Dividend Refund Denied upon Redemption of Donated Private Company Shares

Owner-managers often use spousal trusts to fulfill their philanthropic goals. The position taken by the CRA in a recent ruling (2016-0628181R3(E), January 1, 2017), however, leads to a puzzling result on the redemption of donated private company shares.

The ruling concerns taxpayer A, who created a testamentary spousal trust for his spouse, taxpayer B. The spousal trust holds shares in a portfolio holding company (Holdco), a CCPC. The residue of the spousal trust was to be transferred to a private foundation upon B's death, and the transferred holding company shares would subsequently be redeemed by the private foundation. The CRA opined that subsection 129(1.2) would apply to deny a dividend refund to Holdco on its redemption of the shares held by the private foundation because one of the main purposes of the transactions was to generate a dividend refund.

The ruling is frustrating in that it offers no support for this key conclusion. The transactions appear to be for a philanthropic purpose, not for the purpose of a dividend refund. In the same ruling, however, the CRA opined that if B's estate (not the spousal trust) transferred the Holdco shares to the same private foundation, which then redeemed the shares, a dividend refund would not be denied.

Furthermore, the denial of a dividend refund appears to be inconsistent with the legislative purpose of subsection 129(1.2). According to the explanatory notes (SC 1988, c. 55 (Bill C-139)), subsection 129(1.2) is an anti-avoidance rule that prevents a corporation from structuring arrangements in order to obtain a dividend refund without the related shareholder tax being paid. This point was confirmed by the CRA in Interpretation Bulletin IT-243R4 (February 12, 1996), at paragraph 6.

In this case, the shareholder-level tax would have been paid. This is because, upon B's death, the shares are deemed to have been disposed of at fair market value; in theory, fair market value would reflect the corporate taxes inherent on the appreciation of the underlying portfolio investments. The taxes on the capital gain realized on the deemed disposition upon death would be approximately the same as the combined corporate and personal taxes if the spousal trust had had all the shares redeemed by the holding company immediately before death. For this reason, the denial of the dividend refund would distort integration, which is the general theme of section 129.

(Regrettably, this is not the first time that the CRA has indicated its intention to apply subsection 129(1.2) even when the shareholder-level tax had been paid: see CRA document no. 2013-0480361C6, June 10, 2013.)

A short opinion by the CRA like this one may worry some taxpayers and may frustrate legitimate gift planning. Clarification of the CRA's reasoning would be helpful. Absent that, it would require legislative change to narrow the scope of subsection 129(1.2)—or taxpayers would have to rely on the text, context, and purpose of subsection 129(1.2) for comfort (see "When Does Subsection 129(1.2) Apply To Deny a Dividend Refund?" Tax for the Owner-Manager, July 2017).

Jin Wen
Grant Thornton LLP, Toronto
[email protected]

Canadian Tax Focus
Volume 8, Number 2, May 2018
©2018, Canadian Tax Foundation