Passion, YouTube, indirect transfers and subsection 75(2)

Wow!  That’s quite a title!  Who would think that passion, YouTube and one of the more important provisions in the Income Tax Act (the “Act”) dealing with trust attribution would appear in the same blog?  Well, today they do!

Let’s start with passion…those of you who know me personally know that I am rather passionate about a few topics.  One of them being income tax and the pursuit of solutions to complex income tax problems and the development of proactive plans.   Well, it seems that a rather famous comedian, David Mitchell, has picked up on our tag line “Passionate About Tax Optimization” and created a short skit on this and other things passionate.  This YouTube clip has been floating around the internet for roughly two years now and every time I look at it I chuckle.  In my opinion, the old adage remains that if you can’t laugh at yourself there is not much you can laugh at and therefore I thought I would share this rather humorous skit with you in case you haven’t already seen it – David Mitchell gets Passionate about the Subject of Passion.

That’s a nice segue into announcing that Moodys LLP Tax Advisors has started its own YouTube channel to develop short pieces on tax topics.  We are still experimenting with YouTube and other social media tools, but we believe that short YouTube clips on important tax topics may be valuable.  Take a look at our YouTube channel here, Moodys YouTube, and look regularly for updates.

Now to an important income tax topic that is starting to get a lot of traction.  The issue concerns indirect transfers of property and appears to have been rekindled by the St. Michael Trust Corp. (known better as Garron Family Trust) case – that we blogged about on November 18, 2010.  In that decision, the Federal Court of Appeal had the following to say:

[75]           There are undoubtedly many ways in which a transfer of property may occur directly or indirectly in any manner whatever, and there is very little guiding jurisprudence. However, it is now well established that if the existing common shares of a corporation worth, say, $100, are exchanged for preference shares with a value that is fixed at some lesser amount, say, $80, and new common shares are issued to a new shareholder for nominal consideration, the holders of the preference shares have indirectly transferred property worth $20 to the new subscriber (see Canada v. Kieboom (C.A.), [1992] 3 F.C. 488, at paragraph 21).

[76]           Kieboom recognizes that the entire value of any corporation is represented by its shares, which are property. The allocation of the value of a corporation between shares of different classes is determined by their terms and conditions. Therefore it is possible to change the value of a class of shares, and to shift value from one class of shares to another, by changing their terms and conditions. The hypothetical reorganization described above results in an indirect transfer of property worth $20 from the holders of the fixed value preference shares to the new subscriber.

Kieboom was a case that involved a situation where “Dad’s” shares of a corporation were diluted in value because certain other family members were able to subscribe for shares of the subject corporation for a nominal value.  The Federal Court of Appeal found that Dad had transferred property (indirectly) to the family members equal to the diluted value.

The above two paragraphs are rather controversial amongst the tax community and much has been written about the Kieboom case.  It is my opinion that if one accepts the above two paragraphs and accepts the reasoning in Kieboom then many “garden variety” estate freezes that occur where there is an under-valuation of the preferred shares could result in an indirect transfer of property to the new common shareholder.

For example, let’s assume that “Mom” owns 100% of the shares of OpCo.  OpCo has a purported fair market value (“FMV”) of $1M.  One of the numerous methods to effect an estate freeze in favor of Mom’s family would be to have Mom transfer her OpCo shares on a tax deferred basis to a holding company- “HoldCo” – whereby Mom would receive $1M of redeemable, retractable preferred shares of HoldCo with an aggregate redemption value of $1M.  A new discretionary family trust could be properly settled such that Mom, Dad and family members are beneficiaries of the trust.  Given that the FMV of HoldCo at that point would be nominal (since presumably the only asset of HoldCo would be the shares of OpCo with a $1M value), the newly settled family trust could subscribe, using its own funds, for new common shares of HoldCo for a nominal amount thereby enabling any future increase in the value of its HoldCo shares to accrue in favor of the family beneficiaries. Normally, such an estate freeze transaction would be accompanied by price adjustment mechanisms which would become applicable if the $1M value was found to be the incorrect value.  The price adjustment mechanism would cause the redemption value of the preferred shares to automatically be increased or decreased (as appropriate in the circumstances) thereby still resulting in a tax deferred estate freeze.

Such an above plan is rather standard estate planning and has been for years.  Tax practitioners and advisors go to great lengths to ensure that a devastating trust attribution rule – subsection 75(2) – does not apply when using a trust in such a plan.  Subsection 75(2) reads as follows:

(2) Trusts [revocable, etc.] — Where, by a trust created in any manner whatever since 1934, property is held on condition

(a) that it or property substituted therefor may

(i) revert to the person from whom the property or property for which it was substituted was directly or indirectly received (in this subsection referred to as “the person“), or

(ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust, or

 (b) that, during the existence of the person, the property shall not be disposed of except with the person‘s consent or in accordance with the person‘s direction,

any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of property substituted for the property, shall, during the existence of the person while the person is resident in Canada, be deemed to be income or a loss, as the case may be, or a taxable capital gain or allowable capital loss, as the case may be, of the person.

 To the extent that subsection 75(2) applies in respect of the trust property, all income, losses, capital gains, and capital losses attributes back to the person who transferred the property to the trust.  In addition, if subsection 75(2) was applicable, any transfer of capital property from the trust to a capital beneficiary, in satisfaction or partial satisfaction of one’s capital interest in the trust, would occur at FMV which would often be tax deferred otherwise.  Accordingly, the application of subsection 75(2) is usually devastating for an estate freeze plan including a trust.

Given the comments of the Federal Court of Appeal in Kieboom and recently in St. Michael Trust/Garron Family Trust, if the FMV of the OpCo shares referred to in the example above is actually $3M as opposed to $1M, could it be viewed that Mom transferred $2M of property to the newly settled family trust, thereby evoking the provisions of subsection 75(2)?  If one holds the view that there has been an indirect transfer of property to the trust then the answer would be “yes”.  Given such, tax advisors and their clients will need to be well aware of this fast moving area of tax law and be very careful to ensure that there has been no indirect transfers of property to a trust which might cause subsection 75(2) to apply (especially if the price adjustment mechanisms in the agreements are not effective).

It appears that the CRA is already starting to pick up on this view after the St. Michael Trust/Garron Family Trust decision.  A Technical Interpretation released on April 13, 2011 into the tax databases (Technical Interpretation 2010-0366301I7) describes a fact pattern that is very similar to the example described above.  The CRA uses the reasoning in the St. Michael Trust/Garron Family Trust and Kieboom cases to assert that there is an indirect transfer of property to a trust.  In other words, the CRA is of the view that the freezor transferred property indirectly to a trust that had subscribed for new common shares of a corporation that was the subject of the estate freeze.  To be clear, the CRA has stated for years that it would apply the reasoning in Kieboom in a fact pattern similar to that as described in the example herein (see for example Technical Interpretation 982385 dated October 13, 1999).  However, the CRA has also said that it would not apply the reasoning in Kieboom in the course of an estate freeze where the trust pays full FMV for the equity shares that are issued in the course of an estate freeze (see Technical Interpretation 9225295 dated December 9, 1992).

I could get into a lot more detail on this issue and debate its merits but I will have to leave this to another time where I can spill more ink on this subject (and my assistant’s ears are feeling better so that she can transcribe more of my dictation).  Stay tuned… this subject will certainly be the subject of discussion in the tax community for months and years to come.