Wednesday, 13 November 2013

Subsection 56(2) and a Discretionary Trust

Reprinted with permission from the Canadian Tax Foundation and published in the October 2013 edition of the Canadian Tax Highlights.

At the Foundation’s 2012 Ontario Tax Conference, the CRA was asked to comment on whether subsection 56(2) applies to the sole trustee of a discretionary trust who is also a discretionary beneficiary of trust income.  The CRA concluded that the application of subsection 56(2) was a question of fact and could thus not confirm its application to the sole trustee/beneficiary of a discretionary trust that had other discretionary beneficiaries.

In its published response, the CRA in TI 2012-0462891C6 concluded that the sole trustee was not in a position analogous to that of a corporate director who is also a shareholder and related to the other shareholders.  Income splitting is often structured so that a trust holds the common shares of a family business corporation after an estate freeze or carries on a business of providing services such as managerial services to a closely held family company.  Dividends paid on the common shares are distributed to the beneficiaries on a discretionary basis typically determined by income brackets.  Management fees earned by a trust may also be distributed on a discretionary basis. The jurisprudence supports the CRA’s conclusion that the trustee’s position is not analogous to that of a corporate director.

Subsection 56(2) is rooted “in the doctrine of “constructive receipt” and was meant to cover principally cases where a taxpayer seeks to avoid receipt of what in his hands would be income by arranging to have the amount paid to some other person either for his own benefit (for example the extinction of a liability) or for the benefit of that other person…” (Winter (90 DTC 6681)). The SCC in McClurg ([1990] 3 SCR 1020) concluded that a discretionary dividend payment does not fall within the scope of subsection 56(2)

The purpose of s. 56(2) is to ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an anti-avoidance technique.  This purpose is not frustrated because, in the corporate law context, until a dividend is declared, the profits belong to a corporation as a juridical person…Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer.  Rather, the amount simply would have been retained as earnings by the company.  Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of s. 56(2).

Although obiter in McClurg suggested that subsection 56(2) may apply if the shareholder receiving the dividend made no contribution  to a closely held corporation, the SCC in Neuman ([1998] 1 SCR 770) rejected that view. The SCC reasoned that a dividend is not paid as reward for a shareholder’s contributions but is based on the shares or capital held by her. The court recited the four McClurg conditions before a payment or transfer property  falls within subsection 56(2): the payment must be to a person other than the reassessed taxpayer;  the allocation must be at the direction or with the concurrence of the reassessed taxpayer; the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit; and the payment would have been included in the reassessed taxpayer’s income if it had been received by him or her. Neuman concluded that a discretionary dividend was not subject to subsection 56(2) because by its very nature a dividend cannot satisfy the fourth condition in the absence of a sham or other subterfuge. Both McClurg and Neuman confirmed that subsection 56(2) cannot attribute a discretionary dividend to a closely held corporation’s director and read in an implicit entitlement requirement to the fourth McClurg condition: a director is not entitled to an undeclared dividend, which is simply retained by the corporation as retained earnings. The SCC distinguished Winter, which seemed to challenge the entitlement requirement, because it did not deal with dividend income.

The TI ignored the FCA decision in Ferrel (99 DTC 5111), which cited Neuman in support of the rights of “taxpayers [to] arrange their affairs in a particular way for the sole purpose of deliberately availing themselves of the tax reduction levies on the Income Tax Act.” The taxpayer was the settlor and sole trustee of a trust that carried on the business of providing management services to a family holding company under a written agreement; in a separate written agreement, the taxpayer agreed to provide the trust’s managerial services to the trust to the management company. The management fees earned by the trust were distributed to the child beneficiaries, who paid tax thereon.  The TCC concluded that subsection 56(2) did not apply because there was no evidence that the management fees would otherwise have been paid to the taxpayer in fulfilment of the fourth McClurg condition. And consistent with Winter, the TCC said that the beneficiaries were taxed on the distribution, even though the taxpayer was not entitled to the payment and would have been taxable on its receipt.

Although not referred to in the TI, the SCC in Stubart  ([1984] 1 SCR 536) said unanimously that a transaction should not be disregarded for tax purposes merely because it lacks an independent or bona fide business purpose.  The CRA has also said that GAAR does not apply to Neuman-type income-splitting arrangements (ITTN 16.)

Sunita Doobay
TaxChambers, Toronto


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