Tax Attribution Anti-Avoidance Rules

The Tax Attribution Anti-Avoidance Rules: Back-to-Back Loans and Transfers, Guarantees, and Artificial Transactions—A Canadian Tax Lawyer’s Guide

Introduction – The Tax Attribution Anti-Avoidance Rules

This is our third article in a series focusing on the tax-attribution rules. In our first article, we focused on the basic tax-attribution rules and their exceptions. Our second article described more specialized tax-attribution rules in the Canadian tax system—specifically, those applying to diverted payments, income-splitting with minors, holding corporations, and revocable trusts. In this article, we discuss the anti-avoidance rules supporting these tax-attribution rules.

These anti-avoidance rules divert taxpayers from either sidestepping the tax-attribution rules with artificial transactions or using the tax-attribution rules themselves to garner a benefit that Parliament did not intend.

The Back-to-Back Loans and Transfers (Indirect Loans/Transfers): Subsection 74.5(6)

Subsection 74.5(6) of the Income Tax Act prevents a taxpayer from avoiding the tax-attribution rules by indirectly transferring or lending property to a spouse or related minor. In particular, without this rule, a taxpayer might have been able to escape tax attribution by inserting a third party between the taxpayer and the ultimate transferee—i.e., the taxpayer’s spouse or a related minor.

To prevent that outcome, this rule deems you to have lent or transferred a property directly to your spouse if you transferred or lent that property to a third party who subsequently transfers or lends the property to your spouse. The rule applies in the same way where the ultimate recipient is a related minor.

As a result, the indirect transfer or loan still invokes the tax-attribution rules. That is, the income or loss from the transferred property is deemed to be your income or loss—not that of your spouse or related minor, as the case may be. Likewise, if the ultimate recipient is your spouse, you—and not your spouse—are deemed to realize the resulting capital gain or loss when your spouse sells the property.

Guaranteeing a Third-Party Loan to a Spouse or Related Minor: Subsection 74.5(7)

Like the indirect-loan-and-transfer rule in subsection 74.5(6), subsection 74.5(7) prevents a taxpayer from dodging a tax-attribution rule by indirectly effecting an income-splitting transaction. In particular, subsection 74.5(7) reinforces the attribution rule found in subsection 74.1(3).

Recall, we discussed in our basic tax attribution article, the attribution rule under subsection 74.1(3), which applies if you pay off your spouse’s or a related minor’s investment loan. Say your spouse borrowed funds to buy shares, which pay a dividend. If you pay back some or all of your spouse’s loan, subsection 74.1(3) deems the proportionate amount of your spouse’s dividends to be your income and not that of your spouse.

In response, you might attempt to avoid this rule by not actually repaying the loan but simply agreeing with your spouse’s lender that you will repay the loan—in other words, you guarantee the loan. This is where subsection 74.5(7) comes into play.

As a result of subsection 74.5(7), if you guarantee repayment of a loan (or interest on a loan) made to your spouse or a related minor, you are deemed to have made the entire loan to your spouse or the related minor for the purpose of the tax-attribution rules. And, although the attribution rules generally don’t apply to a loan where the borrower pays market-rate interest, under subsection 74.5(7), the market-rate-interest exception doesn’t apply unless your spouse or the related minor pays the interest. In other words, the attribution persists if you alone pay interest.

Artificial Transactions: Subsection 74.5(11)

Subsection 74.5(11) gives the Canada Revenue Agency the authority to oust an attribution rule if a taxpayer relies on it to avoid tax—for instance, where spouses use an attribution rule to shift deductions from a low-income spouse to a high-income spouse.

Lipson v Canada (2009 SCC 1)illustrates a transaction that might give rise to subsection 74.5(11). (In Lipson,the CRA chose to forego subsection 74.5(11) and relied instead on the general anti-avoidance rule found in section 245 of the Income Tax Act. For more information on section 245, see here.) In this case, a husband and wife relied on an attribution rule to shift interest deductions from the lower-income wife to the higher-income husband.

To fund the purchase of their family residence, the taxpayer and his wife affected a series of transactions. First, the wife borrowed $500,000 from a bank and used these funds to buy shares of a family holding corporation from her husband. Because the wife used the borrowed funds to purchase an income-earning property, she could deduct the interest from her income. But her husband did not elect out of the spousal rollover. So, the wife’s interest expenses were attributed to him. The couple then obtained a $500,000 mortgage from the same bank, and they used the mortgage proceeds to repay the wife’s share-purchase loan. The Income Tax Act allows a deduction for interest on money borrowed to repay previously borrowed money if the interest on the original loan is deductible. As a result, the mortgage interest was deductible since the interest on the share-purchase loan was deductible. In the end, these transactions not only permitted the couple to effectively deduct interest on a personal-home mortgage but also allowed the husband to deduct his wife’s expenses from his income.

Ultimately, section 245’s general anti-avoidance rule precluded the husband from claiming the deduction. But presumably subsection 74.5(11) might have led to the same result if the CRA had relied on that provision.

Attribution Tax Planning Tips

Tax plans that rely on indirect transfers or loans to avoid an attribution rule are doomed for failure. Consult one of our experienced Canadian tax lawyers to evaluate or implement a tax-planning strategy.

Understand that you may incur additional tax liability for guaranteeing to repay a loan made to a spouse or related minor.

The Canadian tax system still allows certain forms of income splitting. You may, for instance, contribute to your spouse’s Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA).