2018-0745861C6 CALU 2018 Q5 - Excess corporate holdings

Principal Issues: Does subsection 188.1(3.3) apply to a situation where a private foundation will receive the residue of an alter-ego trust following the death of the life interest beneficiary?

Position: General comments provided. Subsection 188.1(3.3) must be considered where a private foundation is a beneficiary under a trust.

Reasons: Whether subsections 188.1(3.3) to (3.5) apply to a particular situation is a mixed question of fact and law.

Author: Naufal, Bob
Section: 188.1(3.3), 149.2

CALU Roundtable – May 2018

Question 5 – Excess corporate holdings regime and life interest trusts

Background:

Under the excess corporate holdings regime of section 149.2, where a private foundation, together with relevant persons, own more than 20% of the issued and outstanding shares of any class of shares of a corporation, (the “excess corporate holdings percentage” (“ECHP”) as defined in subsection 149.1(1)), the private foundation is obligated to divest itself of the excess shares (referred to as the “divestment obligation percentage” (“DOP”) as defined in subsection 149.1(1)).  Failure by a private foundation to meet its DOP results in penalties under subsection 188.1(3.1) and could result in the loss of registered charity status under paragraph 149.1(4)(c).  Pursuant to subsection 149.2(5), a private foundation’s DOP for a taxation year is allocated on the basis of how the excess corporate shares were acquired by the private foundation. 

Under paragraph 149.2(5)(b), where shares are acquired by the private foundation in the taxation year by way of bequest, the ECHP will be allocated to the 5th subsequent tax year after the shares are acquired such that the DOP only occurs in that 5th year.  For example, if the shares were acquired by way of bequest in the tax year ending December 31, 2018, the DOP must be met by December 31, 2023.

The term, “bequest”, is not defined in the Income Tax Act.  Black’s Law Dictionary defines bequest as “the act of giving property by will or property disposed of in a will.”  As such it appears paragraph 149.2(5)(b) will only apply in a situation where the private foundation acquires the shares as a beneficiary under an individual’s will.  For tax and other estate planning reasons, an individual will transfer shares to a so-called life interest trust as a will substitute.  Such trusts generally include an alter-ego trust and a joint spousal and common-law partner trust as defined in subsection 248(1) and spousal trusts as described in subparagraph 73(1.01)(c)(i). Reasons can include the ease of administering the property should the individual become incapable, ensuring confidentiality and privacy, and probate tax savings.  

For example, Mr. A, who is a relevant person in respect of a private foundation, settles his freeze shares of a private corporation in an alter-ego trust on a tax-deferred transfer pursuant to subsection 73(1).  Under the terms of the trust, Mr. A is entitled to all of the income of the trust while he is alive and no other person can receive or obtain the use of any income or capital of the trust while he is alive.  After Mr. A’s death, the terms of the trust provide that the residue of the trust is to be distributed to the private foundation.

Where the conditions in subsection 188.1(3.3) are met at a particular time in a taxation year, subsection 188.1(3.5) applies for the purposes of the excess corporate holdings regime to deem the private foundation (and any relevant person in respect of the private foundation) to hold, at the particular time, a portion of the shares of the corporation owned by the trust based on the fair market value of the foundation’s or relevant person’s interest in the trust as a percentage of the fair market value of all of the property held by the trust.

Question

Given that the alter-ego trust may be considered a will substitute for Mr. A and results in the acquisition of shares by the private foundation in circumstances substantially similar to that which would occur under a will (in that Mr. A has all of the use of the freeze shares while he is alive and the shares are distributed to the private foundation after his death) can the CRA comment on whether the private foundation will be subject to subsection 188.1(3.5) such that it will be treated as owning a portion of the freeze shares? 

CRA Response

The excess corporate holdings regime was introduced for private foundations to limit potential opportunities for persons connected with a foundation to use their own and the foundation's shareholdings for their own benefit. All private foundations are subject to the excess corporate holdings regime in respect of both publicly-listed and unlisted shares. The regime places limits on a private foundation’s share ownership that also takes into account the holdings of any relevant person (defined in subsection 149.1(1) to generally mean a person not dealing at arm's length with the foundation).

Subsections 188.1(3.3) to (3.5) apply for the purposes of subsection 149.1(1) and section 149.2, and generally apply in respect of indirect holdings of shares or certain other interests in a corporation by a private foundation or a relevant person through an interest in a trust. More specifically, subsection 188.1(3.5) deems a private foundation (or, in certain circumstances, a relevant person in respect of the foundation) to own shares that are actually held by a trust, in proportion to the value of the foundation's proportionate interest in the trust, where the following conditions in subsection 188.1(3.3) are met at a particular time in a taxation year:

(a)    at a particular time, the private foundation or relevant person (each of which is referred to as an “insider”) is a beneficiary under a trust;

(b)    at or before the particular time

(i)    the insider acquired an interest in or under the trust, or

(ii)    the trust acquired a property;

(c)    it may reasonably be considered that a purpose of the acquisition described in paragraph (b) was to hold, directly or indirectly, shares of a class of the capital stock of a corporation;

(d)    the shares described in paragraph (c) would, if they were held by the insider, cause the private foundation to have a divestment obligation percentage for the taxation year; and

(e)    at the particular time, the insider holds the interest described in subparagraph (b)(i), or the trust holds the property described in subparagraph (b)(ii), as the case may be.

Whether subsections 188.1(3.3) to (3.5) apply to a particular situation is a mixed question of fact and law that can only be determined following a review of the circumstances and all underlying documentation with respect to the situation. Given the broad nature of these provisions, where a private foundation is a beneficiary under an alter-ego trust, consideration must be given to subsections 188.1(3.3) to (3.5) for the purposes of determining the private foundation’s excess corporate holdings percentage and divestment obligation percentage for a taxation year.

Bob Naufal
2018-074586
May 8, 2018

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