“Corporate attribution”: What is it, and how is it affected by a “re-freeze”?

A re-freeze helps by reducing your share values after a decline. Shouldn’t it also reduce punitive “corporate attribution” income?

Sean Rheubottom, B.A., LL.B., TEP

The Income Tax Act contains a little-understood rule known as the “corporate attribution” rule. The rule is somewhat complex, but in short it provides that where an individual has transferred or loaned something to a corporation and an arguable purpose for doing so is to reduce the tax burden of the individual and to benefit a spouse or a minor-aged relative, then the individual is deemed to receive an amount of interest income every year. The deemed interest income applies whether nor not any income splitting (such as payment of dividends to family members) was actually done.

The rule can apply a few different ways, but the most common is where an individual has exchanged his or her shares of a private corporation for preferred or “freeze” shares which no longer grow in value, and then the corporation has issued new common or “growth” shares to the other family members or to a trust for their benefit.

The “small business corporation” exception

Corporate attribution does not apply at any time during which the corporation satisfies the definition of “small business corporation”. Meeting this definition involves an examination of what proportion of the corporation’s assets are assets used in an active business carried on in Canada. This underlines the need to maintain the “purity” of the operating corporation by, for example, having an outlet for excess cash, such as a holding corporation that can receive tax-deferred dividends from the operating corporation. Complex rules must be understood to ensure that these dividends will not attract undesired tax.

Computing the deemed interest income

Where the corporation has a significant amount of non-business assets such as excess cash or investments, corporate attribution is relevant. If applicable it requires the individual to include in their income an amount of interest, computed based on the value of the shares they originally exchanged (the “outstanding amount”). A simple though less precise way to think of the “outstanding amount” is the value of the freeze shares. That value multiplied by the prescribed rate in effect from time to time (currently, 1%) is the deemed interest income.

No income is actually received by the individual, and the corporation does not get any deduction, so the result is purely punitive.

There are a few possible solutions to consider. Some solutions involve restructuring. If there is a chance to plan the corporate structure before there is a problem, there may be opportunities to permanently avoid corporate attribution.

Another idea is to pay taxable dividends to the individual. Under the relevant rules this reduces the amount of the deemed interest income. This might not feel like a big win.

Another idea is to redeem the outstanding freeze shares for cash so that the deemed interest income is accordingly reduced in the following years.

What is a re-freeze?

In volatile times, the value of the corporation may be lower than it was at the time a freeze was done. In some cases it makes sense to “re-freeze”, exchanging the freeze shares for new freeze shares, to effectively reset the value of the freeze shares to the lower value. Future terminal year tax is reduced, and greater future growth can accrue to the other shareholders or the trust. 

Would a re-freeze reduce corporate attribution?

Would a re-freeze be considered to have reduced the “outstanding amount” on which the deemed interest income is computed? CRA says no, and their view is supported by the rules. The value of the property transferred to the corporation in exchange for the original freeze shares would still be used to determine the deemed interest income. To the extent that the new freeze shares are redeemed for cash, this would reduce the value on which the interest is computed.

If a re-freeze is done while corporate attribution applies, the corporate attribution problem may be hard to solve, ever. This is because the new lower-value shares can never be turned into enough cash to offset the original “outstanding amount”.  

CRA has recently said that they assume that tax practitioners are well aware of the need to structure a re-freeze in a manner that that is not subject to the corporate attribution rule.

Takeaways

If you are considering a re-freeze of your interest in a private corporation, be sure to first review it for any corporate attribution issue. Don’t assume that a re-freeze addresses corporate attribution.

© Heritage Private Wealth Law

General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.