Family tax planning, taken lightly, can be dangerous ground for the unprepared taxpayer. It is essential to structure any arrangement with family members carefully in order to avoid the many pitfalls.
When family members purchase shares in a family company, it is important that they actually pay for the shares. The share subscription is the foundation of every other transaction that follows. On a number of occasions, the Canada Revenue Agency (CRA) has exploited the fact that money did not change hands, or that funds from an existing shareholder's account were used, and refused to recognize the transaction as a legitimate share transfer. As a consequence, the attribution rules were applied to attribute the income to the spouse or parent. As with any other share purchase, the individual must pay for the shares with his or her own funds, or with properly structured loans that follow specific exceptions to the attribution rules.
In order to pay a dividend to a family member shareholder, the directors of the company must genuinely pay the money, either by actually writing a cheque or by showing that a note payable was formally accepted in full payment. The funds generally should be deposited into a bank account solely under the control of the adult recipient. For a minor child receiving larger sums, this is best accomplished using a formal trust arrangement. In Ontario, under the Children's Law Reform Act, a person can pay funds up to $10,000 in the aggregate to a parent, who is then responsible to account directly. The parent should keep the funds in a distinct account.
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Trustees of discretionary trusts may wish to make trust payments directly to third parties for the benefit of the beneficiary. It might make more sense to pay a parent or third party directly for reimbursement of a child's expenses. The CRA administratively accepts such, provided:
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the trustee acted within the confines of the trust agreement;
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the amount withdrawn will be declared as income to the child; and
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the payment was a reasonable expenditure made for the benefit of the child.
Every payment must be documented properly. The trustee and parents may be required to provide evidence of the transactions to the CRA in the future.
The recent decision of the Tax Court of Canada in Demers v. The Queen, 2007 DTC 30, is a lesson on point. The taxpayer's problems began with the infant daughters not paying for their shares. The plan was further compromised when the parents, presumably acting as guardians of the infants, agreed to sell the shares to the father on a specified date ten months later. They made the agreement the same day they purchased the shares. Finally, the $12,000 dividend to each child was in fact deposited into the father's bank account and used by him. The father argued the funds were loans that were subsequently paid back with RESP contributions, but he could not provide any evidence of a written agreement to support this claim. In the end, Mr. Justice Dussault ruled that the entire matter was a sham and ordered the dividends paid to be attributed to the father and included in his income.
Careful family tax planning is important. Ensuring the desired effect of transactions requires care to ensure that the factual and legal reality is consistent with the general objectives. Given the potential for disastrous and costly consequences, it is prudent to seek out competent, knowledgeable professionals to guide the plan and ensure it stands on a firm foundation.
Guy Desmarais is a tax partner in the Sudbury office of Collins Barrow.
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