5 October 2018 APFF Roundtable Q. 11, 2018-0768821C6 F - Tax on Split Income

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120.4(1)

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This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.

Principal Issues: Mr. X holds the voting shares of the capital stock of a corporation (“Opco”) and a family trust (“Trust”) holds the participating shares of the capital stock of Opco. Mr. X’s child, (“Child X”) holds all of the voting and participating shares of the capital stock of a holding corporation (“Holdco”). Mr. X, Ms. X (Mr. X’s spouse), Child X and Holdco are beneficiaries of Trust. Mr. X and Ms. X are both age 50 and Child X is age 30. Child X is not involved in any manner in Opco’s business. Holdco owns portfolio investments that have generated $150,000 of passive income in its last taxation year. In the same taxation year, Opco paid dividends of $100,000 to Trust. Trust distributed the Opco dividends to Holdco. Holdco intends to pay dividends of $75,000 to Child X. Whether it is possible for Holdco to pay dividends to Child X with the after-tax income earned on its portfolio investments and not from Opco’s dividends in order to avoid the application of the tax on split income (“TOSI”) for Child X.

Position: If Holdco pays dividends to Child X with the funds received from the dividends paid by Opco, which is a related business in respect of Child X, the dividends would be added to Child X's split income unless one of the exclusions provided in the definition of “excluded amount” applies. If Holdco pays dividends with the after-tax income earned on its portfolio investments, the dividends would be an excluded amount for Child X, whether or not Holdco carries on a business. If Holdco carries on a business, the principal purpose of which is to earn income from its portfolio investments, the dividend would not be derived, directly or indirectly, from a related business as it appears that there is no source individual in respect of Child X who either meets the activity test or the ownership test in respect of Holdco for the purposes of the definition “excluded business”. If Holdco does not carry on a business, the dividend could not be derived, directly or indirectly, from a related business. This will require an adequate tracing of funds in order to establish that the funds used by Holdco to pay the dividends come from its after-tax income earned on its portfolio investments.

Reasons: In accordance with the legislation and tax policy.

FEDERAL TAX ROUNDTABLE 5 OCTOBER 2018
2018 APFF CONFERENCE

Question 11

Section 120.4 - Ability to "track" the source of income

In a Technical Interpretation issued in 2002, the CRA confirmed that it was possible for a discretionary trust to distribute income from a source to one of its beneficiaries and income from another source to another beneficiary. Among other things, the CRA confirmed that a discretionary trust could distribute income from publicly traded shares to a minor child and dividends from a private corporation to an adult beneficiary.

In that context, consider the following situation:

Mr. X holds the voting shares of the capital stock of Opco and a family trust ("Trust") holds 100% of the participating shares of the capital stock of Opco;
Child X holds 100% of the participating and voting shares of the capital stock of Holdco;
Mr. X, his spouse Mrs. X, Child X and Holdco are beneficiaries of Trust;
Mr. X and Mrs. X are 50 years old and Child X is 30 years old;
Child X does not participate in Opco's business in any way;
Holdco holds stock market investments that generated $150,000 of passive income in the past year;
Holdco as a beneficiary of the Trust received a distribution of a dividend from Opco of $100,000 in the last year;

Holdco wishes to pay a $75,000 dividend to Child X (the "Dividend").

Question to the CRA

Would the Dividend be subject to the tax on split income? Would it be possible for Holdco to pay the Dividend as stock market investment income that was not derived from Opco so as to avoid the application of the income splitting rules, similarly to what can be done in the case of a trust?

CRA Response

The Dividend will be split income of Child X by virtue of paragraph (a) of the definition of "split income" in subsection 120.4(1) unless it is an excluded amount.

The Dividend could be an excluded amount of Child X under subparagraph (e)(i) of the definition of "excluded amount" in subsection 120.4(1) if it is not derived, directly or indirectly, from a related business in respect of Child X.

A related business in respect of a specified individual (footnote 1) includes a business carried on by a corporation if a source individual (footnote 2) in respect of the specified individual is actively engaged in the activities of the corporation related to earning income from the business (the "active engagement condition") (footnote 3).

In this regard, since Mr. X is the father of Child X, those persons are connected by blood relationship and are, therefore, related to each other pursuant to paragraph 251(2)(a). Consequently, Mr. X is a source individual with respect to Child X.

A related business in respect of a specified individual also includes a business of a corporation, where a source individual in respect of the specified individual owns shares of the capital stock of the corporation or property that derives, directly or indirectly, all or part of its FMV from shares of the capital stock of the corporation, and the total FMV of the shares or property owned by the source individual is 10% or more of the FMV of all of the shares of the capital stock of the corporation (the “ownership condition") (footnote 4).

For the purposes of this question, we have assumed that Opco carries on a business and that Mr. X satisfies the active engagement condition with respect to Opco.

If it can be determined that Holdco will pay the Dividend to Child X out of the funds from the $100,000 dividend received from Opco or from any dividends previously received from Opco, then we are of the view that the Dividend would thus have come, directly or indirectly, from a related business - that of Opco - in respect of Child X. Thus, the Dividend would be added to the split income of Child X, unless it constituted an excluded amount by virtue of another exclusion in the definition of "excluded amount" in subsection 120.4(1).

On the other hand, if it can be determined that Holdco will pay the Dividend to Child X out of its after-tax income from its stock market investments, then that dividend would be an excluded amount for Child X and would not be included in calculating the child’s split income.

If, on the one hand, it were determined that Holdco carries on a business whose primary purpose is to earn income from its stock market investments, that business would not qualify as a "related business" within the meaning of the definition of that term in subsection 120.4(1). In particular, it appears from the statement in this question that no source individual in respect of Child X satisfies the active engagement condition or the ownership condition with respect to Holdco. Consequently, the Dividend would be an "excluded amount" in respect of Child X by virtue of subparagraph (e)(i) of the definition of that term in subsection 120.4(1) since, although it may be from a Holdco business, that business would not qualify as a related business with respect to Child X.

On the other hand, if it were determined that Holdco does not carry on a business, then the Dividend would also be an "excluded amount" in respect of Child X by virtue of subparagraph (e)(i) of the definition of that term in subsection 120.4(1). Indeed, one of the conditions to be met in the definition of "related business" in subsection 120.4(1) is that there must be, in the first place, a business carried on by an entity. Consequently, in the event that Holdco does not carry on a business, the Dividend could not come, directly or indirectly, from a related business in respect of Child X, but rather from property held by Holdco.

Based on the foregoing, Holdco must adequately monitor its funds derived from stock market investments in order to determine whether those funds were used to pay the Dividend.

Jean Lafrenière
(613) 670-9013
5 October 2018
2018-076882

FOOTNOTES

Due to our system requirements, footnotes contained in the original document are reproduced below:

1 We have assumed that Child X is resident in Canada at all relevant times. Child X is therefore a specified individual as defined in subsection 120.4(1).

2 The term "source individual" is defined in subsection 120.4(1) and means an individual, other than a trust, who is resident in Canada and is related to the specified individual.

3 Subparagraph (a)(ii) of the definition of "related business" in subsection 120.4(1).

4 Paragraph (c) of the definition of "related business" in subsection 120.4(1).

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Text of Severed Letter

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principales Questions: Mr. X holds the voting shares of the capital stock of a corporation (“Opco”) and a family trust (“Trust”) holds the participating shares of the capital stock of Opco. Mr. X’s child, (“Child X”) holds all of the voting and participating shares of the capital stock of a holding corporation (“Holdco”). Mr. X, Ms. X (Mr. X’s spouse), Child X and Holdco are beneficiaries of Trust. Mr. X and Ms. X are both age 50 and Child X is age 30. Child X is not involved in any manner in Opco’s business. Holdco owns portfolio investments that have generated $150,000 of passive income in its last taxation year. In the same taxation year, Opco paid dividends of $100,000 to Trust. Trust distributed the Opco dividends to Holdco. Holdco intends to pay dividends of $75,000 to Child X. Whether it is possible for Holdco to pay dividends to Child X with the after-tax income earned on its portfolio investments and not from Opco’s dividends in order to avoid the application of the tax on split income (“TOSI”) for Child X.

Position Adoptée: If Holdco pays dividends to Child X with the funds received from the dividends paid by Opco, which is a related business in respect of Child X, the dividends would be added to Child X's split income unless one of the exclusions provided in the definition of “excluded amount” applies. If Holdco pays dividends with the after-tax income earned on its portfolio investments, the dividends would be an excluded amount for Child X, whether or not Holdco carries on a business. If Holdco carries on a business, the principal purpose of which is to earn income from its portfolio investments, the dividend would not be derived, directly or indirectly, from a related business as it appears that there is no source individual in respect of Child X who either meets the activity test or the ownership test in respect of Holdco for the purposes of the definition “excluded business”. If Holdco does not carry on a business, the dividend could not be derived, directly or indirectly, from a related business. This will require an adequate tracing of funds in order to establish that the funds used by Holdco to pay the dividends come from its after-tax income earned on its portfolio investments.

Raisons: In accordance with the legislation and tax policy.

APFF - CONGRÈS 2018

Question 11

Article 120.4 L.I.R. - Possibilité de « suivre » la provenance du revenu

Dans une interprétation technique publiée en 2002, l’ARC a confirmé qu’il était possible pour une fiducie discrétionnaire de distribuer du revenu provenant d’une source à l’un de ses bénéficiaires et du revenu provenant d’une autre source à un autre bénéficiaire. Entre autres, l’ARC a confirmé que la fiducie discrétionnaire pouvait distribuer les revenus provenant d’actions cotées en bourse en faveur d’un enfant mineur et les dividendes provenant d’une société privée en faveur d’un bénéficiaire adulte.

Dans ce contexte, prenons la situation suivante :

M. X détient les actions avec droit de vote du capital-actions d’Opco et une fiducie familiale (« Fiducie ») détient 100 % des actions avec droit de participation du capital-actions d’Opco;
Enfant X détient 100 % des actions avec droit de participation et avec droit de vote du capital-actions d’Holdco;
M. X, sa conjointe Mme X, Enfant X et Holdco sont bénéficiaires de Fiducie;
M. X et Mme X sont âgés de 50 ans et Enfant X est âgé de 30 ans;
Enfant X ne participe pas à l’entreprise d’Opco de quelque façon que ce soit;
Holdco détient des placements boursiers qui ont généré 150 000 $ de revenus passifs dans la dernière année;
Holdco s’est vue distribuer, à titre de bénéficiaire de Fiducie, un dividende provenant d’Opco de 100 000 $ dans la dernière année;

Holdco désire payer un dividende de 75 000 $ à Enfant X (« Dividende »).

Question à l’ARC

Le Dividende sera-t-il assujetti à l’impôt sur le revenu fractionné? Est-il possible pour Holdco de verser le Dividende à même les revenus de placements boursiers ne provenant pas d’Opco afin d’éviter l’application des règles sur le fractionnement de revenus comme c’est possible dans le cas d’une fiducie?

Réponse de l’ARC

Le Dividende sera un revenu fractionné d’Enfant X en vertu de l’alinéa a) de la définition de l’expression « revenu fractionné » au paragraphe 120.4(1) L.I.R., sauf s’il s’agit d’un montant exclu.

Le Dividende pourrait être un montant exclu quant à Enfant X en vertu du sous-alinéa e)(i) de la définition de l’expression « montant exclu » au paragraphe 120.4(1) L.I.R. s’il ne provient pas, directement ou indirectement, d’une entreprise liée relativement à Enfant X.

Une entreprise liée relativement à un particulier déterminé (footnote 1) comprend une entreprise exploitée par une société, si un particulier source (footnote 2) relativement au particulier déterminé participe activement aux activités de la société qui se rapportent au fait de tirer un revenu d’entreprise (« critère de participation ») (footnote 3).

À cet égard, M. X étant le père d’Enfant X, ces personnes sont unies par les liens du sang et sont donc liées entre elles en vertu de l’alinéa 251(2)a) L.I.R. Par conséquent, M. X est un particulier source relativement à Enfant X.

Une entreprise liée relativement à un particulier déterminé comprend également l’entreprise d’une société, lorsqu’un particulier source relativement au particulier déterminé est propriétaire d’actions du capital-actions de la société ou de biens dont une partie ou la totalité de la JVM provient, directement ou indirectement, de ce capital-actions et que la JVM totale des actions ou des biens qui appartiennent au particulier source est égale à au moins 10 % de la JVM totale du capital-actions de la société (« critère de détention ») (footnote 4).

Aux fins de la présente question, nous posons comme hypothèses qu’Opco exploite une entreprise et que M. X respecte le critère de participation à l’égard d’Opco.

S’il pouvait être établi qu’Holdco paiera le Dividende à Enfant X à même les liquidités provenant du dividende de 100 000 $ reçu d’Opco ou de tout dividende reçu antérieurement d’Opco, alors nous sommes d’avis que le Dividende proviendrait alors, directement ou indirectement, d’une entreprise liée – celle d’Opco – relativement à Enfant X. Ainsi, le Dividende serait ajouté au revenu fractionné d’Enfant X, à moins qu’il ne constitue un montant exclu en vertu d’une autre exclusion prévue à la définition de l’expression « montant exclu » au paragraphe 120.4(1) L.I.R.

Par contre, s’il pouvait être établi qu’Holdco paiera le Dividende à Enfant X à même les liquidités provenant de son revenu après impôts tiré de ses placements boursiers, alors ce dividende constituerait un montant exclu quant à Enfant X et ne serait pas inclus dans le calcul de son revenu fractionné.

D’une part, s’il était établi qu’Holdco exploite une entreprise dont le but principal est de tirer des revenus provenant de ses placements boursiers, cette entreprise ne se qualifierait pas d’« entreprise liée » au sens de la définition de cette expression au paragraphe 120.4(1) L.I.R. En effet, il appert de l’énoncé de la présente question qu’aucun particulier source relativement à Enfant X ne respecte le critère de participation ou le critère de détention relativement à Holdco. Par conséquent, le Dividende serait un « montant exclu » quant à Enfant X en vertu du sous-alinéa e)(i) de la définition de cette expression au paragraphe 120.4(1) L.I.R. puisque, bien qu’il puisse provenir de l’entreprise d’Holdco, cette entreprise ne se qualifierait pas à titre d’entreprise liée relativement à Enfant X.

D’autre part, s’il était établi qu’Holdco n’exploite pas une entreprise, alors le Dividende serait également un « montant exclu » quant à Enfant X en vertu du sous-alinéa e)(i) de la définition de cette expression au paragraphe 120.4(1) L.I.R. En effet, une des conditions à respecter à la définition de l’expression « entreprise liée » au paragraphe 120.4(1) L.I.R., est qu’il doit y avoir en premier lieu une entreprise exploitée par une entité. Par conséquent, dans l’hypothèse où Holdco n’exploite pas d’entreprise, le Dividende ne pourrait provenir, directement ou indirectement, d’une entreprise liée relativement à Enfant X, mais proviendrait plutôt des biens détenus par Holdco.

Compte tenu de ce qui précède, Holdco devrait assurer un suivi adéquat des liquidités provenant des placements boursiers afin qu’elle puisse établir que ces liquidités ont servi à payer le Dividende.

Jean Lafrenière
(613) 670-9013
Le 5 octobre 2018
2018-076882

FOOTNOTES

En raison des exigences de nos systèmes, les notes de bas de page contenues dans le document original sont reproduites ci-dessous :

1 Nous tenons pour acquis qu’Enfant X réside au Canada à tout moment pertinent. Enfant X est donc un particulier déterminé au sens de la définition de cette expression au paragraphe 120.4(1) L.I.R.

2 L’expression « particulier source » est définie au paragraphe 120.4(1) L.I.R. et signifie un particulier, autre qu’une fiducie, qui réside au Canada et qui est lié au particulier déterminé.

3 Sous-alinéa a)(ii) de la définition de l’expression « entreprise liée » au paragraphe 120.4(1) L.I.R.

4 Alinéa c) de la définition de l’expression « entreprise liée » au paragraphe 120.4(1) L.I.R.

Summaries

Summary Under

Tax Topics - Income Tax Act - Section 120.4 - Subsection 120.4(1) - Excluded Amount - Paragraph (e) - Subparagraph (e)(i)

dividends derived from stock portfolio of Holdco excluded because stock portfolio not a related business or not a business

Mr. X holds all the voting shares of Opco, a family trust (“Trust”) holds all the participating shares of Opco, and Child X (age 30 and not involved in the Opco business) holds all the voting participating shares of Holdco, which generated $150,000 of passive income in the prior year from stock market investments. Holdco (which along with Mr. and Mrs. X, and Child X, is a Trust beneficiary) also received in the prior year a $100,000 distribution of a dividend that Trust had received from Opco, and now wishes to pay a $75,000 dividend to Child X (the “Dividend”). Would it be possible for Holdco to pay the Dividend on the basis that it was derived from income on the stock market investments rather than from Opco, so as to avoid the split income tax?

After noting that Mr. X was a source individual respecting Child X, assuming that Mr. X satisfied the active engagement condition with respect to Opco’s business, and further finding that if “Holdco will pay the Dividend to Child X out of the funds from the $100,000 dividend received from Opco or from any dividends previously received from Opco, then … the Dividend would thus have come, directly or indirectly, from a related business - that of Opco - in respect of Child X.” so that the Dividend would be added to the split income of Child X, unless it constituted an excluded amount by virtue of another exclusion, CRA then stated:

[I]f it can be determined that Holdco will pay the Dividend to Child X out of its after-tax income from its stock market investments, then that dividend would be an excluded amount for Child X and would not be included in calculating the child’s split income.

…[I]f it were determined that Holdco carries on a business whose primary purpose is to earn income from its stock market investments, that business would not qualify as a "related business" …[as] no source individual in respect of Child X satisfies the active engagement condition or the ownership condition with respect to Holdco. Consequently, the Dividend would be an "excluded amount" in respect of Child X… .

On the other hand, if it were determined that Holdco does not carry on a business, then the Dividend would also be an "excluded amount" in respect of Child X by virtue of subparagraph (e)(i) of the definition … [since] there must be … a business carried on by an entity. …

Based on the foregoing, Holdco must adequately monitor its funds derived from stock market investments in order to determine whether those funds were used to pay the Dividend.

Summary Under

Tax Topics - Income Tax Act - Section 120.4 - Subsection 120.4(1) - Related Business - Paragraph (a) - Subparagraph (a)(i)

stock market investing business of child's holdco not a related business as father not involved

All the voting shares of Opco are held by Mr. X and all its participating shares are held by a family trust (“Trust”). In the prior year, Holdco, which is wholly-owned by Child X (age 35, who is not involved in the Opco business) generated $150,000 of passive income, and also received qua beneficiary a $100,000 distribution of a dividend that Trust had received from Opco. Could Holdco now pay a $75,000 dividend (the “Dividend”) on the basis that it was derived from income on the stock market investments rather than from Opco, so as to avoid the split income tax?

CRA concluded that “Holdco must adequately monitor its funds derived from stock market investments in order to determine whether those funds were used to pay the Dividend.” Split income tax would apply if the Dividend came “out of the funds from the $100,000 dividend received from Opco or from any dividends previously received from Opco.”

On the other hand “if it can be determined that Holdco will pay the Dividend to Child X out of its after-tax income from its stock market investments, then that dividend would be an excluded amount for Child X and would not be included in calculating the child’s split income.” There were two possibilities in this regard. First, the stock portfolio of Holdco might represent an investment “business,” in which case it would not be a “related business” because Mr. X (the father) was not involved in this business. Alternatively, if it was not a business, then it would again follow that it could not be a related business. Thus, either way, the stock portfolio would represent a good source for the Dividend that would not engage the tax on split income.

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5 October 2018 APFF Roundtable Q. 11, 2018-0768821C6 F - Tax on Split Income

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