Income Sprinkling – The Revised Proposals

The federal government has quickly made good on its promise to release revised draft legislation with respect to its “income sprinkling” proposals.

The government’s objective in releasing this legislation now is to ensure that it takes effect for 2018 as originally envisioned.

The centerpiece of the proposals is the idea that the Tax on Split Income (“TOSI”) will be applied to adults in addition to minor children. The original proposals were heavily criticized as being extremely complex and unwieldy. The Minister of Finance has reworked the rules and they are now extremely complex and unwieldy; however, they are a bit narrower in scope, offering some more objective exceptions. The Canada Revenue Agency has concurrently published a guide on how they will apply the rules.

Extension of TOSI application to adults
If none of the exceptions applies, TOSI rules will be extended to all taxpayers over the age of 17 with respect to certain income (mainly dividends) from a “related business”. Generally, a business is a related business if an individual who is related to the taxpayer is either actively engaged in the business or owns more than 10 per cent of the equity in the corporation that carries on the business.

Extension of TOSI to capital gains
TOSI will apply to taxable capital gains on dispositions of property where the income from that property would be TOSI.

Now let’s explore the main exceptions to TOSI treatment. As we can see, there are different exceptions available to different age groups:

“Excluded Business” – all adults
There will be no TOSI treatment where an adult individual is “regularly and continuously” working in the business. This is a subjective test, but if the taxpayer can show an average of 20 hours of activity per week, he is deemed to qualify for this exclusion. The exclusion applies if the work qualifies in the year or in any five previous years (not necessarily consecutively).

“Excluded Shares” – 25 or older
The TOSI will not apply to a taxpayer aged 25 or older who directly owns shares representing at least 10 per cent of votes and value of the company. The company must not be a professional corporation or earn more than 90% of its income from the provision of services. As transitional relief, taxpayers have until the end of 2018 to reorganize their corporate shareholdings to fit within these rules.

General reasonableness test – 25 or older
For taxpayers aged 25 or older there is a general “reasonableness” test that could apply to income received. TOSI will not apply to amounts paid if they are reasonable in the circumstances based on a number of factors including work performed, capital contributed or risks assumed in respect of a related business.

General prescribed rate of return – 18-24 years
For taxpayers aged 18-24, there is a general prescribed rate of return test that could apply. That is, TOSI will not apply to an amount equal to a prescribed rate (currently 1%) that would be allowed as a return on capital contributed to the company.

Retirement income splitting
The TOSI will not apply to income received by the spouse of a contributing individual where the contributing individual has reached the age of 65 years.

Capital gains exclusions
The TOSI will not apply to taxable capital gains realized on death, or on the disposition of property to the extent that the gains would otherwise qualify for the enhanced capital gains exemption. This is true regardless of whether the exemption is actually claimed.

Inherited property
The TOSI exemptions will carry over to property inherited by a taxpayer to the extent that the deceased qualified for the exemptions. In other words, the heir will step into the shoes of the deceased for the purposes of the rules.

Year-end planning
The new rules are not in effect for 2017. Accordingly, these next few days may offer the opportunity for one final dividend payment to take advantage of income splitting benefits before they disappear.

2018 planning
In the next year, current corporate structures should be reviewed to determine if the TOSI will apply to future dividends paid. Any reorganization required to fit within the “excluded shares” exemption must be completed before the end of 2018. If shares are currently held through a family trust, consider distributing to the beneficiaries.

For taxpayers who work in the business, time records may be recommended to ensure evidence that they meet the 20-hour per week threshold.

Morneau Proposals – Take Two

Morneau’s Tweet

As most readers are aware, the federal government’s small business July 18 tax proposals created an enormous backlash, with many groups and individuals, including yours truly making submissions to voice their concern. It appears the government heard the outcry as it has softened its stance to varying degrees on its new proposals. Here is a summary of how things now stand:

Income Sprinkling

The original proposals would extend the Tax on Split Income (“TOSI”) to dividends received by adults, unless they can show that the dividends are reasonable in light of their labour and/or capital contributions to the business.

The response by the tax and business communities focused mainly on the uncertainty of what might be considered “reasonable” and how this might translate into an acceptable dividend.

The finance minister has announced that it intends to move forward with the income sprinkling proposals. It intends to ensure that the rules will not impact businesses to the extent there are clear and meaningful contributions by family members. It will introduce reasonableness tests for adults in two categories – those aged 18-24 and those aged 25 and older. Adults will be asked to demonstrate their contribution to the business based on four basic principles:

  • Labour contributions
  • Capital or equity contributions
  • Financial risk, such as co-signing a loan, and/or
  • Past contributions of labour, capital or risks

While no new draft legislation has been released, the government states that the concerns surrounding uncertainty have been heard and they will simplify the proposed measures and reduce the compliance burden. Stay tuned to see what the specific legislation will contain.

Multiplication of the Capital Gains Exemption (“CGE”)

The original proposals would have disallowed the lifetime capital gains exemption on the sale of Qualified Small Business Shares and Qualified Farming Property as follows:

  • Elimination of CGE for minor children
  • Imposing TOSI reasonableness tests on availability of the CGE
  • Elimination of CGE for property held in a trust

After review, the government has backed off on all of the above proposals and will not be going forward with any of them.

Converting Income into Capital Gains

These proposals were designed to curtail what the government perceived as abusive “surplus stripping”.  It would have extended the rules in section 84.1, to any non-arm’s length sale of shares to a corporation. It would also have applied dividend treatment to any such sale, even where tax had already been paid on a previous capital gain on the same shares.

These proposals would have eliminated the “pipeline” strategy, widely used to limit the incidence of taxes on the death of an individual shareholder to a single capital gain in the hands of the deceased. It would have greatly increased the chances of gains on private company shares being taxed twice.

Thanks to the concerns expressed by the tax and business communities, the government has backed off completely on these proposals and will not be going forward with them.

This is great news for those who still have reservations about the legitimacy of implementing the Pipeline strategy on the death of a private company shareholder as the government specifically mentioned that it was responding to concerns about taxation on death.

Holding Passive Investments

The initial proposals addressed concerns that shareholders of private corporations are able to defer the ultimate taxation on their savings, thereby creating a larger pool of capital to be invested for retirement. This is an advantage that a shareholder of a private corporation enjoys compared to a person without a company and is to be eliminated.

After consulting with the public, the government, while not abandoning the proposals, has agreed to relax them.

First, any capital already in existence will not be affected by the new rules. They will not apply retroactively to existing retained earnings.

Second, there will be a base amount of $50,000 of passive income that a corporation may earn each year while still not having the rules apply. This is the equivalent of $1 million of capital invested at a 5% rate of return. Any income above that amount will not benefit from the tax deferral.

There is still no draft legislation to indicate exactly which mechanism will put in place. The new year should bring new announcements and more details in this important area.

Response to Tax Proposals – Part 2

Yesterday, I published Part 1 of my letter to Bill Morneau, addressing the general tone of the presentation of the federal government’s July 18 proposals to reform the taxation of private corporations. In today’s Tax Issue, Part 2 of my submission, dealing with the specific proposals themselves, and offering some suggestions for improvement, and in some cases, abandonment.

Part 2 – The Proposals – Suggestions for Improvement

Having aired my general concerns with the sweeping nature and tone of the Proposals, my experience as a tax professional leads me to acknowledge that there are, within the Proposals, certain areas that should, in all fairness be addressed. In this section I will review the four areas covered by the Proposals and offer my suggestions for improvement where warranted.

Income Sprinkling

The sprinkling of dividends among family members and other shareholders is a legal right sanctioned by the Supreme Court of Canada in the decision of McLurg v. Canada. Since that time, incorporated business owners have often structured their affairs to multiply low marginal income tax rates by issuing shares to family members, often minor children, even new born babies. The ability to use minor children in this manner was eliminated in 2000 with the introduction of the tax on split income (“TOSI”).

The Proposals now seek to extend these TOSI rules even further, to spouses and adult children. They have introduced legislation that will create an inordinate amount of complexity and uncertainty into the system.

First of all, the sprinkling of income with a spouse should not be disallowed. Often, a business is a family endeavour and a spouse offers support in many ways. Further, there are many instances, such as pension income splitting, where the distribution of family income among spouses is specifically allowed. I would recommend that the proposals with regard to spouses be abandoned.

Secondly, the sprinkling of dividend income to adult children is beneficial generally only to the extent that the child is not otherwise employed. In other words, the real benefit accrues during the time the child is still in school and not earning a salary. If it offensive to sprinkle income with adult children, then I would suggest that the TOSI simply be extended to an age where the most benefit is being attained, i.e., to age 25. After that, the benefits are virtually non-existent, unless the child is, in fact, involved in the business full time.

On the other hand, if the government is intent on introducing another reasonableness test with respect to dividend income paid to children, then they should amend the TOSI rules for minor children as well, since even a 15-year-old child, for example, can work in the business in the summertime and after school.

The proposals with regard to Capital Contributions should be abandoned. The fact is anyone who starts a small business through incorporation will normally capitalize the company with a nominal amount of share capital. No dividend paid on a common share of a small business corporation would meet the proposed reasonableness test in this regard, and it simply introduces more complexity into the law.

Lifetime Capital Gains Exemption

I have been involved in the structuring of many corporations where minor children are issued shares for the purposes of multiplying the capital gains exemption. My feeling is that the parent is using for his or her own purpose, without consent, a benefit that belongs to the child that he or she may wish to access in the future. I therefore agree that the participation of minor children in the ownership of a small business corporation for the purpose of multiplying the capital gains exemption should be curtailed.

With respect to family members over the age of 18, my feeling is that if they are legally allowed to contract, they should be allowed to own shares of a corporation, and as such, make their own decisions as to whether or not to claim the capital gains exemption on the sale of their shares. For spouses and children over the age of 18, therefore, I disagree with any restrictions on the use of the capital gains exemption on qualifying shares. These proposals should be abandoned.

Holding Passive Investments

The deferral of income within the corporate structure has been a staple of small business since the 1930’s. It is correctly considered to be the “nest egg” that a business owner can rely upon for retirement. If we add up the pros and cons of small business owners vs. Rich CEO’s as I did earlier, this item is perhaps the biggest reward that a small business owner can look forward to at the end of his or her career. While the Rich CEO can enjoy a large severance package and a generous pension upon retirement, the small business owner can rely on the accumulated investments in a holding company. The income from these investments is taxed at the highest marginal rate, so there is currently no income tax advantage to earning investment income through a holding company.

The idea that the government would attack accumulated wealth within a small business corporation and undermine a lifetime of labour by its owner seems excessive and cruel.

In my view, these proposals should be abandoned.

Converting Income into Capital Gains

Currently, the rules in section 84.1 address the issue of surplus stripping. Furthermore, the avoidance transaction that the Proposals are trying to address in this area has essentially been settled in cases such as Macdonald v. Canada. The CRA has successfully applied the General Anti-Avoidance Rule to curtail abusive transactions in this regard. Due to the CRA’s success in the courts in attacking these transactions, I would not recommend them to any of my clients. I therefore see no need to introduce legislation that would not only target abusive transactions, but would also deny capital gains treatment in cases where bona fide share sales were made. The Proposals make no allowances for the possible transfer of a business from a parent to a child or a sale between siblings. In fact, the Quebec government has recently gone in the reverse direction, introducing legislation that facilitates business transfers to the next generation.

Furthermore, these proposals will subject estates to double and in some cases triple taxation. Upon the death of an individual, there is a deemed disposition of shares at fair market value. The estate pays capital gains tax. When the company then liquidates its assets for distribution, there is a second tax that must be paid on the accrued increase in the value of investments within the company. Finally, upon distribution of the corporate assets to the heirs, a third dividend tax is levied. This is clearly unfair.

There is only one mechanism currently in place within the law that directly relieves this burden. Subsection 164(6) allows for an election to be made to offset the capital gains tax on death, but only where the company is dissolved within one year from the date of death. The administration of an estate can run much longer than one year. The government has acknowledged this with its newest laws regarding Graduated Rate Estates (“GRE”), which have a life of 36 months.

The Proposals will eliminate the ability of estates to implement what is commonly referred to as the “Pipeline” plan, which involves capitalising the cost base of shares that were taxed on death. In my opinion, the Pipeline is not an unfair advantage. The capital gain triggered on the death of an individual is clearly not a voluntary tax outcome. It is an automatic tax triggered by virtue of the law. The government seems not to be satisfied with this tax, and by denying the ability to plan to limit their taxes to this involuntary event, wishes to force a second and more onerous tax on the estate. Again this seems cruel and unfair.

My recommendation is that the anti-avoidance provision contained in the Proposals be abandoned and that the “Pipeline” transaction be expressly sanctioned by the CRA.

Failing this, at the very least, the election under subsection 164(6) should be made available to an estate for as long as it remains a GRE. Further, the designation currently allowed in certain circumstances under paragraph 88(1)(d) should be extended to corporations that have been liquidated in favour of a GRE. This would limit the tax burden on an estate to one incidence of tax, albeit the result of a forced transaction yielding a higher tax burden.

Response to Tax Proposals – Part 1

As predicted, the Minister of Finance, Bill Morneau started a firestorm in July with his proposals to reform the small business corporations tax system. I have added my voice to the concerns of my colleagues and clients in a letter to the minister. Due its length, I will reproduce it here in two parts. Part 1, deals with the general tone and sweeping nature of the proposals. In Part 2, to be published tomorrow, I address the specific proposals themselves, offering suggestions for improvement.

Part 1 – Overall Tone and Targeting of Incorporated Small Businesses

I am troubled, as are many of my clients and colleagues, by the language used in the Minister’s letter introducing the proposals. He states that the government is taking steps to “close loopholes that are only available to some – often the very wealthy or the highest income earners – at the expense of others.” He goes on to state that “There is evidence that some may be using corporate structures to avoid paying their fair share, rather than to invest in their business and maintain their competitive advantage.”

This language is disturbing. The Income Tax Act sitting on my desk at this moment weighs in at 2484 pages of charging provisions, income inclusions, allowable deductions, tax rates, formulas, incentives, penalties and anti-avoidance rules. The rules used by everyday small business owners in carrying on their day-to-day businesses, which you have characterized as “loopholes” have been entrenched in the law since its inception. They were addressed in the Carter Commission report in 1966. They have been sanctioned and approved in numerous decisions of the Supreme Court of Canada. For you to suggest that incorporated small business owners are using “loopholes” to “avoid paying their fair share” “at the expense of others” seems unfair. With respect, it appears that you are using this kind of inflammatory language to bolster your popularity among what you perceive as your political base of support, at the expense of hard working and honest tax-paying Canadian small business owners.

Furthermore, for you to suggest that small business owners should be using their accumulated earnings to “invest in their business and maintain their competitive advantage” is presumptive and unwarranted. The business decisions made by owners of small enterprises are not the concern of the government. While the tax system currently does provide incentives for certain types of investment behaviour, the suggestion that a business owner who chooses to invest his hard-earned money for his retirement rather than risk it in further business investment is going beyond your purview. Indeed, even the Supreme Court of Canada, in the Case of Stewart v. Canada refused to allow the government to interfere with a taxpayer’s business decisions, regardless of whether they generated profits or losses.

While it may be true that there are certain ways in which taxpayers who conduct their businesses through corporations have the potential to enjoy certain advantages from a tax point of view, there are many factors and moving parts in making the decision to incorporate. Furthermore, there are many extraneous factors that affect incorporated businesses which should be taken into account when comparing the tax status of an incorporated business with that of an employed individual. It appears that these factors have been totally ignored by your government, which is why the only conclusion that many taxpayers, myself included can reach, is that that these proposals are a clear attack on a specific segment of the taxpaying public, designed to increase the government’s political capital with so-called “average Canadians”.

Here are some of the factors that I refer to:

A taxpayer who makes the decision to go into business takes risks with their lives that cannot be measured in dollars and cents. They often leave the security of a job for an uncertain future. If the rewards of success are diminished, as they surely would be under the Proposals, the incentive to leave a job and risk starting a business endeavour is reduced.

The Proposals are a clear attack on small business owners. While it is true that the tax benefits of incorporation don’t really kick in unless the business earns, as a general rule of thumb, more than $150,000 of profit, the Proposals are singling out business owners as being so-called “wealthy Canadians”. Firstly, the use of the buzzword “wealthy” was clearly intentional and has its obvious negative connotations in a political context. Secondly, small business owners are not the only taxpayers who earn higher than average incomes. The government does not address the advantages enjoyed by salaried individuals. And let’s not compare small business owners earning over $150,000 with the average salaried employee who makes $50,000. Let’s compare them with employed individuals who make over $150,000 per year. Let’s call them “Rich CEO’s”, for lack of a less inflammatory term. Rich CEO’s, in general are able to enjoy the following benefits:

  1. No risk to personal capital
  2. Stock option benefits
  3. Company-funded private registered pension plan
  4. Paid vacation time
  5. Paid maternity/paternity leave
  6. Employment insurance
  7. Severance package upon termination
  8. Low-interest housing loans
  9. Health insurance benefits
  10. Life insurance benefits
  11. Automobile benefits
  12. Entertainment expense accounts
  13. Reimbursements for travel expenses
  14. Reimbursement of relocation expenses
  15. Golf club membership
  16. Prizes and corporate scholarships
  17. Christmas bonuses
  18. Performance bonuses

None of the above seems to have been affected by the Proposals.

On the other hand, a small business owner enjoys none of the above Rich CEO perks. On the contrary, he or she makes the following sacrifices when becoming involved in a business endeavour:

  1. Risk of capital – often life’s savings
  2. Risk of start-up losses
  3. Risk of business failure
  4. Risk of personal bankruptcy
  5. Risk of legal attack from clients and suppliers
  6. Risk of audit by CRA and/or Revenu Quebec
  7. Incurring personal debt, often mortgaging their homes
  8. Entering into lease obligations
  9. Requirement to keep bookkeeping records and file corporate returns
  10. Payroll obligations
  11. GST/HST/QST obligations
  12. Employer portion of CPP/EI/Health care
  13. Personal liability for deductions at source
  14. Personal liability for GST/HST/QST payments
  15. Unstructured and unlimited working hours
  16. Need for family involvement

None of the above risks are taken by Rich CEO’s and again, none of these factors is mentioned in the Poposals.

I personally offer my services to both incorporated business owners and Rich CEO’s. I would like to offer an example of a comparison of the annual accounting and legal fees involved in incorporating and maintaining a small business with those incurred by a Rich CEO.

Incorporated Business                                                          Rich CEO


Initial Incorporation fees                         $     2,500
Annual bookkeeping fees                               10,000
Annual legal fees                                                2,000
Annual external accounting fees                   15,000
Annual registration fees                                        107
Annual personal tax preparation                     1,500                         1,500

Total fees                                                      $    31,100                        $1,500

As you can see, the increased costs faced by a business owner simply to comply with existing tax laws and legal obligations makes the Proposals that much more difficult to digest.

In conclusion, the Proposals seem to me to be a clear attack on a large sector of the population that the average middle class Canadian – your constituency, would not have a problem hurting, especially given that you have characterized them as wealthy Canadians taking advantage of tax loopholes. This is clearly not the case, and the Proposals in general are prejudicial and unfair.

The Morneau Massacre of 2017


If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.

The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:

  • Income sprinkling
  • Multiplication of the capital gains exemption
  • Converting a private corporation’s regular income into capital gains
  • Holding investments inside a private corporation

Income Sprinkling

This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.

With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.

The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.

These proposals are scheduled to apply to for the 2018 and later years.

Multiplication of the capital gains exemption

A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.

The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:

Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.

Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.

Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.

These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.

Converting a private corporation’s regular income into capital gains

Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.

The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.

The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.

These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.

Holding investments inside a private corporation

One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.

Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.

The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.

These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.

What’s Your Tax Issue?

Tax season is upon us, and here at The Tax Issue, the questions are streaming in at a furious pace. I had a few free minutes this afternoon, so I thought I’d tackle some of the backlog.

The Tax Issue:

My partner and I each have holding companies that have joint ownership of our operating company.  If we wanted to sell a 1/3rd share in the operating company is there a mechanism to utilize our personal capital gains exemption?

The Answer:

The capital gains exemption is a $750,000 lifetime limit available to all Canadian resident individuals. It can be used to shelter capital gains on the sale of either qualified farm property or qualified shares of a small business corporation.

Since the shares of your operating company are held through a holding company, the exemption would not be available in the situation you describe. Your holding company would be the vendor of the shares and the exemption is available to individuals only.

Having said that, there may be some “reorganization” of shares you could perform to get you into a better position. Such planning would go beyond what I could explain here, so I would explore these options with a tax professional.

The Tax Issue:

I am a Canadian living/working in the US and considered non-resident of Canada for tax purposes. I do have a rental property in Canada and looking for an easy way to file my income tax on the rental property. What I have read so far makes me believe that I must file my taxes through an agent in Canada. I am wondering if I can file my taxes without using an agent and what is the process to do that.

The Answer:

The short answer is that you do not need to file a tax return through an agent.

Since you are a non-resident of Canada, the Canadian person who pays you rent must withhold taxes and remit them to the CRA on a regular basis. This person could be your tenant directly, or a Canadian agent who manages the property and collects rent on your behalf. Either way, there has to be a Canadian responsible for withholding and remitting these taxes.

You then have the option of filing a tax return under section 216 of the Income Tax Act. The taxes previously withheld would be treated as a credit against your taxes payable. There are two options for withholding and filing under section 216. I have discussed this mechanism in a previous post. Check it out. Also, the CRA has an extensive section on their web site dealing with the issue.

The Tax Issue:

My mother passed away in 1995 and my father gifted her 50% portion of a house to me, however kept himself on title for the other 50%.   He had another house that he resided in.   He kept his name on solely to protect my interest in case of divorce.    He passed away in May 2010 and now I’m told that I may have to pay capital gains.   I don’t understand why I have to pay capital gains if I’m not selling the property and the property has been my principal residence.   He had nothing to do with the house.   Is there anything I can do to avoid paying this capital gains tax?

The Answer:

Unfortunately, it sounds like your father was the owner of more than one principal residence. Upon the death of an individual, he is deemed to have disposed of all his capital property at fair market value. That includes any real estate he owned. There is an exemption for a principal residence. The definition of “principal residence” includes, not only the house he lived in, but can also include a house occupied by his child. The downside is that his estate can only claim one property as a principal residence.

Your father’s executor will have to determine which of the properties he should claim as his principal residence in order to minimize the taxes on his death. I would call in the help of a good tax accountant to crunch those numbers.

The Corporate Beneficiary

The family trust is alive these days and thriving more than ever. More and more taxpayers are beginning to appreciate the tax saving possibilities of income-splitting. The trustee has the absolute power to allocate income or capital of the trust to any beneficiary of his choice with no restrictions.

In a simple structure, a trust is created, with children as beneficiaries. The trust owns shares of an operating company (“Opco”) which pays annual dividends to the trust. The dividends are then distributed to the beneficiaries and taxed at their graduating marginal rates.

One spin on the family trust is to add a corporation to the list of trust beneficiaries. This option provides even more flexibility and advantages to the common family trust.

In an income splitting situation, it may not be desirable to pay dividends to the trust over a certain amount – that is the amount that would yield the lowest rates of tax when distributed to beneficiaries. For example, a Quebec taxpayer with no other income may earn up to $12,500 in dividends before paying any tax. The trustee may not wish to distribute more than this amount to the beneficiaries annually. If Opco has high income, its directors may find such a limitation restraining.

Adding a holding company (“Holdco”) to the list of beneficiaries wipes out this limitation. Opco could pay a large dividend to the trust. The trustee would allocate a portion of the dividend to the individual beneficiaries, and the excess would be assigned to Holdco.

A dividend paid by one corporation to a connected company is non-taxable. However, since Holdco does not own any shares directly in Opco, care would have to be exercised to ensure that the two companies were technically connected for tax purposes. Generally, this could be accomplished if the trust controlled Opco, or Opco and Holdco were controlled by persons who do not deal at arm’s length with each other.

Where Opco generates high levels of cash, the ability to pay dividends in this manner provides certain advantages. First, it allows protection from creditors in that cash may easily be moved out through dividends and away from potential claims.

Where individual beneficiaries have not claimed their capital gains exemption, this structure provides an easy means of having the company qualify as a small business corporation by paying excess “non business” cash out as a dividend.

Sometimes, the implementation of a family trust involves an estate freeze. In such a case, corporate attribution rules may apply to assign deemed dividends to the value of preferred shares issued to a parent as part of the freeze. One exception to this rule is to ensure Opco remains a small business corporation throughout the year. The ability to pay unlimited dividends to the trust on an ongoing basis would allow Opco to retain its small business corporation status so the exception applies.

Finally, if the trust is wound up, it may be possible to distribute the Opco shares to Holdco free of tax, thereby eliminating the need to give up eventual ownership of the shares to children.

Before implementing any such complex structure, care should be taken to ensure that all legal requirements are met, and that the tax advantages are worth the added costs.

What’s Your Tax Issue? Gift or Sale to Kids

The Tax Issue:

I am a partner in a Canadian co-ownership of real estate rental property and my siblings and my mother are also part owners. I would like to make a gift of my share to my children. Can this be done tax-free? Could I sell the property to them for a dollar?

The Answer:

In Canada, we don’t have a gift tax. However, when a gift is made between family members there is a deemed disposition at fair market value. So any gain that has accrued on your share of the co-ownership will be realized and you will be taxed. I’m not sure of your particular situation, but you might want to check your 1994 income tax return (if you can find it). That’s the year that the $100,000 general capital gains exemption was repealed. A special election was available to make one final use of the exemption and “bump up” the cost base of capital assets. If  you made the election on your real  estate venture, that could shelter part of the tax on a future disposition.

Special rules would also apply to your kids if you make this gift to them. Their cost amount for depreciation purposes could be reduced by the amount of your proceeds that results in the non-taxable portion of a capital  gain.

One of my pet peeves is when people make the mistake of thinking that a sale for a dollar is the same as a gift. It isn’t. A sale at an amount less than fair market value is not a gift, and different, much harsher rules apply. Your proceeds will still be equal to fair market value, but the cost base to the purchasers will be equal to exactly what they pay, i.e. one dollar. Then, when they decide to sell, they would be paying tax again on the full amount of proceeds. This “double tax” is the penalty for making a sale to a related person at an amount less than fair market value.

What’s Your Tax Issue?: Surplus Stripping

The Tax Issue:

Can I claim the capital gains exemption if I sell my shares to my brother’s company?

The Answer:

This could be the most common question I get on this topic. The capital gains exemption is intended to shelter the gains from the sale of private company shares. The exemption is available to individuals only, up to a lifetime cumulative limit of $750,000. The shares must meet certain tests which are too complicated to get into here. Suffice to say, you would not want to claim the exemption without consulting a tax professional first.

Generally, any sale of shares that qualifies should be eligible for the exemption, even a sale to a non-arm’s length party, such as your brother’s company. However, if you plan on receiving any consideration other than shares, such as cash, forget it.

Let’s cut to the real question. What you are really asking is, “can I get cash out of a non-arm’s length company without paying tax?” What the CRA calls this is “surplus stripping”, and there are rules in place to stop you.

Specifically, the most common anti-surplus-stripping rule in the Income Tax Act is found in section 84.1, which will convert your capital gain into a taxable dividend if you receive cash as part of your proceeds from the sale of shares to a non-arm’s length company.

If you wish to take back shares of your brother’s company as your proceeds, that’s ok, but any subsequent redemption of those shares will be taxed as a dividend.