Recent CRA Rulings Suggest that Some Dividends Paid to Trusts By Small Business Corporations May Not be Taxable
Canada Revenue Agency ("CRA) has issued three related technical interpretations1 (the "CRA Interpretations") addressing the application of ss.75(2) of the Income Tax Act ("ITA") to a corporation which issues shares (from treasury) to a trust of which it is a discretionary beneficiary. In them CRA acknowledges that in certain situations s.75(2) of the ITA may cause dividends which are paid to trusts to not be taxable at all.
S.75(2) of the ITA is an anti-avoidance provision. It provides (among other things) that where, by the terms of a trust, property which is held by a trust can "revert" to the person from whom the property was directly or indirectly received, all income2 earned on the property3 will be attributed to the transferor or, in other words, will be taxable in the hands of the transferor rather than the trust. Thus, if a beneficiary transfers property to a trust and, in its capacity as a beneficiary of the trust, may receive the property back from the trust, the s.75(2) of the ITA attribution rule will apply. Such attribution will continue for so long as the transferor continues to exist and is a resident in Canada.
Discretionary trusts are typically used in the estate planning context to make provision for one's family members and, often, as a mechanism to reduce a principal's estate taxes by causing future growth in the value of the principal's estate to accrue to other family members or, in other words, to effect an "estate freeze." In many cases, discretionary family trusts will be set up to own shares of a small business corporation which will qualify for the $750,000 capital gains exemption. This arrangement allows gains realized on the sale of such shares to be allocated to family members who have not fully used their exemptions.
In order for the shares of a small business corporation to qualify for the capital gains exemption over 90% of its assets must be used in an active business carried on primarily in Canada. Consequently, it is often necessary for small business corporations which generate income in excess of their business needs to make distributions to their shareholders by way of dividend.4 A technique which is sometimes used, so that a trust does not have to pay taxes on dividends which it receives from a small business corporation, is to include other corporations as discretionary beneficiaries of the trust, and to flow such dividends through the trust to the corporate beneficiaries. For tax purposes, such dividends will be treated as inter-corporate dividends paid directly to the corporate beneficiaries and, as such, will not be taxed.5 From an estate planning perspective, it can be advantageous to have the trust own the corporate beneficiary to which the dividends are paid, so that dividends paid to the corporate beneficiary will ultimately benefit the trust and its other beneficiaries.
The CRA Interpretations
The CRA Interpretations dealt with the situation where a corporate beneficiary of a trust issued shares to that trust. In the first two interpretations, CRA stated that, in its view, the issuance of shares by a corporate beneficiary to a trust would result in a transfer of property to the trust and, therefore, s.75(2) of the ITA would cause all income generated by such shares to be attributed to the corporate beneficiary. Consequently, any dividends paid on such shares would not be taxed in the hands of either the trust or its other beneficiaries. CRA stated further that because they would constitute inter-corporate dividends, s.112 of the ITA would exempt the attributed dividends from tax in the hands of the corporate beneficiary. CRA took the view that the trust could retain the dividends, or pay them to any of its beneficiaries, but because the dividend income would be attributed to the corporate beneficiary, which would not be taxable on the dividend income, no one would pay any taxes on the dividend6 (unless GAAR applied).
In its third ruling, CRA reversed its previous position, and stated that because the issuance of shares by a corporation does not involve a transfer of property from the issuing corporation to the shareholder, in its view s.75(2) of the ITA would not apply to an issuance of shares, and, therefore, would not attribute to a corporate beneficiary income earned by a trust on shares issued to that trust by the corporate beneficiary7 However, a key aspect of the two earlier rulings, that dividends received by a trust which are attributed to a corporation by s.75(2) of the ITA constitute inter-corporate dividends, which are exempted from tax by s.112 of the ITA, was not altered. This raises some interesting planning opportunities as well as some pitfalls to be avoided when affecting an estate plan.
Transfers of Property
S.75(2) of the ITA applies where property is transferred to a trust by a beneficiary if under the terms of the trust that property can be returned to the beneficiary. Consequently, even though the issuance of shares does not constitute a transfer of property, if a corporate beneficiary was to (i) pay a dividend to, or redeem shares from, a trust which invested the dividend or sale proceeds in shares or (ii) sell shares to a trust, in either case there would be a transfer of property which would cause all dividends paid on such shares to be attributed to the corporate beneficiary.
Part IV Tax
Corporate dividends paid (or deemed by s.75(2) of the ITA to be paid) by one corporation to another will be subject to a 33% refundable tax (called "Part IV Tax") unless the payor corporation is "connected" with the payee corporation. The payor corporation will be "connected" with the payee corporation only if it is controlled (or deemed to be controlled) by the payor corporation or the payee corporation owns more than a 10% interest in the payor corporation. This requirement has two implications:
(a) Firstly, the situation described in the technical interpretations – which involved a corporation being deemed to receive its own dividends – would not permit the receipt of tax-free dividends because a corporation cannot be "connected" with itself.8 Part IV Tax would be exigible.
(b) Secondly, because they are always subject to Part IV Tax when received (or deemed to be received) by a private corporation, the attribution rule in s.75(2) of the ITA will not allow portfolio dividends to be paid to a trust on a tax-free basis. The corporate beneficiary would be required to pay Part IV Tax on such dividends.
Part IV Tax will not apply, however, where dividends are paid (or deemed to be paid) by a small business corporation to corporate beneficiaries with which it is "connected". This situation will often occur in the estate planning context which makes the CRA Interpretations of interest primarily to persons who have effected or are effecting estate freezes involving small business corporations.
The ITA contains a general anti-avoidance rule ("GAAR") which can be applied by CRA to disallow a transaction or a series of transactions which result in a reduction, avoidance or deferral of tax which is attributable to the misuse of a provision of the ITA unless the transaction, or the series, was entered into primarily for bona fide non-tax reasons – such as business or estate planning reasons. In its interpretations, CRA stated that it would apply GAAR if s.75(2) of the ITA was used in combination with s.112 of the ITA in order to allow a trust to receive tax-free dividends or, in other words, if that was one of the taxpayer's primary objectives.
It follows that if the GAAR rules do not apply because the transaction which causes s.75(2) of the ITA to apply (or the series, if any, of which such transaction was a part) was effected primarily for a bona fide non-tax reasons, tax-free dividends could be received by the trust (and paid to its beneficiaries without tax as a distribution of capital). In this regard, it is worth noting that if a business transaction or estate plan can be effected in more than one way, a taxpayer is not obliged to use the method which results in the highest taxes, or any taxes, being paid. Thus, if an estate plan which is being implemented primarily for non-tax reasons can be effected in several ways, one of which will cause s.75(2) of the ITA to attribute dividend income to a corporate beneficiary, choosing to use that procedure should not cause the GAAR rules to apply.
The ITA also contains a number of specific anti-avoidance rules which can cause inter-corporate dividends to be taxed. They can be avoided with proper planning and are not discussed in this paper.
Loss of Rollover from Trust to its Beneficiaries
One of the advantages to using a discretionary trust to effect an estate plan is that it may transfer property which has increased in value on a "rollover" basis (i.e., without causing any taxes to become exigible) to any of the trust's beneficiaries at any time within 21 years after the trust is established. Unfortunately, if any of a trust's income is at any time attributed to any person under s.75(2) of the ITA, none of the trust's property can rollover to any of its beneficiaries while that person continues to exist. The loss of the ability to transfer property from a trust to its beneficiaries on a rollover basis would not only make most estate freezes ineffective from a tax perspective, but could trigger a taxable disposition which would not otherwise occur prior to the principal's death.
Loss of Capital Gains Exemptions
Another advantage to using a discretionary trust to effect an estate plan is that it may own shares of a small business corporation and, if a gain is realized on the disposition of such shares qualifies for the $750,000 capital gains exemption, it may allocate some or all of such gain to individual beneficiaries who have not fully utilized their capital gains exemptions. However, if s.75(2) of the ITA causes the dividends earned on shares to be attributed to a corporate beneficiary, it will also apply to attribute any gains realized on the disposition of such shares to the same corporate beneficiary. This would subject the gains to corporate tax and would prevent the individual beneficiaries of the trust from using their capital gains exemptions. The loss of access to the beneficiaries' capital gains exemptions would in many cases make an estate freeze quite ineffective from a tax perspective.
Wind Up of A Corporate Beneficiary
Theoretically, the two disadvantages discussed above, the loss of the rollover and the loss of the capital gains exemption, might be cured by causing the corporate beneficiary to which s.75(2) of the ITA applies to be wound up. If it no longer exists, then s.75(2) of the ITA will no longer apply. Of course, if the winding up was not effected primarily for non-tax reasons, CRA might attempt to tax any dispositions made by the trust as if the corporate beneficiary still existed using the GAAR rules.
What is important about the CRA Interpretations is that they support the position that:
(a) s.75(2) of the ITA may apply to property transferred to a trust by a corporate beneficiary;
(b) where shares (of another corporation) are transferred to a trust by a corporate beneficiary, dividends paid on such shares will be included in the income of the corporate beneficiary and not the trust; and
(c) such dividends will be exempt from tax (under Part I of the Act) as tax-free inter-corporate dividends.
It follows from the foregoing that dividends paid on shares which are attributed to a corporate beneficiary by s.75(2) of the ITA will not be taxed at all9 provided the two corporations are "connected" so that Part IV tax does not apply to them. This result could well be advantageous in some situations. One must remember, of course, that, if this result was one of the taxpayer's primary objectives, CRA has stated that it would tax the dividends using the GAAR rules.
If s.75(2) of the ITA applies to any property owned by a trust, then:
(a) none of the trust's property10 can be distributed to its beneficiaries on a rollover basis while the transferor of the property continues to exist; and
(b) none of the gains realized on the disposition of shares to which s.75(2) of the ITA applies can be allocated by the trust to its individual beneficiaries while the transferor continues to exist and remains resident in Canada.
These results negate two of the main advantages to using a discretionary family trust when effecting an estate plan and, depending on the circumstances, could result in the payment of substantial unanticipated tax. The possible application of s.75(2) of the ITA to family trusts with corporate beneficiaries constitutes a potential trap for the unwary. Query whether these adverse results could be reversed by arranging for the corporate beneficiary which transferred property to the trust to be wound up before the trust effects any dispositions made taxable by its continued existence?