Doug Carroll – Page 56 – Tax, Estate & Financial Planning Advocate

Selling an advisor’s book [6/8] – Caveats and limitations

[Eight-part series, current to publication date only]
1 – Why and how do we prepare
2 – Finding the right buyer
3 – Getting the best price
4 – Tax issues overview
5 – Incorporation issues overview
6 – Caveats and limitations
7 – Selling when incorporated vs. unincorporated?
8 – Ways to get paid

6 – Caveats and limitations

As we saw in my last column, incorporation has tax and estate benefits, especially when selling your book. But it may not be possible for all advisors.

Life insurance

In most provinces, a corporation can be licensed to receive insurance commissions, including commissions on insurance-based investment products such as annuities and segregated funds. The corporation must be controlled by individuals who are similarly licensed in the province.

The corporation is a licensed advisor in its own right, and is the taxpayer earning the income that’s at issue. On the other hand, where income is earned by a taxpayer and then redirected to a person or corporation at a lower tax bracket, it will be attributed back to its original earner. This is the default administrative approach of CRA.

Wallsten V. R (TCC) [2001] 1 CTC. 2847

In this case, Wallsten’s contract with Sun Life prohibited the assignment of commissions. When he received commission cheques from Sun Life, Wallsten deposited them to the bank account of his corporation. CRA reassessed Wallsten to include the income as his, rather than the corporation’s. The court found the corporation was actually carrying on the business. Even though the assignment of the cheques violated his contract with Sun Life, there was nonetheless a valid assignment under tax law.

Mutual Fund Dealer’s Association (MFDA)

The MFDA rule that enabled redirection of commissions to a corporation (Rule 2.4.1) was suspended in 2006.

Technical letter 2006-0176531I7E—Commission income assigned to a corporation, April 18, 2006

In response to Wallsten, the CRA originally stated in Income Tax Technical News (ITTN) 22 that it would not be following the ruling. The author of the 2006 CRA technical letter says commissions could be redirected to a corporation as long as the advisor is not otherwise precluded from doing so, and the corporation is actually carrying on the business. It was also noted that neither the OSC nor the MFDA were at that point pursuing the respective rules prohibiting or disallowing the practice at the time.

Rule 2.4.1 was republished in 2010. Under the rule, an MFDA dealer may agree with an Approved Person (i.e., a licensed advisor) to redirect commissions to a corporation. The agreement must be executed in writing in the form approved by the MFDA. (Note that the MFDA explicitly stated at the time of the republication that MFDA staff could not provide guidance on the tax implications of the rule change.)

The rule applies to advisors in all provinces except Alberta. It also does not apply to income related to clients resident in Alberta, even if the advisor is located elsewhere.

On republication and adoption of the rule in 2010, the OSC noted the dealer and advisor would be expected to “comply with any and all applicable tax legislation when any portion of an Approved Person’s remuneration, in respect of business conducted by the Approved Person on behalf of a Member firm, is being directed to an unregistered corporation.” As to what those requirements may be, the OSC made no further comment.

Boutilier v. R. 2007 TCC 96

Boutilier was an advisor who assigned mutual fund trailers to his corporation. The evidence showed that dividends were paid from the corporation to a trust and on to (presumably) lower-bracket family members. The net funds appear to have ended up with Boutilier personally. The court upheld the CRA reassessment attributing the income to Boutilier. In support, the judge noted that there was no formal employment contract, no remuneration was paid to him, and there were few or no business expenses paid by the corporation. The judge commented: “Although I believe, given the right set of circumstances, a company could be engaged in the active business of providing services to earn trailer fees, that is not the case here.” This case was decided after CRA letter 2006-0176531I7E, and before MFDA rule 2.4.1 was reinstated in 2010, though neither of those would bind a court.

Investment Industry Regulatory Organization of Canada (IIROC)

Corporations cannot be licensed to receive commissions earned under the authority of IIROC.

In December 2014, Alberta amended its Securities Act to allow for licensing of a “registered professional corporation.” However, the province has not yet taken the final step to proclaim the provisions in force.

Council of Ministers of Securities Regulation

In 2013, the council committed to moving forward with its incorporation project, intended to give “financial representatives the flexibility to provide dealing and advising services […] though a corporation, without compromising investor protection.”

At the time, the expectation was that all jurisdictions would bring forward legislative amendments before the end of 2014. Apart from Alberta’s 2014 amendments, Saskatchewan had passed (but not proclaimed) changes in 2012, and Quebec brought forward draft legislation in 2013 that died on the order paper.

Using the preferred beneficiary election with new qualified disability trusts

At issue

Testamentary trusts may come into being at and as a result of a person’s death. Commonly this is done using a Will, less often using an insurance or RRSP/RRIF beneficiary designation, and occasionally as a result of a court order.

For decades the tax benefit of such trusts has been their entitlement to use graduated tax brackets, as opposed to top bracket treatment for inter vivos trusts. As of 2016, testamentary trusts no longer have this preference, except for the first 36 months of an estate and for certain trusts for disabled beneficiaries. In the former case of an estate, there are limited opportunities to engage in meaningful tax planning.

On the other hand, trustees can and must act strategically on behalf of disabled beneficiaries. In the first place, there is a positive obligation to file an election to preserve those graduated brackets, and only one trust can be so-elected. This can complicate how a parent approaches trust drafting in isolation, let alone where multiple contributors may be contemplated.

As well, trustees need to be certain how existing trust tax rules for disabled beneficiaries may be affected. At the head of that list is the continuing use of the preferred beneficiary election.

Income Tax Act (ITA) Canada – 104(14) — Preferred beneficiary election

The term “preferred beneficiary” is a defined term in the ITA, and for present purposes includes someone who has a mental or physical impairment that entitles the person to claim the disability tax credit.

Section 104(14) sets forth that: “Where a trust and a preferred beneficiary under the trust … elect in respect of the particular year … such part of the accumulating income of the trust … shall be included in computing the income of the preferred beneficiary for the beneficiary’s taxation year”.

The effect of the election is that some or all of the trust income is allocated to the beneficiary. Tax is calculated based on the beneficiary’s graduated rates, and the trust pays that tax. The net income remains in the trust under the care and control of the trustee.

ITA 122(3) — Qualified disability trust (QDT)

As noted, testamentary trust usage of graduated tax brackets is now very limited. However, where the QDT definition is met, a trust remains entitled to use graduated brackets to calculate its taxable income. To qualify, a joint election must be filed by the trust and a beneficiary of the trust who, by reason of mental or physical impairment, is entitled to claim the disability tax credit.

Importantly, the electing beneficiary cannot “jointly elect with any other trust, for a taxation year of the other trust that ends in the beneficiary year, to be a qualified disability trust.” To the point, there may be only one QDT for a given person in any taxation year.

2015-0605111E5 (E) — Qualified Disability Trusts – Preferred beneficiary election

The taxpayer described a hypothetical situation in which an individual with a disability has four grandparents and each grandparent establishes under his/her will a trust for the individual. It is acknowledged that only one of the trusts could be a QDT for the 2016 and subsequent tax years. The inquiry goes on to ask whether the trustees of the additional three testamentary trusts created for the benefit of the same individual can make a preferred beneficiary election for each additional trust.

In response, the CRA author confirms that there have been no changes to the preferred beneficiary election rules as a result of the changes to the rules applicable to testamentary trusts, including the introduction of the QDT.

Both the QDT and preferred beneficiary election are elective provisions, and those elections are not mutually exclusive. As such, the trustees together with the disabled beneficiary can choose which joint election will be made, if any, and it is indeed possible for a trust that has made a joint election to be a QDT to also make a preferred beneficiary election.

Practice points

As of 2016, most testamentary trusts cannot use graduated tax brackets, but the new qualified disability trust preserves that treatment for disabled beneficiaries.
For existing trusts, additional tax filing obligations are required to assure QDT treatment, which fortunately may be coordinated with the preferred beneficiary election.
For families in the preparatory stages, they should confirm with legal counsel that appropriate powers and permissions have been explicitly drafted into trusts and other planning documents.

Selling an advisor’s book [5/8] – Incorporation issues overview

5 – Incorporation issues overview

Last time, we talked about the tax treatment of a business sale, depending on whether the parties are employees or self-employed. This article will discuss incorporation and how it affects a sale transaction.

TAX IMPACT OF INCORPORATION

A corporation is an artificial person, so it’s a separate taxpayer from the shareholders that own it. This means a corporation has specific tax characteristics, some of which can provide benefits not available to unincorporated taxpayers.

Tax rate on business income. Income received by an employed or self-employed person is taxed at his or her marginal rate. Depending on the province, that can range from the teens to more than 50% at top brackets. Comparatively, a Canadian-Controlled Private Corporation (CCPC) is entitled to make use of the small business tax rate, which ranges from about 11% to 19%, depending on the province. The small business rate applies to the first $500,000 of income for both federal and provincial purposes (though Manitoba uses $425,000 and Nova Scotia $350,000).

Integrated with personal. A corporation is an intermediary before distribution of income to the shareholder. The corporation takes a full deduction for wages paid to an employee, such that the employee pays the all associated income taxes. For amounts the corporation’s been taxed on, it pays out a dividend on which the shareholder tax is reduced to account for previously paid corporate taxes.

Reinvested earnings. If the shareholder does not need all corporate earnings for current personal needs, the excess can be invested within the corporation. This allows tax deferral at the personal level that will eventually apply on dividends. Bear in mind that complex rules apply to passive/investment income in a corporation, requiring careful management with the benefit of professional tax advice.

Retirement and health savings options. With the legal separation of corporation and employee (even if the shareholder is the employee), it becomes possible to use RRSPs or even an individual pension plan (IPP). An IPP is able to house even larger deposits than are allowed under RRSPs. Beyond registered savings, there is also the possibility of using a retirement compensation agreement (RCA). Corporations also open up more options for providing health care benefits.

Income splitting. It is possible to employ others, such as a spouse and family members, whether someone is self-employed or operating with a corporation. In either case, the amounts paid must be commensurate with services provided. Beyond that, the corporation also enables ownership sharing; though, for corporations governed by a professional body, the participation of non-professionals may be limited. Assuming others can be shareholders, dividends may be paid to them, which is particularly beneficial if they are in lower tax brackets.

Tax on disposition. A corporation can sell its client list, or the shareholder could choose to sell shares of the corporation. If the shares are sold, the shareholder will be subject to capital gains tax, with the potential to make use of the lifetime capital gains exemption.

NON-TAX FACTORS

While tax is often the driving force behind incorporation, there are many non-tax reasons for using a corporation.

Creditor protection. As a separate legal entity, the corporation is liable for its actions, but the liability of shareholders is generally limited to losing what they have invested in the corporation. On the other hand, if a creditor requires a shareholder to guarantee the corporation’s debts, then exposure to that creditor is no longer limited. Absent such guarantees, creditors will only be able to look to the corporation’s assets to satisfy their claims.

Ongoing professional liability. While creditor protection is available to professional corporations in general business dealings, there is no shield against malpractice claims. The professional remains personally responsible for professional services and advice given, for which appropriate liability insurance is required.

Continuity. As a separate legal entity, a corporation can survive past the departure or death of its shareholders. Where the business is distinct from those who operate it, this can support its independent value and facilitate its transfer.

Professional image. A business operating through a corporation may be seen as a more stable and durable operation.

Broadened and shared ownership options. It can be helpful to formally isolate business interests in a corporation from personal interests. As things grow, an additional corporate layer may be desired to separate operating assets from surplus assets held through a holding corporation. Where multiple business principals are involved, it may be necessary to create two or more lines of holding companies. And, as family are involved, trusts may be used to house and protect their interests, and to guard against their over-involvement in the business while preserving intended tax benefits.