Published: April 10, 2020
Last Updated: February 21, 2022
The Income-Diversion Rules: Section 56 of the Income Tax Act—A Canadian Tax Lawyer’s Analysis
Introduction: Income-Diversion Arrangements
A taxpayer might try to reduce his or her taxable income by diverting an incoming payment to another party. For example, an employee might direct her employer to pay a portion of the employee’s salary directly to a creditor of the employee. Similarly, a creditor might direct his debtor to make interest payments to the creditor’s mother.
Of course, these sorts of arrangements may serve legitimate non-tax purposes, and they may be perfectly legal and enforceable under private law. But Canada’s tax law will sometimes ignore legally effective arrangements when discerning the proper taxable recipient of income.
The income-diversion rules in section 56 of the Income Tax Act identify several cases where tax law will ignore a transaction that private law might see as valid. (The attribution rules also illustrate this same principle. For more on the attribution rules, see here)
This article looks at three income-diversion rules:
- the indirect-payment rule in subsection 56(2);
- the income-assignment rule in subsection 56(4); and
- the rule applying to interest-free or low-interest loans in subsection 56(4.1).
Indirect Payments—Subsection 56(2) of the Income Tax Act
Subsection 56(2) will include in a taxpayer’s income a payment that was:
- made to a person other than the taxpayer;
- made pursuant to the direction of, or with the concurrence of, the taxpayer;
- made for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person; and
- would have been included in the taxpayer’s income if it had been made to the taxpayer.
Put differently, when 56(2) applies, it renders a diverted payment ineffective for tax purposes. So, if (as in our previous example) an employee directs her employer to pay a portion of the employee’s salary directly to a creditor of the employee, then the employee must still pay tax on that income. Likewise, a creditor is still taxed on interest income where the creditor directs his debtor to pay the loan interest to the creditor’s mother. In each case, the taxpayer would have to report the income even though she or he didn’t actually directly receive it.
Subsection 56(2) doesn’t apply to preferential dividend declarations. For instance, in R v McClurg,  3 SCR 1020, a closely held corporation had four shareholders: the taxpayer, his business partner, and each of their wives. The husbands held one class of shares; the wives held another class. In addition, the taxpayer and his business partner were the directors, and the corporate articles gave them unfettered discretion in allocating dividends among the classes of shares. The directors declared a $20,000 dividend only for their wives’ shares. As a result, the taxpayer’s spouse received a $10,000 dividend that year, but the taxpayer received nothing.
The Canada Revenue Agency (“CRA”) reassessed the taxpayer and attributed $8,000 of the wife’s dividend to the taxpayer under subsection 56(2). The Minister argued that if the directors had declared equal dividends for both classes of shares, the taxpayer would have received $8,000 and his wife $2,000.
A majority of the Supreme Court of Canada held that subsection 56(2) didn’t apply. The majority reasoned that a dividend payment doesn’t fall within the scope of subsection 56(2). The provision’s purpose, the majority explained, was to prevent a taxpayer from avoiding tax by diverting payments that he or she would otherwise have received. But a shareholder has no right to undeclared dividends. In corporate law, until a dividend is declared, the profits belong to the corporation. On this basis, the majority concluded that “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).”
Writing for the dissent, La Forest J. concluded that subsection 56(2) did apply. La Forest reasoned that the transaction satisfied all four preconditions of subsection 56(2). First, the dividend was a payment made to a person other than the taxpayer—i.e., his wife. Second, the payment was made under the taxpayer’s direction per his status as the corporation’s director, and it was made with the taxpayer’s concurrence per his status as a shareholder. Third, the preferential dividend benefitted the taxpayer by reducing his income-tax liability. Finally, if the dividend had been declared on the taxpayer’s class of shares, it would have been included in the taxpayer’s income.
A unified Supreme Court would later confirm that subsection 56(2) doesn’t apply to preferential dividend payments. In Neuman v MNR,  1 SCR 770, the taxpayer and his wife jointly owned a family corporation. They each held different classes of shares. The wife was the corporation’s director, and the corporate articles gave her unfettered discretion in allocating dividends among the share classes. The wife declared a $5,000 dividend for the taxpayer’s class of shares and a $14,800 dividend for her own class of shares. She immediately loaned $14,800 to the taxpayer in exchange for a promissory note as security. But she unfortunately died before the taxpayer repaid the loan.
The Canada Revenue Agency reassessed the taxpayer under subsection 56(2) and sought to include the wife’s $14,800 dividend in the taxpayer’s income.
The Supreme Court of Canada unanimously held that 56(2) didn’t apply, and the dividend shouldn’t be attributed to the taxpayer. Subsection 56(2), the Court observed, requires “that the payment would have been included in the reassessed taxpayer’s income if it had been received by him or her.” But dividend income doesn’t meet this requirement since “the dividend, if not paid to a shareholder, remains with the corporation as retained earnings; the reassessed taxpayer, as either director or shareholder of the corporation, has no entitlement to the money.”
In R v Ferrel,  2 CTC 101, the Federal Court of Appeal affirmed the Tax Court’s holding that subsection 56(2) didn’t apply where a taxpayer diverted his management fees to his minor children through a trust in their name. The taxpayer settled a trust under which he was the trustee and his children the beneficiaries. The trust provided management services to a corporation, which the taxpayer and the trust equally owned. In his capacity as the trustee, the taxpayer managed the corporation, which in turn paid the management fee to the trust, which in turn paid this sum to its beneficiaries, who paid tax on the income.
The Canada Revenue Agency reassessed the taxpayer under subsection 56(2) and sought to allocate the trust’s management fee to the taxpayer’s income.
The Tax Court of Canada held that subsection 56(2) didn’t apply and the payment shouldn’t be attributed to the taxpayer. The court observed that the taxpayer wasn’t entitled to receive the management fee because the corporation retained the trust—not the taxpayer—to provide the management services. The court acknowledged that subsection 56(2) might still apply where a taxpayer isn’t entitled to receive the payment. But the court clarified that, if a taxpayer isn’t entitled to receive the payment, subsection 56(2) applies only if the payment wasn’t taxable in the hands of a third party. Here, the trust allocated the management-fee income to the beneficiaries, who paid income tax on that income. So, 56(2) didn’t apply. The Federal Court of Appeal affirmed the Tax Court’s decision.
In response to the Ferrel decision, Parliament enacted section 120.4 (a.k.a. the kiddie tax). For more on section 120.4, see here.
Assignment of Income—Subsection 56(4) of the Income Tax Act
If a taxpayer assigns the income to a non-arm’s-length person, subsection 56(4) attributes that income to the taxpayer. An author, for instance, might assign a right to royalties to her spouse. Subsection 56(4) attributes the royalty income back to the author for tax purposes.
The CRA announced that it will apply subsection 56(4) in the following cases:
- An individual, instead of transferring property into joint ownership with a spouse, transfers the right to receive the income from the property to the spouse.
- A mutual-fund or insurance salesperson earning commission under her own name assigns that right to a non-arm’s-length corporation.
- A real-estate salesperson, who is licensed to sell real estate in his own name, assigns his commission to a non-arm’s-length corporation.
Interest-Free or Low-Interest Loans—Subsection 56(4.1) of the Income Tax Act
Subsection 56(4.1) applies to a non-arm’s-length loan bearing little or no interest if the borrower invests the loan in an income-producing property. If subsection 56(4.1) applies, it attributes the income from the property to the lender.
But this rule doesn’t apply unless “it may reasonably be considered that one of the main reasons for making the loan… was to reduce or avoid tax.” In other words, the rule requires that the loan be made for a tax-avoidance purpose.
Tax Tips – Taxable Income Diversion
If you own and control a corporation, you won’t trigger the indirect-payment rule in subsection 56(2) if you pay dividends to other shareholders instead of yourself. You must, however, ensure that the corporate articles and share ownership allow this sort of dividend distribution.
If you failed to report income that arose as a result of section 56, you may be liable to interest and penalties. You may have certain remedies available. Speak with one of our experienced Canadian tax lawyers about the Voluntary Disclosures Program or Taxpayer Relief.
Subsection 56(2) didn’t apply to the transaction in R v Ferrel. Yet the kiddie-tax rule in section 120.4 may still apply and result in unexpected tax liability. For more on section 120.4’s kiddie tax, see here. For specific tax-planning advice, speak with one of our Canadian tax lawyers.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."