The new income splitting rules are causing many tax practitioners to re-examine even the most basic tax planning structures. For instance, taxpayers for many years have been able to effectively income split with family members through the use of prescribed-rate loans to a family trust. But does this type of planning still work?
A typical structure would involve creating a trust in favour of an individual’s spouse and minor children. The person (“Principal”) would normally be one of the trustees in order to maintain some control over the trust assets. The Principal would then loan funds to the trust at the prescribed rate of interest thereby ensuring that the income generated on the loaned funds would not be attributed back to the Principal each year. The trust would invest these loaned funds into arm’s length investments. Finally, the trust would pay and allocate the income generated each year to the spouse and/or children to be taxed at their lower marginal tax rates. The trustee would then ensure that the interest on the loan is paid to the Principal during the year or within 30 days following the year-end to avoid the attribution rules.
New paragraph (c) of the definition of “split income” under 120.4(1) is generally relevant for trust distributions and may now catch the distributions described in the scenario above. This would result in the income paid and allocated out to the spouse and/or children to potentially be taxed at the highest marginal rate. (In fact, paragraph (c) may even have caught such transactions involving minor children as far back as 2014).
Paragraph (c) will generally apply where two criteria are met. The first criterion is that the trust distribution is not otherwise a taxable dividend or shareholder benefit from shares that are not traded on a designated stock exchange (“Public Shares”) or taxable dividends from shares that are not of a mutual fund corporation (“MF Shares”).
In general terms, the second criterion is that the trust distributions to an individual must reasonably be considered to be, or to be from, one of four underlying sources:
- taxable dividends received in respect of shares of a corporation (other than Public Shares or MF Shares);
- a shareholder benefit in respect of the ownership by any person of shares of a corporation (other than Public Shares);
- income derived directly or indirectly from one or more related businesses in respect of the individual for the year; or
- certain income derived from the rental of property.
A “related business” in respect of an individual under the new rules generally includes a business carried on by a trust if a related individual (resident in Canada) in respect of the individual at any time in the year is actively engaged on a regular basis in the activities of the trust related to earning income from the business.
Thus, it appears that trust distributions may be split income where they are income derived directly or indirectly from a related business in respect of the individual receiving the distribution.
Moreover, there appear to be two elements to this test. First, the trust must be carrying on a business. Second, a person related to the trust beneficiary must be actively engaged on a regular basis in the activities of the trust related to earning income from the business.
Trust Carrying on a Business
A “business” under the Act is defined very broadly to include an “undertaking of any kind whatever” (248(1) “business” ITA). Moreover, there is a long history of jurisprudence on this point, and the vast majority tends to afford a very low threshold for business activity. In fact, some cases even suggest that any activity engaged in by a corporation with a view to profit can be characterized as a business. (For a good summary of the relevant jurisprudence, see Allan Lanthier, “Business or Property Income” (2015) 23:4 Canadian Tax Highlights 5-6).
For instance, in one SCC decision, the taxpayer was found to be engaged in a business simply by investing excess funds in commercial paper (Canadian Marconi Co. v. R.,  2 CTC 465).
In a more modern FCA case, the court cited approvingly the decision above and appeared to accept the notion derived from the jurisprudence that there was very little a corporation might do that would not comprise the carrying on of an active business (Weaver v. R., 2008 FCA 238 at para. 19). This case has been cited approvingly more recently as well (Ollenberger v. R., 2013 FCA 74 at para. 28; 0742443 B.C. Ltd. v. R., 2014 TCC 301 at para. 15).
The CRA has also provided its interpretation of “business” under 84(2). Under that provision, a deemed dividend may result where a corporation distributes amounts to its shareholders upon the “winding-up, discontinuance, or reorganization of its business.” In such a case, the CRA appears to have taken the position that the purpose and context of 84(2) suggest that a broad interpretation of “business” is warranted. Moreover, the CRA acknowledges that this is in accordance with the broad definition of “business” under 248(1) (i.e., an “undertaking of any kind”). The CRA also cites Marconi approvingly and notes that the definition of “specified investment business” in 125(7) contemplates that a business can include an undertaking to derive income from property (2012-0445341C6).
Although the above jurisprudence and CRA position almost exclusively deal with the case of a corporation, it is nevertheless suggestive that the threshold for what constitutes a business in general may be extremely low. Therefore, it is an open question as to whether the investment by a trust in arm’s length passive investments can be caught by this low threshold for “business”.
Actively Engaged on a Regular Basis
The phrase “actively engaged on a regular basis” is not defined under the Act. However, the CRA has stated that the phrase under the old income splitting rules should be interpreted in light of the use of the phrase “actively engaged on a regular and continuous basis” used in other parts of the Act. In particular, the CRA highlights the use of the phrase in the context of several provisions related to farming and the definition of “specified member” of a partnership in 248(1) (2015-0595521C6).
With respect to the farming provisions, the CRA has stated that it will consider a person to be “actively engaged” in a business where the person is involved in the management and/or day to day activities of the business. Moreover, the person would be expected to contribute time, labour and attention to the business to a sufficient extent that such contributions would be determinant in the successful operations of the business. In addition, the CRA has stated that it will not consider an activity to be engaged in on a “regular and continuous basis” where the activity is infrequent or frequent at irregular intervals (See IT-349R3 at para. 16, IT-268R4 at para. 27 and 2003-0024401E5).
Finally, the CRA underscored that whether a person is “actively engaged on a regular basis” in a business is a question of fact. Moreover, for this reason, the CRA could not confirm that a person would avoid the provision where the administration of the business was given to an arm’s length party. However, the CRA did confirm that the provision could be avoided (and split income avoided) where the person takes no part in the activities of the business (2015-0595521C6).
Thus, if the trust is considered to be operating a business, and the Principal (or anyone related to the trust beneficiaries and resident in Canada) is participating in any way in the investment decisions of the trust, there appears to be a risk that the trust distributions may be considered split income.
Exception for Investment in Public Shares or MF Shares
Under (A) of the second criterion of paragraph (c) above, the income from investments in Public Shares or in MF Shares is explicitly carved out from split income. However, this carve out would be meaningless if the return on such investments would also be considered income to the trust from a related business in respect of the individual and therefore split income under (C).
It is a fundamental principle of statutory interpretation that one provision should not be interpreted in such a manner as to render another provision inoperative (Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 SCC 20; Randy S. Morphy, “The Modern Approach to Statutory Interpretation” (2013) 61:2 Canadian Tax Journal 367-385 at p. 10).
Thus, it may be reasonable to take the position that having the trust only invest in Public Shares or MF Shares would avoid the necessity to analyze whether the trust is carrying on a business and someone related to a beneficiary is actively engaged in that business.
If the trust is not investing in Public Shares or MF Shares, it may be prudent for the trust document to make clear that certain trustees should have no part in the administration or decision making with respect to the investing activities of the trust. These would be any trustees who are related to a beneficiary and resident in Canada. If this is not an option such as if the trust is already in existence, one alternative solution may be to have such trustees resign and not participate in future investment decisions of the trust.
Text initially published on the Canadian Tax Foundation website
- Canadian Tax Foundation
- Volume 18, number 2, April 2018
- ©2018, Canadian Tax Foundation