Income Splitting - Toronto Tax Lawyer Commentary
The common income splitting tax planning technique of issuing different classes of shares to a husband and wife in order to pay discretionary dividends has to be re-evaluated in light of the Federal Court of Appeal decision in Neuman.
Facts in Neuman
Neuman, a lawyer, set up a holding company in which he and his wife held different classes of shares. The holding company was set up for the sole purpose of splitting income with his wife. His wife was the sole director of the corporation and, with his advice, declared a dividend of $14,800 on her shares and $5,000 on his shares.
Revenue Canada attacked this arrangement under subsection 56(2) and was unsuccessful at the Tax Court and at the Federal Court Trial Division.
Neuman - Federal Court of Appeal Decision
Revenue Canada appealed their loss to the Federal Court of Appeal where they were successful.
The issue of income splitting on discretionary dividends was dealt with by the Supreme Court of Canada in McClurg, which was decided in favour of the taxpayer.
However, the Federal Court of Appeal relied on what has been thought to be a non-binding obiter comment made in McClurg. The Supreme Court of Canada said that if a distinction is to be drawn in the application of subsection 56(2) between an arm’s length and a non-arm’s length transaction, it should be made between the exercise of a discretionary power to distribute dividends when the non-arm’s length shareholder has made no contribution to the company. In McClurg, the Supreme Court of Canada found that a contribution had been made. In Neuman, it was quite clear that Mrs. Neuman made no contribution.
In what is a very weak decision, the Federal Court of Appeal found that the comment in McClurg was binding and was applicable and that subsection 56(2) should be applied to tax the dividend paid to Mrs. Neuman in the hands of Mr. Neuman.
Income Splitting Tax Planning
There are several tax planning methods recommended by our Toronto tax lawyers that may be effective to avoid the effects of Neuman.
One approach might be to avoid the use of a discretionary dividend clause. This would mean that both husband and wife would receive pro rata dividends on the same class of shares. Or, alternatively, only one spouse could hold shares in the corporation.
One other obvious approach is to ensure that the spouse with whom income splitting is to be carried out makes a contribution to the company so as to fall within the McClurg rule rather than the Neuman rule. This could include paying a substantial amount of money to subscribe for the shares, doing actual work for the corporation, or guaranteeing debts of the company. Note that if an inactive spouse is a director or guarantor of the corporation, that spouse who, as a matter of basic creditor proofing, may very well own most of the family assets, exposes those assets to potential creditor liability. It is therefore important to remember the creditor proofing implications when carrying out any such income splitting tax planning. If you wish to reduce your taxes payable through income splitting or other tax planning techniques contact our CRA tax lawyers for tax help.
"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."