Reverse Attribution and LCGE Multiplication Plans Foiled

Mady v. The Queen (2017 TCC 112) involved two issues: (1) an income-splitting plan was foiled because subsection 74.5(11) applied to prevent reverse attribution; and (2) a strategy to multiply the lifetime capital gains exemption (LCGE) was struck down, but on the basis of subsection 69(1) instead of subsection 86(2), which was used by the minister.

With respect to the first issue, shares of the professional corporation were held by a discretionary family trust of which the taxpayer and his spouse were beneficiaries. A change in the regulatory regime in Ontario in 2002 allowed only a licensed dentist to hold voting shares. To achieve income splitting under the new regime, the shares were transferred from the trust to the spouse and then gifted to the taxpayer. Dividends of $660,000 in 2010 and $110,000 in 2011 were paid to the taxpayer but attributed back to his lower-income spouse under section 74.1.

The minister applied subsection 74.5(11)—an anti-avoidance provision that prevents the application of certain attribution rules when one of the main reasons for a transfer was to reduce the amount of tax that would be payable on income derived from the property. Accordingly, the taxpayer was reassessed to include the dividend income reported by his spouse.

At the TCC, the taxpayer argued that the purpose of the transfer of shares by the spouse to the taxpayer should be determined only by the transfer to the taxpayer (to ensure compliance with the profession's regulatory regime), not by looking at the overall series of transfers. Hogan J disagreed and held (on the basis of Lehigh Cement, 2014 FCA 103) that "even in the absence of a 'series of transactions' concept, the entire series of transactions may form part of the relevant circumstances in determining the purpose of the transfer of property." Even if the purpose was to ensure compliance, it does not override the other purpose of triggering section 74.1. The phrase "one of the main purposes" was found to be "unambiguous and implies that a taxpayer may have more than one main motive in acquiring shares" (Groupe Honco, 2013 FCA 128).

It appears that the CRA may arrive at a similar conclusion even if the taxpayer was not a beneficiary of the trust, so that the trust could transfer its shares only to the spouse (CRA document no. 2014-0519661E5, March 24, 2014).

With respect to the second issue, the multiplication of the capital gains exemption involved a pre-closing reorganization in which, after an internal freeze pursuant to section 86, the taxpayer sold shares to his spouse and children for $0.01 per share. The spouse and children immediately sold the same shares to an unrelated third party for $8,600 per share. (This remarkable same-day difference in value appears to be an error in execution of the tax plan.) The capital gains realized by the spouse and children were sheltered by their capital gains exemptions.

The minister applied the indirect gift provision in subsection 86(2), causing the taxpayer to realize a capital gain equal to the value that was purported to have been shifted to the spouse and children. Subsection 86(2) applies when (1) the FMV of the old shares exceeds the combined FMV of the new shares and any non-share consideration and (2) it is reasonable to regard any portion of the difference as a benefit that the taxpayer desired to have conferred on a related person.

Hogan J ruled that subsection 86(2) did not apply, because the taxpayer was the sole shareholder immediately before and after the share exchange; for the subsection to apply, the spouse and the children would have to be shareholders of the corporation either prior to or as a result of the section 86 share exchange. However, subparagraph 69(1)(b)(i) applied to deem the taxpayer's sale of the shares to his spouse and children to have occurred at FMV. The bottom-line outcome was similar to the original result obtained by the minister's reassessment: the taxable capital gains of $4,300 per share were included in the taxpayer's income.

Nancy Lum
D & H Group LLP, Vancouver

Canadian Tax Focus
Volume 7, Number 4, November 2017
©2017, Canadian Tax Foundation