2019-0824401C6 2019 CTF Q7 - TOSI and Inherited Property

Principal Issues: Whether shares are acquired as a consequence of death for purposes of paragraph 120(1.1)(b).

Position: 7(A) No. 7(B) Yes.

Reasons: Consistent with prior positions and rulings.

Author: Chong, Henry
Section: 120(1.1)(b)(ii)

2019 CTF Annual Conference

CRA Roundtable

Question 7: TOSI and Inherited Property

Does subparagraph 120.4(1.1)(b)(ii) apply in two fact scenarios?

Background

Mr. X owns 100,000 voting preference shares of a corporation (“Investco”).

The common shares of Investco are non-voting and are held by a discretionary inter vivos trust (the “Family Trust”). The settlor of the Family Trust is Mr. X. The trustees of the Family Trust are Mr. X and two arm’s length third parties. The beneficiaries of the Family Trust include Ms. X, Ms. Y and Ms. Z. Ms. X is Mr. X’s spouse. Ms. Y and Ms. Z are the children of Mr. X and Ms. X.

The Family Trust acquired its common shares of Investco as a result of an estate freeze.

The terms of the Family Trust include the restrictions described in subsection 74.4(4). But for such restrictions, subsection 74.4(2) would have applied to Mr. X as a result of the freeze.

None of the other attribution rules in sections 74.1 to 74.3 and subsection 75(2) will apply.

Mr. X, Ms. X, Ms. Y and Ms. Z are now all over age 18.

Each of Mr. X, Ms. X, Ms. Y and Ms. Z is a “specified individual.”

Investco’s business is carried on by Mr. X and Ms. Y.  Mr. X and Ms. Y are each a “source individual” and Investco’s business is a “related business” with respect to Mr. X, Ms. X, Ms. Y and Ms. Z.

“Specified individual, “source individual” and “related business” have the meaning assigned by subsection 120.4(1).

Mr. X has worked in Investco’s business on average for more than 20 hours per week a year for more than five years.

In Year 1, Mr. X passes away. Pursuant to the terms of Mr. X’s will, Mr. X leaves one preference share to Ms. Y, one preference share to Ms. Z and 999,998 preference shares to Ms. X.

In Year 2, Investco pays a dividend on its common shares. The Family Trust pays the dividend to Ms. Z in the year and makes a designation in respect of Ms. Z under subsection 104(19). The Family Trust deducts the amount of the dividend from its income under subsection 104(6) and the amount is included in Ms. Z’s income as a dividend received on the Investco common shares under subsections 104(13) and (19).

The amount of the dividend included in Ms. Z’s income will be split income and will be subject to the tax on split income (TOSI) under subsection 120.4(2) unless such amount is an “excluded amount” in respect of Ms. Z.

Under subsection 120.4(1), where an individual has attained the age of 17 years before the year, an “excluded amount” includes an amount derived directly or indirectly from an “excluded business” of the individual.

An “excluded business” of a specified individual is defined under the same subsection and includes a business if the specified individual is actively engaged on a regular, substantial and continuous basis in the activities of the business in any five prior taxation years.

Under paragraph 120.4(1.1)(a), an individual may be deemed to be actively engaged in a business in a taxation year where the individual works at least an average of 20 hours per week during the portion of the year in which the business operates.

Paragraph 120.4(1.1)(b) expands the scope of the deeming rule in paragraph 120.4(1.1)(a) in certain circumstances for inherited property.

Because Mr. X worked on average at least 20 hours per week during the portion of the year the business operates for more than 5 years, Investco’s business is an excluded business of Mr. X.

A.    Would the taxable dividend deemed to be received by Ms. Z be an excluded amount because it is an amount derived directly or indirectly from an “excluded business” of Ms. Z taking into consideration the application of the deeming rule in subparagraph 120.4(1.1)(b)(ii)?

B.    Assume the same facts as Question 7(A), except that Mr. X leaves all of his preference shares to Ms. X and the terms of the Family Trust dictate that, on the death of Mr. X, the trustees of the Family Trust are subject to an absolute obligation and must wind-up and distribute the trust property (i.e. the Investco common shares) equally to Mr. X’s children in satisfaction of their capital interest.

As a result, and pursuant to the terms of the trust, the dividend paid by Investco in Year 2 will be received directly by Ms. Z on the Investco common shares distributed to her on the winding-up of the Family Trust following the death of Mr. X.

Would the CRA consider the acquisition of shares by Ms. Z to be “as a consequence of the death” of Mr. X for the purposes of paragraph 120.4(1.1)(b)?

CRA Response (A)

In general, paragraph 120.4(1.1)(b) provides a continuity rule for inherited property. It applies to amounts that would, absent the application of the provision, be split income of a specified individual who has attained the age of 17 years before the year in respect of property that was acquired by or for the benefit of the specified individual as a consequence of the death of another person.

Subparagraph 120.4(1.1)(b)(ii) provides that for purposes of the definition of excluded business, if a deceased person was actively engaged on a regular, substantial and continuous basis in the activities of a business throughout any five previous taxation years, then the individual is deemed to have been engaged on a regular, substantial and continuous basis throughout those five years.

Where subparagraph 120.4(1.1)(b)(ii) applies, an individual’s income on inherited property will qualify as an “excluded amount” to the extent that an amount, had it been received by the deceased person, would have been from an “excluded business” because the deceased person was actively engaged on a regular, continuous and substantial basis in the activities of the related business in any five previous taxation years.

Based on the facts, the relevant amount for purposes of paragraph 120.4(1.1)(b) is the amount of the taxable dividend deemed to be received by Ms. Z under subsection 104(19) on the common shares of Investco owned by the Family Trust.

If subparagraph 120.4(1.1)(b)(ii) applies, the amount of the taxable dividend deemed to be received by Ms. Z would be an excluded amount from an excluded business of Ms. Z because she would be deemed to have been actively engaged on a regular, substantial and continuous basis in Investco’s business based on Mr. X having worked at least an average of 20 hours per week for a period exceeding 5 years during his lifetime.

In order for subparagraph 120.4(1.1)(b)(ii) to apply to the dividend, however, that amount must, inter alia, be in respect of property that was acquired by or for the benefit of the specified individual as a consequence of the death of another person as required by subparagraph 120.4(1.1)(b)(ii).

In general, whether property is acquired as a consequence of the death of another person is in part a question of fact to be determined based on the circumstances of each case.

Subsection 248(8) includes an extended definition of when property is considered to be acquired as a consequence of death that is not relevant to the circumstances of this question.

Because the dividend is in respect of the common shares of Investco, paragraph 120.4(1.1)(b) would not apply because such shares are owned by the Family Trust and were not acquired by or for the benefit of Ms. Z as a consequence of the death of Mr. X.

As a result, the taxable dividends deemed to be received by Ms. Z on the common shares of Investco will not be an excluded amount by reason of being an amount derived directly or indirectly from an excluded business in respect of Ms. Z.

The taxable dividend may fall within another category of excluded amount. If not, then the taxable dividend will be included in computing Ms. Z’s split income and will be subject to the TOSI.

CRA Response (B)

As discussed, in order for subparagraph 120.4(1.1)(b)(ii) to apply to an amount, the amount must be in respect of property that was acquired by or for the benefit of the specified individual as a consequence of the death of another person as required by paragraph 120.4(1.1)(b).

As well, whether property is acquired as a consequence of the death of another person is in part a question of fact to be determined based on the circumstances of each case.

In this case, the amount of the dividend received by Ms. Z was in respect of the Investco common shares acquired by her by distribution on the winding-up of the inter vivos Family Trust.

In general, we have taken the position that property received from an inter vivos trust, the terms of which require without condition the trust to distribute the property to an individual on the death of another person, can be considered to be property that was acquired as a consequence of the death of the person.

Based on the facts, the Investco common shares received by Ms. Z from the Family Trust under the terms of the trust that require such shares to be distributed to her on the death of Mr. X will be considered in the circumstances to be property that was acquired by her as a consequence of the death of another person (her father) for purposes of paragraph 120.4(1.1)(b).

Accordingly, subparagraph 120.4(1.1)(b)(ii) should apply in the circumstances to the amount of the dividend received by Ms. Z on the Investco common shares for purposes of determining whether such amount was derived directly or indirectly from an excluded business of Ms. Z and will deem Ms. Z to have been actively engaged on a regular, substantial and continuous basis in Investco’s business based on Mr. X having worked at least an average of 20 hours per week a year for a period exceeding 5 years during his lifetime. As a result, Investco’s business will be an excluded business of Ms. Z and the amount of the dividend received on the Investco common shares will be an excluded amount and not subject to TOSI as an amount derived from an excluded business.

A different result would apply, however, where it is reasonable to infer in the circumstances that the terms of the trust were arranged to inappropriately benefit from paragraph 120.4(1.1)(b) and subparagraph 120.4(1.1)(b)(ii) in light of the stated object and purpose of those provisions to provide continuity rules for inherited property, including by reason of the application of the GAAR.

Henry Chong
2019-082440
December 3, 2019

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