Discretionary shares are a popular income-splitting tool for professional corporations and owner-managed corporations. They have gained popularity since the Neuman decision from the Supreme Court of Canada in 1998 (Melville Neuman v. Her Majesty the Queen). Not surprisingly, the Canada Revenue Agency (CRA) is still looking for ways to attack the use of discretionary shares.
Overview
Discretionary shares allow the directors of a corporation to pay a dividend on the shares at a different rate or to the exclusion of other shares outstanding in the corporation. The directors can then pay dividends to select shareholders, which is beneficial for income splitting. In contrast, dividends paid on non-discretionary shares are split based on the percentage ownership of the class of shares.
Discretionary shares typically are issued for a nominal amount (e.g. one dollar), and can be repurchased by the corporation at any time for that amount plus any declared but unpaid dividends. The shares generally do not appreciate in value. The shares are set up at incorporation or as part of a share reorganization of the company, a fact that supports the nominal value. Each shareholder is given a separate class of discretionary shares so that dividends can be paid to different shareholders in different amounts if necessary.
The low value of the shares makes it easier for a family member to buy into the corporation, and for that family member to be bought out later.
The main benefit of using discretionary shares is to split income with adult family members. For example, if an Ontario business owner was the sole shareholder of his company and needed $40,000 as an ineligible dividend for his daughter’s post-secondary education, he would pay approximately $13,800 in personal taxes (2012 top rate in Ontario). If he restructured his company to provide his daughter with a separate class of discretionary shares, his daughter would pay the Ontario Health Premium of approximately $600 and less than $100 in personal taxes on this dividend. The use of discretionary shares would result in tax savings of just under $13,200 per year.
Discretionary shares can also be used for asset protection where surplus funds can be moved to a related holding company and protected from the operating company’s creditors. This structure is also useful in ensuring the shares of the corporation qualify for the capital gains exemption, as it removes surplus assets (e.g. investments) out of the operating company.
How is the CRA attacking discretionary shares?
The tax savings from using discretionary shares can be large, so it is no surprise that the CRA has tried to find ways to limit their use. After losing in the Neuman case, the CRA introduced the "kiddie tax" rules, which taxed dividends to minor children at the top tax rate, thereby eliminating the income-splitting benefit. However, these "kiddie tax" rules do not apply to adult children or spouses so the use of discretionary shares continued to grow.
A more recent case in 2006 (Patrice Demers v. Her Majesty the Queen) involving discretionary shares was won by the CRA on the basis that the discretionary shares were not properly issued and the transactions involving the use of the dividends were a sham. The father in the case could not prove that the shares were issued for consideration. Further, the dividends paid on the daughter’s shares were paid directly to the father’s account, and he was unable to prove that the funds were used for the daughter’s benefit.
The valuation of discretionary shares at the time of issue is another way the CRA is trying to attack these shares. In response to a question posed at a 2012 tax conference, the CRA stated that, if the shares were issued at less than fair market value, the CRA may assess a shareholder benefit to the holder of the discretionary shares. This response suggests that the shares are worth more than the nominal issued value because they are going to receive substantial dividends in future years. This position is subject to debate if the shares are issued upon incorporation or as part of an estate freeze. It may take another court case to determine the issue for certain.
The CRA is also hinting that it may apply the General Anti-Avoidance Rules (GAAR) to discretionary shares, depending on the situation. The CRA has not yet provided details on how they would do this. Income splitting is permitted for spouses and adult children if done properly, so it is difficult to see at this point how discretionary shares "avoid" any parts of the Income Tax Act.
Reduce the likelihood of an attack by the CRA
The best way to reduce the likelihood of a CRA attack on discretionary shares is to structure the transaction properly and ensure the shares are issued properly. When issuing discretionary shares in an existing company, it is recommended that an estate freeze be completed prior to the issue of new shares. The estate freeze transfers all the existing value in the company to the existing shareholders who own the "freeze" shares. The company can then issue the discretionary shares for a nominal amount, with a strong argument that this is an appropriate value at this point in time. After the estate freeze, it is important that dividends are not paid on the discretionary shares if doing so results in a reduction in the value of the "freeze" shares.
It is also important to keep the following documentation related to the share purchase and payment of dividends:
- proof that family members paid for the discretionary shares with their own funds; and
- proof that dividends were paid to the family members or used to pay expenses on their behalf.
When issuing discretionary shares to family members, be aware of the association rules. Specifically, if the family member has an interest in another company, it is possible the two corporations may be associated and therefore required to share the small business limit eligibility for the low corporate tax rate.
Tom Hill, CPA, CA, is a tax partner in the Durham Region office of Collins Barrow.
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