Corporate Attribution: What it is and How to Avoid it
Income splitting has become a very popular technique used by many individuals for effective income tax planning. The concept is simple: shift the income from one family member who is subject to a high rate of tax to another family member who is subject to a lower rate of tax. The end result is overall reduced taxes. But, though the concept may be simple, the strategies to implement income splitting can be extremely complex. The decision of the Supreme Court of Canada in the case of n B. Lipson, Earl Lipson v. The Queen on January 8, 2009 is a prime example of a complex income splitting strategy that was successfully challenged by the CRA. You can read more about this case in the winter 2009 issue of Tax Alert.
The Income Tax Act does permit certain income splitting arrangements, but there are still many arrangements that are considered improper and subject to the attribution rules, which are designed to reduce or eliminate the income splitting benefit.
Section 74.4 of the Act contains an attribution rule commonly referred to as "corporate attribution." Corporate attribution applies when an individual tries to split income with family members by transferring or lending property to a corporation in order to benefit those specific family members while reducing the transferor's income. Consider this example: John has $500,000 of investments producing $25,000 of additional income that will be taxed at the high marginal tax rate due to John's current salary level. If John sets up a company with his family members (spouse and minor children) as shareholders, and then transfers the $500,000 of investments to the company in an attempt to divert this income to his family members indirectly through the company, corporate attribution would apply.
Corporate attribution effectively reduces or eliminates the income splitting benefit by attaching a deemed interest rate to the consideration received on the transfer, thereby requiring the transferor to include into income a deemed taxable benefit. This taxable benefit is punitive because it results in taxable income to the transferor with no corresponding deduction to the company. Nor does it improve the transferor's ability to increase his or her shareholder's loan.
Corporate attribution applies if the following two conditions are present
property was transferred or loaned to a corporation, and
- the main purpose of the transfer or loan may reasonably be considered to reduce the income of the transferor and to benefit a designated person (spouse or minor child under 18 years of age).
The two conditions above are usually key ingredients in most income splitting strategies. Consequently, corporate attribution occurs frequently with many reorganizations and transactions, and it can catch the unwary taxpayer.
Common corporate attribution situations
Corporate attribution applies in some of the most common corporate reorganizations, such as:
Estate freezes - An individual freezes the value of the company into fixed value preferred shares, thus allowing his or her spouse or minor children to own common shares directly or indirectly through a family trust. In either situation, an exchange of shares is considered to be a transfer of property to the corporation.
Creditor protection - A corporation operating a business that has certain elements of risk may consider a creditor protection corporate reorganization. This would involve setting up a holding company and transferring the corporation's redundant assets or retained earnings to the holding company. Corporate attribution might apply if the shareholders of the holding company are "designated persons." A designated person is defined as a person who is the spouse or common-law partner of the individual or a person who is under 18 years of age and who does not deal at arm's length with the individual or is the niece or nephew of the individual.
Income Splitting - Corporations that only have one shareholder will usually freeze the value of the company in order to introduce family members as shareholders for the purpose of sharing dividends to reduce personal income taxes. This reorganization is usually carried out in the same manner as the estate freeze above, which may lead to corporate attribution if the family members are designated persons.
Bonuses and dividends - Bonuses and dividends occur not as part of a reorganization, but as a normal part of a profitable business. One would not think that a normal bonus or dividend could result in corporate attribution because there is no property being transferred to the corporation. But consider this common scenario: a bonus or dividend is declared, appropriate withholding taxes are paid, and a journal entry is posted to the individual shareholder's account to record his or her entitlement to the cash. The journal entry to post the bonus or dividend is simply the shortcut approach to actually providing the shareholder with the money, and the shareholder loaning it back to the company. In this situation, corporate attribution may apply because the loan is considered a transfer of property to a corporation.
Corporate attribution tips
Clearly, there are some common situations that can result in the application of corporate attribution. How can the impact of corporate attribution be minimized or avoided? Here are some tips:
Do not transfer or loan property. In an estate freeze of a company, consider a stock dividend instead. A stock dividend is not considered a transfer of property and is thus not subject to corporate attribution.
If a transfer or loan of property is required, ensure that it is not made for the main purpose of reducing the individual's income and/or benefiting a designated person. Consider the example where two spouses hold equal interests in a company, and they equally exchange their shares for fixed value preferred shares to accomplish an estate freeze in favor of their adult children. Each spouse would be considered a designated person but, since they have equal interests in the company, we can conclude that neither spouse is attempting to reduce his or her income to benefit the other.
If a transfer or loan is required and one of the main purposes of the transfer or loan is to reduce the income of the individual, ensure that a designated person is not involved in the transaction. Consider a spouse who is the sole shareholder of a holding company, and exchanges her common shares for preferred shares to affect an estate freeze. As long as the transaction does not include a designated person (spouse, minor children or minor nieces or nephews), corporate attribution would not apply.
It is easy to write about what not to do in a reorganization to ensure that corporate attribution does not apply, but actually implementing a reorganization is not always that easy. Sometimes, the objectives to be accomplished do not permit the avoidance of corporate attribution. In such cases, there are two exemptions that can be applied to avoid or minimize the deemed interest benefit that will result from corporate attribution. They are:
maintaining the small business corporation (SBC) status; and
paying out the prescribed rate on the consideration received for the transferred or lent property.
Maintaining the SBC status when corporate attribution applies is particularly important. This status requires the corporation to be a Canadian Controlled Private Corporation where 90% of the fair market value of the assets is used in an active business carried on primarily in Canada. As long as the corporation remains an SBC, corporate attribution will not apply. The SBC status is a "point in time" test; if at any point in time the company temporarily losses its status, corporate attribution will apply for that time period. Therefore, the corporation should monitor on a continuous basis to ensure that the SBC status continues to apply. There are many situations that can arise to cause a company to go offside on its SBC status, including, among others, retaining cash to pay a bonus, investing in non-active assets, and operating a profitable foreign branch or subsidiary. If corporate attribution applies, and the company cannot maintain its SBC status, the company may pay a rate of return on the consideration received for the transferred property. If property was transferred to the company in exchange for a note payable or share capital, interest could be paid on the note or dividends could be paid on the shares. The amount paid to the transferor will reduce the deemed benefit, with the entire benefit being eliminated when the amount paid equals the calculated benefit amount.
As you can see, corporate attribution can apply in many situations, reducing the effectiveness of your income splitting strategies. Seek the professional advice of your Collins Barrow advisor before implementing any reorganization to ensure that you have properly considered the application of corporate attribution.
John Oakey is a Tax Partner in the Halifax office of Collins Barrow.
Information is current to April 14, 2009. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.