DFK Tax Newsletter

Don’t Let 74.4(2) Plan Your Trust

Lately we have been seeing more and more Family Trust templates prepared by a client’s lawyer including something to the effect of:

“Notwithstanding any other provision of this Agreement, no person may receive or otherwise obtain the use of any of the income or capital of the Trust Fund while such person is a “designated person” for the purposes of subsection 74.4(2) of the Income Tax Act in respect of any individual who is then alive and who has transferred or lent property either directly or indirectly, by means of a trust or any other means whatsoever, to a corporation in which this Trust is a shareholder, it being the intention of the Settlor that this Trust will satisfy the requirements of paragraphs 74.4(4)(a) to (c) of the Income Tax Act and that no income will be deemed to have been received by such individual under subsection 74.4(2) thereof.”

Generally, the purpose of this provision in the Trust Agreement is to protect against the attribution rules of subsection 74.4(2) applying (deemed interest benefit and double taxation). On the surface, it’s understandable. The rules can be quite punitive and impair the benefits the Trust was set up to provide in the first place. Unfortunately, at best, it acts as a blunt instrument that prioritizes a specific attribution rule above the purpose of the Trust. Essentially, such a provision disallows capital or income distributions to beneficiaries that would cause subsection 74.4(2) to be triggered. As it is part of the Trust Agreement, this means it applies for the existence of the Trust. 

Think about that for a moment. 

A provision is included in the Trust Agreement that may cause the Trust to be unable to distribute income or capital to a beneficiary – forever. Imagine explaining to your client that the Qualified Small Business Corporation (‘QSBC’) capital gains exemption cannot be multiplied with their spouse because the Trust Agreement prohibits distributions to designated persons as defined in subsection 74.4(4). There have been lawsuits on exactly that outcome. 

Wasn’t the point of the Trust in the first place to hold property on behalf of the beneficiaries? In essence, we are letting the fear of subsection 74.4(2) now determine how the Trust functions, and possibly ruin the whole point of the Trust.

Often as tax professionals we get fixated on the tax implications within a particular structure. Certainly, some tax laws want to be avoided at all costs (think the subsection 75(2) reversionary trust rule and its consequential invoking of the especially concerning subsection 107(4.1) which forces the recognition of accrued capital gains within the trust when there is a capital distribution to a beneficiary). However, we shouldn’t lose the forest through the trees and end up letting tax laws dictate the plan. Rather, they should be the guard rails we are navigating in order to help our clients achieve their goals. 

So then, how do we deal with the subsection 74.4(2) attribution rules?

Fortunately, there are a number of ways to either plan into the exemptions to subsection 74.4(2), or mitigate the deemed interest benefit. 

Small Business Corporation Exemption 

Often, a structure including a Family Trust and a Canadian Controlled Private Corporation (‘CCPC’) has the added objective of utilizing the beneficiaries’ lifetime capital gains exemption (‘LCGE’) to multiply the benefit of the exemption on a future disposition. As we know, Small Business Corporation (‘SBC’) status as defined in subsection 248(1), is one of the tests in the QSBC definition in subsection 110.6(1). Keeping the balance sheet of the CCPC purified on a regular basis serves the dual purposes of avoiding the application of subsection 74.4(2) and making it easier to qualify for the LCGE in the event a disposition is on the horizon. 

The challenge, however, is keeping the ‘active business assets’ at or above 90% of the fair market value (‘FMV’) of all the assets of the corporation. Knowing the FMV on a continuous basis isn’t simple, particularly since goodwill most often is not a readily identifiable amount. Instead, the focus should be on keeping passive assets and excess cash off the balance sheet. Interestingly enough, the Trust should help facilitate the distribution of excess cash to a corporate beneficiary regularly.  

Mitigate Deemed Benefit through Compensation Planning

Often a subsection 74.4(2) problem will arise on the fixed value special or preferred shares (‘freeze shares’) received from the initial estate freeze prior to the Trust becoming a shareholder. Once a structure is set up, the owner-manager generally holds the freeze shares personally. If the freeze shares are shares of an SBC, then it’s no problem. However, if down the road this changes (i.e. the business has an asset sale, or winds down its operations), or if it never qualified as an SBC, then we would need to mitigate any application of the subsection 74.4(2) deemed benefit to avoid double taxation. 

Very briefly, the deemed benefit is determined by multiplying the prevailing CRA prescribed interest rate by the value of the freeze shares (or indebtedness) that is applicable to subsection 74.4(2) and deducting the taxable amount of any dividends (or interest) actually paid on the shares (or debt). For example, if the freeze shares held have a redemption value of $1,000,000, the prescribed rate for the 4 quarters of that calendar year is 5%, and no dividends were paid, then the deemed interest benefit is $50,000. Unfortunately, this deemed benefit functions in the absence of integration. The company does not get a deduction for deemed interest paid, therefore causing double taxation. 

To mitigate this impact, consider how the owner-manager is currently compensated. Assuming they are taking something out of the business, simply redirecting how they are receiving it can reduce or eliminate the impact of subsection 74.4(2). Using the same example as above, if the owner-manager receives a non-eligible dividend paid on the freeze shares of $43,500, the taxable grossed-up amount being ~$50,000, then there is no deemed benefit. Taking it one step further, if some of the freeze shares can be redeemed annually, in addition to the dividend paid on the shares, then the subsection 74.4(2) exposure is decreased and eventually eliminated.

Trying to protect from the negative implications of the corporate attribution rules in subsection 74.4(2) using targeted wording in the Trust Agreement may work in certain cases, however I believe it is overused as a crutch, that may in fact cause much larger problems in the future. Before assuming it should be in the agreement, consider first what options are available to plan around it, and what could go wrong by including it.