Avoiding family business tax traps, Part 2
In my previous article on tax traps to avoid in family-owned corporations, I looked at the tangle you can get into with the so-called association rules. But another, equally nasty, tax trap lies in the corporation attribution rules. Here’s a look at how to avoid running afoul of them.
For most of 2018, tax pundits obsessed about the rules for Tax On Split Income (TOSI) that came into effect in 2018. But we should not forget about the original corporate anti-income splitting rules, which have been in effect for a long time now, and which continue to be applicable (in addition to the TOSI rules).
Corporate attribution rules
The corporate attribution rules provide that where an individual (“Mr. X”) has transferred or lent property to a corporation either directly or indirectly by means of a trust or any other means:
* And where one of main purposes of the transfer or loan was to reduce income and benefit a “designated person” in respect of Mr. X (a “designated person” is someone’s spouse, or minor child, minor niece or nephew or a minor grandchild); and
* That designated person is a “specified shareholder” of the company (i.e., who owns directly or indirectly 10% of more of the issued shares of any class at any time);
* Then, Mr. X will be subject to a tax based on a deemed interest component based on the amount of the transferred/lent property.
Estate freeze traps
Although it may seem simple enough to steer clear of these rules by not making any transfer or loan as noted above, it is still quite easy to trip into the rules by implementing a common estate freeze.
How? Well, you should keep in mind that a corporate reorganization can be classified as a transfer, e.g., where shares are transferred to a holding company, or exchanged for other shares of the company, which is a common way to implement an estate freeze. Therefore, the corporate attribution rules can apply both to estate freezes that involve transfers to holding companies as well as to those involving a direct reorganization of the capital of the corporation itself.
Interest-free loan trap
Here’s another example of how you can run afoul of these rules:
Let’s assume the shareholders of a company include the father, mother, and a family trust for the benefit of the minor children. Father decides to lend money to Opco on an interest-free basis (a commonly-used strategy).
But here’s the problem: By transferring the cash to Opco, Father has reduced his potential investment income (i.e., income he would have earned had he kept the cash in his own hands), and that potential income (now earned by Opco) will accrue to the family member shareholders (spouse and minor children), thus triggering the corporate attribution rules.
Two ways to dodge the pitfalls
But like any tax rule, there are certain exceptions to the application of the corporate attribution rules:
* Small business corporation. An exception may apply if a company is a “small business corporation” throughout the taxation year, at all times (meaning Canadian controlled, with 90% or more of the fair market value of its assets being used more than 50% in an active business in Canada).
The trouble is that if a significant portion of the corporation’s asset base is in the form of investments rather than in business activities, the small-business corporation exception may no longer apply until the small business corporation status is restored. (Strategies can be devised to continually jettison non-qualifying assets on a tax-efficient basis.)
* Anti-attribution clause in trusts. An exception may apply if an anti-attribution clause is included in the family trust that would prevent distributions to the spouse or minor children. However, this would then prevent access to certain other tax advantages, such as the capital gains exemptions for minors. Moreover, it does not protect against a spouse who owns shares directly in the company.
Before relying on any of these exceptions, it’s important to get the appropriate tax advice from your advisor to ensure that the particular exception is one that will apply and is practical in light of your situation.
These are just a couple of tax traps to be aware of when implementing any corporate transactions, whether it be an estate plan or simply setting up a family business as a start-up. Family business planning can be complicated and you can be ensnared in any number of obscure tax traps the Canada Revenue Agency has set up. The best tip I can give is to speak to your tax advisor to ensure your family-owned corporation remains a trouble-free net tax benefit as designed, rather than a burden you wish you’d never undertaken.
Previously published in The Fund Library on January 29, 2019 by tax and estate planning lawyer, Samantha Prasad. Portions of this article first appeared in The TaxLetter, © 2018 by MPL Communications Ltd. Used with permission.