3520-6: last updated on October 16, 2019 1 Lecture 6: Non-Arm’s Length Transactions, Departure from Canada and Death of a Taxpayer 1.1 Recommended Exercises and Self-study Problems ▪ ▪ 2 Exercises 9-8, 9-9, 9-10, 9-11, 9-12, 8-15, 8-16, 9-14, 9-15, 9-16, 9-17, 11-10 Self-study problems 9-7, 9-8, 9-9, 9-10, 9-11 (ignore the part about farm land) Non-Arm's Length Transfers [CTP 9-142 to 9-172] ▪ The non-arm’s length transaction rules determine the deemed proceeds of disposition and adjusted cost base (ACB) for gifts and transfers to non-arm's length persons. This is relevant for determining: (a) the capital gain at the time of the transfer and (b) the future capital gain to the new owner of the property (when he/she sells the property) ▪ Rules apply to transfers (gifts or sales) when the transfer is between persons (individuals, corporations, etc.) who are not at “arm’s length” ▪ ▪ ITA 251(1): Related persons are deemed to not deal with each other at arm's length ▪ ▪ see example at 9-168 for a theoretical tax avoidance opportunity in non-arm’s length transfers It is a question of fact whether others deal at arm's length Related = connected by blood, marriage, common-law partnership or adoption ▪ Connected by blood ▪ = child, parent, grandparent (and great-grandparent, great-great grandparent, etc.) ▪ = brother, sister ▪ = horizontal or vertical relationship on family tree ▪ ▪ Related by marriage ▪ 2.1 2.2 But not aunts, uncles, nieces, nephews, cousins = spouse and in-laws • e.g. mother-in-law, daughter-in-law, sister (or brother)-in-law Inadequate Consideration [ITA 69] ▪ All gifts are deemed dispositions at FMV (even gifts to arm’s length persons) except for gifts to spouses [ITA 69 and 73(1)] ▪ See Figure 9-2 Sales to non-arm's length persons ▪ Sales to non-arm’s length persons should take place at FMV except for transfers to spouses because the one-sided adjustment in ITA 69 is intentionally harsh ▪ If the sales price is > FMV, the purchaser's ACB is deemed to be FMV ▪ If the sales price is < FMV, the seller's proceeds of disposition is deemed to be FMV ▪ Sales price too low (< FMV) is the more common situation This edition of the notes was updated by Priya Shah [email@example.com]. 3520-6: last updated on October 16, 2019 ▪ 2.3 2.4 Read 9-154 carefully ▪ A gift or sale to a spouse automatically occurs at tax cost (ACB for capital property, UCC for depreciable property) [ITA 73(1)] ▪ However, if the transferor makes an election not to have ITA 73 apply, ITA 69 and the above rules apply (i.e., the disposition will occur at FMV). These rules for spouses apply to spousal trusts and common-law partners Attribution Rules [9-187 to 9-201] ▪ The income attribution rules can determine the tax on the future income and capital gains earned by the new owner of the property. Special rules apply when (a) a property is loaned or transferred to a spouse or minor child (child under 18) or minor niece or nephew [ITA 74.1 (income) and 74.2 (capital gains)]; (b) a property is loaned to another non-arm’s length person (e.g., a 30 year old child, an 84 year old parent) and one of the main purposes of the loan was to reduce the income of the lender [ITA 56(4.1)] ▪ The attribution rules move the income (and capital gains in the case of a spouse) from the family member’s tax return to the lender/transferor’s tax return ▪ If a loan or transfer is to a spouse, any income or capital gains earned by the spouse is taxed in the lender/transferor's hands [ITA 74.1 (1) and 74.2(1)] ▪ If a loan or transfer is to a minor child (or minor niece or nephew), only the income earned by the minor (not capital gains) is taxed in the lender/transferor's hands [ITA 74.1(2)] Tax on Split Income (“TOSI”) [11-110 to 11-147] ▪ The 1999 Federal Budget introduced “tax on split income” (TOSI) measures (which were commonly referred to as the “kiddie tax”), the purpose of which was to prevent the shifting of certain types of income to minors for tax advantage. ▪ In 2017, new TOSI legislation was introduced aimed at preventing a shift of income that would otherwise be realized by a high-tax rate individual to lower-tax rate family members: ▪ ▪ Changes are intended to extend the “kiddie tax” rules to adult children, spouses and other family members where certain types of income are allocated to family members not ‘involved’ in earning the income The new TOSI rules became effective January 1, 2018 ▪ Split Income is taxed at the top rate. The only credits available against the resulting tax payable is the dividend tax credit, foreign tax credits that relate to the amount included in split income, and the disability tax credit ▪ Most common encountered types of split income ▪ ▪ ▪ ▪ Dividends from private companies Shareholder benefits on loans received from a private company Interest received on debt issues by a private corporation Capital gains on the disposition of private company shares This edition of the notes was updated by Priya Shah [firstname.lastname@example.org]. 3520-6: last updated on October 16, 2019 ▪ ▪ Note: There could be other instances of split income involving private corporations, trusts, or partnerships, so a tax expert should be consulted Note that there are various exceptions to the general TOSI rules, which may exempt/exclude certain payments from TOSI (depending on the age of the individual): ▪ Individuals under 25: ▪ Income or taxable capital gains from a property that is acquired as a result of: ▪ The death of a parent; or ▪ The death of any person as long as the individual is either a full-time student at a post-secondary institution or eligible for the disability tax credit ▪ Individuals 18 and older: ▪ Amounts received from an excluded business (a business there the individual is actively engaged regularly, continuously, and substantially) See CTP 11-135 for more details ▪ Individuals 25 and older: ▪ Amounts received from excluded shares ▪ Excluded shares: taxpayer must own at least 10% of the outstanding shares of the corporation and: • The corporation must not be a professional corporation; • Less than 90% of the corporation’s income from the previous year is from the provision of services; and • Less than 10% of the corporation’s income from the previous year is from a related business ▪ If the amount received represents reasonable return, it is not split income ▪ Must factor in labour contributions, the assumption of business risk, and capital contributions ▪ Individuals aged 18 to 24: ▪ Amount received represents Safe Harbour Capital Return return on property contributed by the individual, provided that the return does not exceed a prescribed capital return ▪ If the amount received represents reasonable return, it is not split income ▪ Only factor in capital contributions (more restricted than reasonableness test for those over the age of 25) ▪ ▪ ▪ Individuals of any age: ▪ Capital gains on qualified property (eligible for the lifetime capital gains deduction) ▪ Property acquired through marriage breakdown ▪ See CTP 11-140 Salary payments are not caught by TOSI but continue to be subject to the existing “reasonableness” test The new TOSI rules are highly complex. A detailed review of these rules is beyond the scope of this course This edition of the notes was updated by Priya Shah [email@example.com]. 3520-6: last updated on October 16, 2019 2.5 Avoiding Income Attribution [9-202 to 9-205] ▪ ▪ ▪ ▪ ▪ 2.6 There is no attribution when: ▪ ITA 74.5(1)(a): the spouse, child, or minor niece or nephew pays, from his/her own resources, consideration equal to the fair market value of the asset transferred ▪ ITA 74.5(1)(b): money is borrowed and interest is charged equal to (or more than) the prescribed interest rate. The interest must be paid in the year (or within 30 days after yearend) ▪ ITA 74.5(1)(c): in spousal transfers income attribution rules apply without regard to consideration provided by the transferee unless the spouse elects out of ITA 73(1) Read 9-202 and 9-203 carefully Read example about Mrs. Blaine in 9-204 Read 9-205 for reinvestment of proceeds Remember that when TOSI applies, the attribution rules will not apply. TOSI taxes the income at the top personal tax rates, so if TOSI applies there is no need for the attribution rules to apply Attribution Anti-Avoidance Provisions and Tax Planning [9-206 to 9-212] ▪ ▪ ▪ Read 9-211, especially on ITA 74.1(3), ITA 74.5(6), ITA 74.5(7) Read 9-212 Read 9-206 to 9-209 on giving adult children cash gifts and making interest-free loans to adult children ▪ If a loan or transfer is to a non-arm's length major (a “major” is someone who is not a minor) who is not a spouse, the attribution rules apply only to loans if one of the main purposes of the loan is: (a) to reduce tax; and (b) to income split [ITA 56(4.1)] ▪ ITA 56(4.2) exempts a loan to a “major” from ITA 56(4.1) if the interest rate charged is the prescribed rate ▪ 3 This interest must be paid in the year or within 30 days after the end of the year Departure from Canada (Departure Tax) [8-132 to 8-133] ▪ ▪ ▪ If you have ceased to be a resident of Canada, you have a deemed disposition at FMV of all your property except for Canadian real estate and RRSPs and pensions (and a few other less common exceptions) [ITA 128.1] For most Canadian residents, this means that they will have to report deemed dispositions (and hence capital gains or capital losses) on their shares and other investments (e.g., mutual funds, rental properties) The good news, however, is that the tax on these deemed capital gains is not due until property is actually sold as long as acceptable security is provided to the government (and no interest is charged on the (postponed) unpaid tax) This edition of the notes was updated by Priya Shah [firstname.lastname@example.org]. 3520-6: last updated on October 16, 2019 ▪ ▪ Taxpayers leaving the country and ceasing to be a resident of Canada must also file a list of properties owned at the time of departure with their tax return so that the CRA can verify that all deemed capital gains have been reported Five-year rule [ITA 128.1(4)(b)(iv)] ▪ If you have been resident in Canada less than 60 months in the last 10 years, then the deemed disposition rules will not apply to any property brought to Canada ▪ ▪ 4 This rule was designed to facilitate short-term executive transfers to Canada When you become a resident of Canada, the cost of each of your capital properties (other than taxable Canadian property) for Canadian tax purposes is deemed to = FMV at the immigration date (the purpose of this rule to ensure that only capital gains accrued while being a resident of Canada are subject to Canadian tax) Death of a Taxpayer [9-177 to 9-185 and 11-50 to 11-54] ▪ ▪ ▪ ▪ ▪ The Deemed Disposition rules on Emigration and Death determine the capital gains on emigration [ITA 128.1] and death [ITA 70]. The rules for gifts or bequests on death [ITA 70) are virtually identical to the rules for gifts during lifetime [ITA 69] There is a deemed disposition of all capital property for proceeds equal to FMV immediately before death and the recipient gets the property with a cost equal to FMV [ITA 70(5)] ITA 70(6) provides for an automatic exemption to these rules for property transferred to a spouse (or spousal trust or a common-law partner) ▪ There is a tax-free rollover for these spousal transfers ▪ The deemed disposition takes place at ACB or UCC ITA 70(6.2) allows the executor (i.e., the person who handles the financial and other matters of the deceased person) to elect out of a spousal rollover on an asset by asset basis, if they want to trigger a capital gain ▪ The deemed disposition at FMV rules would then apply ▪ Why elect out of the spousal rollover? ▪ To utilize a taxpayer's unused $866,912 lifetime capital gains deduction on death Allowable Capital Losses and Net Capital losses ▪ ITA 111(2) allows these losses to be applied against any type of income in the year of death or the immediately preceding year. Recall: capital losses can typically only be used to offset capital gains. ▪ ITA 164(6) allows capital losses realized in the first year of the estate to be carried back to the year of death (but not the immediately preceding year) This edition of the notes was updated by Priya Shah [email@example.com]. 3520-6: last updated on October 16, 2019 Review Problem: 1. Income Attribution Sandra Bolt is 49 years of age and is married to Tod Bolt. They have two children. On December 31, 2019, her son, Dirk, is 20 years old and her daughter, Dolly, is 15 years old. Each of the children earns about $10,000 per year in income from part time jobs. While her husband Tod qualified as a professional accountant, he did not enjoy the work and, for the last ten years, he has assumed the role of house parent. As a consequence, his only current source of income is the interest on $335,000 that he has in his personal savings account. This interest amounts to about $20,000 per year and all of the savings were accumulated from amounts that he earned while working as a professional accountant. On December 28, 2019, Sandra is holding shares in a Canadian public company that have an adjusted cost base of $185,000 and a fair market value of $225,000. She is considering transferring these shares to either her husband or to one of her two children. She seeks your advice as to the tax consequences, both to herself and to the transferee, which would result from such a transfer. During your discussions, Sandra has indicated the following: The transfer will take place on December 31, 2019. Any proceeds she receives from her family on the share transfer will not be invested in income producing assets. She wishes you to assume that the securities would pay eligible dividends during 2020 of $18,500 and that the transferee would sell the securities on January 1, 2021 for $260,000. The gross up on the eligible dividends would be $7,030 [(38%)($18,500)], resulting in a taxable amount of $25,530 ($18,500 + $7,030). The federal dividend tax credit would be $3,835 [(6/11)($7,030)] Required: Each of the following independent Cases involves a transfer by Sandra to a member of her family. Indicate, for both Sandra and the transferee, the 2019, 2020, and 2021 tax effects of: the transfer on December 31, 2019, the assumed 2020 receipt of the dividends, and the assumed 2021 disposition by the transferee. *Note that some of the Cases have been included to illustrate specific provisions of the relevant legislation and do not necessarily represent a reasonable course of action on the part of Sandra. Case A Sandra gives the securities to her husband and does not elect out of the provisions of ITA 73(1). Case B Sandra’s husband uses money from his savings account to purchase the securities for their fair market value of $225,000. Sandra does not elect out of the provisions of ITA 73(1). Case C Sandra’s husband uses money from his savings account to purchase the securities for their fair market value of $225,000. Sandra elects out of the provisions of ITA 73(1). This edition of the notes was updated by Priya Shah [firstname.lastname@example.org]. 3520-6: last updated on October 16, 2019 Case D Sandra’s husband uses money from his savings account to purchase the securities for $140,000. Sandra does not elect out of the provisions of ITA 73(1). Case E Sandra’s husband uses money from his savings account to purchase the securities for $140,000. Sandra elects out of the provisions of ITA 73(1). Case F Sandra gives the securities to her daughter, Dolly. Case G Sandra gives her daughter, Dolly, a $225,000 loan. The loan requires interest to be paid at commercial rates and Dolly uses the proceeds of the loan to purchase her mother’s securities at fair market value. Sandra believes that the combination of dividends on the securities and Dolly’s income from part time jobs will be sufficient to pay the interest on the loan. Case H Sandra gives her son, Dirk, a $225,000 interest free loan. Dirk uses the proceeds to purchase his mother’s securities at their fair market value of $225,000. Solution Case A 2019 o o 2020 o o 2021 o deemed disposition at adjusted cost base of $185,000 Therefore no capital gain for Sandra and ACB of the securities to Tod would be $185,000. $25,530 taxable dividend attributed back to Sandra She would also claim the related dividend tax credit Capital gain of $37,500 [(1/2)($260,000-$185,000)] is attributed back to Sandra Case B Without electing out of ITA 73(1), the transfer still takes place at ACB and the results are the same as in Case A. Case C 2019 o Transfer recorded as a disposition at FMV o Capital gain for Sandra of $20,000 [(1/2)($225,000-$185,000)] o ACB to Tod is $225,000 There would be no attribution for the dividends in 2020 or taxable capital gain in 2021. Tod would report the income Case D Without electing out of ITA 73(1), the transfer still takes place at ACB and the results are the same as in Case A. This edition of the notes was updated by Priya Shah [email@example.com]. 3520-6: last updated on October 20, 2018 Case E 2019 o o o 2020 o o 2021 o Case F 2019 o o 2020 o o 2021 o o Case G 2019 o 2020 o o 2021 o Sandra elected out of 73(1) and paid consideration that is less than FMV ITA 69(1) is applicable proceeds are deemed to be the FMV amount Sandra would record a taxable capital gain of $20,000 [(1/2)($225,000-$185,000)] Since the transfer was at less than FMV, the attribution rules apply Taxable dividends of $25,530 included in Sandra’s net income for tax purposes and she would claim the related dividend tax credit Tod’s ACB is $140,000, so the taxable capital gain is $60,000 [(1/2)($260,000$140,000)] and it would be attributed back to Sandra 69(1) non-arm’s length gift is deemed to be at disposition and acquisition at FMV Therefore Sandra has a taxable gain of $20,000 [(1/2)($225,000-$185,000)] Gift was to a minor, therefore attribution rules apply Divided of $25,530 is attributed back to Sandra. Sandra would also claim the related dividend tax credit In the case of a transfer to a minor, attribution rules do not apply to capital gains Therefore Dolly would include the taxable capital gain of $17,500 [(1/2)($260,000$225,000)] in her net income for tax purposes Transfer at FMV; Sandra has a taxable gain of $20,000 [(1/2)($225,000-$185,000)] Since transfer was at FMV and the related loan requires interest at commercial rates, attribution does not apply Dolly will include taxable dividends of $25,530 in her net income for tax purposes and she will claim the related dividend tax credit Dolly will include the taxable capital gain of $17,500 [(1/2)($260,000-$225,000)] in her net income for tax purposes This edition of the notes was updated by Priya Shah [firstname.lastname@example.org]. 3520-6: last updated on October 20, 2018 Case H 2019 o 2020 o o 2021 o Transfer at FMV Sandra has taxable capital gain of $20,000 Although Dirk is not a minor, ITA 54(4.1) says attribution applies where an interest free or low interest loan has been given to a non-arm’s length individual, and one of the main purposes of the loan is to avoid overall taxes Therefore the dividend of $25,530 is attributed back to Sandra and she would claim the related dividend tax credit Taxable capital gain of $17,500 [(1/2)($260,000-$225,000)] is not attributed back to Sandra and is included in Dirk’s net income for tax purposes. This edition of the notes was updated by Priya Shah [email@example.com].