the settlor of the trust under subsection 75(2) of the Canadian Income Tax Act. This provision attributes to the settlor the income from property that the settlor transferred to a Canadian resident trust if either:
- under the terms of the trust, the property may revert to the settlor;
- the settlor has the power to determine, after the creation of the trust, who receives the property; or
- during the settlor’s life, the trust can’t distribute the property without the settlor’s consent.
These conditions speak to the settlor’s power over property that the settler transferred into the trust. If the settler didn’t transfer the income-earning property into the trust, the attribution rule doesn’t apply.
In contrast to the trust attribution rules in sections 74.1 and 74.2, which attribute the beneficiary’s income to the transferring taxpayer, subsection 75(2) attributes the trust’s income to the settlor. So, this attribution rule applies whether the trust retains the income from the transferred property or pays the income to the beneficiaries. And the attribution occurs regardless of the relationship between the trust beneficiaries and the settlor. That is, subsection 75(2) isn’t confined to trusts for spouses or related minors. The idea is that the settlor shouldn’t be able to divert taxable income to the trust beneficiaries while continuing to retain substantial control over the trust.
In more detail, where 75(2) applies, it attributes to the settlor both:
- the income or loss generated from the transferred property and
- the taxable capital gain/allowable capital loss if the trust subsequently disposes of the property
These amounts are therefore not included in the trust’s income. And they aren’t included in the beneficiary’s income, even if they were payable to the beneficiary.
Also, as with the other attribution rules, subsection 75(2) attributes not only the income/loss/capital gain/capital loss of the transferred property but also the income/loss/capital gain/capital loss of “substituted property.” So, if the trust disposes of the transferred property and acquires a substitute, the attribution rule continues.
Attribution Tax Tips
Despite these attribution rules, some income-splitting strategies still remain viable—e.g., contributing to a spouse’s Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA).
If you unknowingly triggered an attribution rule, you may have underreported your taxable income. To avoid problems with the Canada Revenue Agency, contact one of our expert Canadian tax lawyers for advice on the remedies available, such as the Voluntary Disclosures Program.
If ignored, the attribution rules can undermine an assortment of tax planning structures. For example, section 74.4 can wreak havoc on an estate freeze, and subsection 75(2) can undermine a family trust. Moreover, when you trigger an attribution rule, your spouse or related minor, as the case may be, is jointly and severally liable for your tax on the attributed amount. Do yourself and your loved ones a favor and discuss proper tax planning with one of our best Toronto tax lawyers.