In recent years, multiplying the Lifetime Capital Gains Exemption (LCGE) using a family trust has been a common, tax-planning strategy for many families with private corporations. A family trust provides an opportunity to split the income from the sale of private corporation shares by dividing the capital gain among the income beneficiaries. Generally speaking, the trust allocates the qualifying capital gain to the income beneficiaries of the trust. The individual beneficiaries then use their LCGE to reduce the tax payable on the capital gain. The key to the success of this planning is that the beneficiary keeps the cash and assets they are allocated. When they don't get to keep the cash and assets, things get interesting.
In the case of Daniel Laplante, (DL) v. The Queen, 2018 CAF 193, The Federal Court of Appeal upheld the decision of the Tax Court of Canada (TCC) of 2017 TCC 118, which ruled that such an allocation was a sham and included the full capital gain that was previously allocated to the beneficiaries into DL's income.
The family trust (DLT) and DL were the shareholders of a qualified, small-business corporation. The shareholders sold the shares of that corporation, which created a capital gain that was allocated to DL and the beneficiaries of DLT. Since the corporation was also a qualified, small-business corporation, the beneficiaries were able to claim their LCGEs to eliminate any tax attributed to the capital gain. The beneficiaries then gave all the funds distributed from the DLT back to DL. When the beneficiaries filed their tax returns, they also had to pay alternative minimum tax (AMT). DL reimbursed the beneficiaries for the cash outlay to pay the AMT, and the beneficiaries kept the funds from the subsequent recovery of that AMT in later years.
The basis for the Crown's decision was that the arrangement between DL and the beneficiaries was a simulation or a sham. The issue at play was a secret contract that required the beneficiaries to return the trust distribution to DL. This secret contract was not disclosed to the Canada Revenue Agency and it was outside of the actual legal contract. The TCC ruled that the court was not obligated to follow the methodology used for the legal transaction since it did not reflect the true transaction.
This case highlights the importance of trust beneficiaries being entitled to keep the funds and assets distributed to them. The beneficiaries should not simply be conduits to facilitate a tax benefit (such as multiplying the LCGE or income splitting) on behalf of the principal of the business so that they can lower their tax rate.
This case is an example of last-minute tax planning that didn't work. The taxpayer intended to sell his shares to an arm's length party. He asked his tax advisor to provide innovative tax planning within a short period of time before the sale. Unfortunately, the advice given didn't pass the tax authority's scrutiny. If DL had taken a higher income from the corporation or saved some excess retained earnings in a holding company in earlier years and invested those funds (for example, in life insurance), the tax liability he faced on a disposition of his shares may not have been as significant.
Now DL has to pay his tax as if he received all of the proceeds. Maybe it's a bit of "too little too late" but, DL has additional funds from the sale of his business. He could consider using the funds to purchase a life insurance policy to fund taxes at death and/or increase funds available to his heirs.
