(from the March 17, 1995 Sales Bulletin)
As stated in our February 27 Federal Budget commentary, we will be following up the overview with a more detailed analysis of the tax changes and their implications for your and your clients.
The budget commentary noted that any individual who is the sole owner of an unincorporated business or a professional corporation or is a member of a partnership now has the ability to select a fiscal year end other than December 31. The budget proposes to take away this ability so that these persons will be required to have a fiscal year end of December 31. A 10-year transitional rule has been proposed to allow "softening of the blow" for those affected. To illustrate how the system will work, consider an Investors representative who has a year end of February 28 and who earns $60,000 annually ($5,000 per month). When the representative files his/her 1995 tax return in April 1996, he/she will pay tax on the $60,000 earned from March 1, 1994 to February 28, 1995. He/she will also be taxed on 5% of $50,000 earned from March 1, 1995 to December 31, 1995.
For the next 8 years, tax is due on the amount earned in that calendar year plus 10% of the $50,000 earned from March 1, 1995 to December 31, 1995. In the 10th year, tax is due on the amount earned in the calendar year plus 15% of the amount earned from March 1, 1995 to December 31, 1995. At this point the representative has paid all the tax owing on the $50,000 earned from the end of the fiscal period ending in 1995 to the end of calendar year 1995, and has become fully integrated into a reporting system using a calendar year end.
Of course, anyone who starts a sole proprietorship, partnership or professional corporation after February 26, 1995 will be required to report income with a December 31 year end.
Clients and representatives who are affected by this change should be planning ahead to ensure that cash is available to pay the extra tax liability that will arise over each of the next 10 years.
From a planning perspective, it is not possible to "move" income artificially into 1996 to minimize the tax effect of this change. (Please note that the 1997 Federal Budget proposes to expand the definition of preferred beneficiary (commencing for trust taxation years ending after February 18, 1997) so as to include adults who are dependent on other by reason of medical or physical infirmity (such individuals may not necessarily qualify for the disability tax credit). In order to qualify as a dependent, the beneficiaries income (computed without reference to any amount designated under the preferred beneficiary election) cannot exceed $6,456. This maximum amount of income will be indexed for inflation). For example, an Investors representative cannot request deferral of his/her 1995 no limit performance bonus so that it is paid in early 1996. What affected individuals can do, however, is to reduce 1995 income earned after fiscal year end up to December 31 by incurring any justifiable expenses planned for 1996 in 1995.
While the Minister of Finance stated that income splitting using family trusts is being stopped, this is not really the case for most of our clients and prospective clients.
The budget proposed only two changes, both of which are directed toward specific situations. The first change relates to the former 21-year deemed disposition rule, which was loosened by the previous government to allow a deemed disposition of trust assets to be deferred until the death of the last "exempt beneficiary" (refer to Chapter 12 in the Tax Library for a definition of an exempt beneficiary). This election will be eliminated effective January 1, 1999, at which time we will revert to the former 21-year deemed disposition rules.
For those trusts already in existence, there is a provision to allow trust property to be distributed at its cost valuation to an exempt beneficiary before 1999. The accrued capital gain will be realized only at the actual disposition of the property or the death of the exempt beneficiary, whichever occurs first.
Even when we revert back to the old 21-year deemed disposition rule, it is possible to defer realization of accrued gains in the trust by "rolling out" trust property to the beneficiary (refer to Chapter 12 for details). The realization of the gain would then be at the earlier of actual disposition of the property or the death of the beneficiary. Assuming the terms of the trust allow the trustee to make such a transfer and the trustee is prepared to do so, the deemed disposition can be deferred in this manner. We expect this rule change will have little effect on the majority of our clients.
The second change is effective for taxation years commencing after 1995 and proposes to eliminate the preferred beneficiary election except where the beneficiary is mentally or physically disabled.(Please note that they 1997 Federal Budget proposes to expand the definition of preferred beneficiary (commencing for trust taxation years ending after February 18, 1997) so as to include adults who are dependent on other by reason of medical or physical infirmity (such individuals may not necessarily qualify for the disability tax credit). In order to qualify as a dependent, the beneficiary's income (computed without reference to any amount designated under the preferred beneficiary election ) cannot exceed $6,456. This maximum amount of income will be indexed for inflation). As discussed in Chapter 12, the preferred beneficiary election allows income to be allocated to one or more beneficiaries for tax purposes, without legally requiring it to have actually been paid to the beneficiary. To illustrate, suppose a family trust is created where two children, Tom and Mary, are the beneficiaries. Each year, the trust earns $10,000 and allocated $5,000 via the preferred beneficiary election to each child who, in turn, reports the amount on his or her personal tax return. If, in a future year, Mary turns out to be incapable of handling money, all income previously allocated to her could now be paid to Tom.
Under the budget proposals, this "control" feature is lost but certainly not the ability to split income. The new rules simply state that income will be taxed to the trust unless it is actually paid or payable to a specific beneficiary. This means that to be taxed to Mary rather than the trust in the example above, the income must actually become her legal property in the year. This will occur if the trustees actually pay the income to Mary or make it payable to her so that she could legally enforce payment.
Where income of a trust has vested in a minor but is not payable solely because the person is a minor, the Income Tax Act deems the income to have become payable in the year. The terms of the trust document will determine whether the trustees have the ability to actually pay or make income payable to beneficiaries. If, as is common with family trusts, the trust is discretionary, the trustee will have to take steps to formally exercise his/her discretion in order for amounts to be considered payable to a beneficiary. A resolution or written direction should be prepared and executed in order to demonstrate that a legally enforceable obligation exits to make the amount payable to the beneficiary/ies.
Again, as outlined in Chapter 10, don't overlook the impact of the attribution rules. Speaking of the attribution rules, nothing in the budget prevents income splitting with non-arm's length individuals where the moneys are paid to them in the form of dividends from a small business corporation. Thus, if a trust is created to hold shares of a SBC for minors and/or the spouse of the primary business owner, dividends flowing to the trust will be taxed in the hands of the beneficiaries without attribution.
To quickly recap, although the government has stated that it has closed the door on income splitting via trusts, it has not. The change in the 21-year deemed disposition rule will have little effect on the great majority of our clients, and the inability to use the preferred beneficiary election (except where the beneficiary is disabled) only takes away the ability to make a "notional" allocation of income to a beneficiary without actually distributing income.
The information in these tax notes is based on the budget proposals, which are subject to clarification when the actual legislation is drafted. The purpose of this bulletin is to provide you with current developments, not to provide legal advice. Clients should consult their professional advisors for specific advice relating to their own unique circumstances.