2019-0798461C6 2019 STEP Conference Q16 - Passive Income

Principal Issues: Would the anti-avoidance rule in subsection 125(5.2) apply in a situation where Opco has established a pattern in the past of paying dividends equal to substantially all of its annual income to related but not associated Holdcos?

Position: Question of fact and will depend whether one of the reasons for Opco paying the dividends to the Holdcos can reasonably be considered to be to reduce the amount of the "adjusted aggregate investment income" of the associated group for the purposes of the "passive income reduction" rule in paragraph 125(5.1)(b).

Author: D'Angelo, Sandro
Section: 125(5.1), 125(5.2)

2019 STEP CRA Roundtable – June 7, 2019

QUESTION 16. Small Business Deduction and Passive Income

Effective for taxation years beginning in 2019, the amount that can be claimed under the small business deduction will be reduced if investment income (adjusted aggregate investment income) of the corporation and associated corporations for taxation years ending in the preceding calendar year exceeds $50,000.

An anti-avoidance rule (subsection 125(5.2)) deems corporations which are related but not associated to be associated for the purposes of this rule where it may reasonably be considered that one of the reasons for a loan or transfer was to reduce investment income and increase the amount which can be claimed under the small business deduction.

Assume that a corporation (Opco) is owned by five corporations (Holdco 1 through Holdco 5). All corporations are related to one another but not associated.

Opco has established a pattern in the past of paying dividends equal to substantially all of its annual income. The Holdco’s have built up large amounts of investment funds.

In these circumstances, would CRA generally accept that the anti-avoidance rule in subsection 125(5.2) would not apply if Opco continues its practice of paying annual dividends?

This anti-avoidance provision also specifies that these transfers include transfers via a trust.  There are conceivably numerous situations in which a taxpayer may want to transfer property to a trust or entities controlled by a trust for estate planning reasons unrelated to the SBD.

Can the CRA please provide guidance on how CRA plans to enforce this rule for the large number of transfers to trusts which may result in a dissociation of assets previously held in a corporation and a reduction in AAII?

CRA Response

A corporation’s entitlement to the small business deduction for a particular taxation year is determined by reference, among other things, to the business limit of the corporation for the particular taxation year that is otherwise determined under section 125 of the Income Tax Act.

Subsection 125(5.1) of the Act is amended to provide an additional restriction to a corporation’s business limit based on certain investment income of the corporation and its associated corporations.  The corporation’s business limit will now be reduced by the greater of the reduction provided under the existing rule (the taxable capital reduction), now contained in paragraph 125(5.1)(a), and the new “passive income reduction,” contained in paragraph 125(5.1)(b).

The passive income reduction reduces a corporation’s business limit for a taxation year (as otherwise determined) by five dollars for every dollar by which the corporation’s “adjusted aggregate investment income” (as newly defined in subsection 125(7)), and that of its associated corporations, for taxation years ending in the preceding calendar year exceeds $50,000.

The passive income reduction will apply to taxation years that begin after 2018.  However, the passive income reduction may also apply to a taxation year beginning before 2019 if certain planning is undertaken to defer the application of either the passive income reduction or the amendments to section 129.

Subsection 125(5.2) contains an anti-avoidance rule that applies to a loan or transfer of property between corporations that are related but not associated.

Subsection 125(5.2) operates to deem two corporations associated with each other when they are otherwise not associated.  It applies where the corporations are related to each other, one corporation (directly or indirectly) transfers assets to the other corporation and one of the reasons for the transfer can reasonably be considered to be to reduce the amount of the adjusted aggregate investment income of the associated group for the purposes of the passive income reduction rule in paragraph 125(5.1)(b).

Whether subsection 125(5.2) would apply in any given situation remains a question of fact that can only be made once all the relevant facts of a particular situation are known and have been fully considered.  However, if it may reasonably be considered that one of the reasons that the payment of dividends was made was to reduce the adjusted aggregate investment income as determined in paragraph E of paragraph (5.1)(b) in respect of Opco, or of any corporation with which Opco is associated, then in our view the anti-avoidance rule in subsection 125(5.2) could apply.

When the Canada Revenue Agency detects an aggressive tax plan or a potentially abusive transaction, it will consider whether a technical provision and/or a specific anti-avoidance provision in the Act can be applied. The determination of any specific audit approach is dependent on the specific facts and circumstances of each situation.

Sandro D’Angelo
2019-079846

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