in law, we trust

Non-Arm’s Length Disposition – Estate Taxation 4/4

Many tax-related topics are covered in detail under the Blogs → Taxation section. This article will focus specifically on a few key tax considerations for estates.

When a property is sold or transferred at a price below its fair market value (FMV) or to a related party, it is considered a “deemed disposition” at FMV under tax rules. This means that for tax purposes, the transaction is treated as if the property was sold at its full market value, regardless of the actual price paid.

Example:
A testator purchased an investment property 30 years ago for $300,000 and rented it out. By the time the testator is 60 years old and drafting a will, the property’s FMV has increased to $1 million. He decides to transfer the property to his child for $500,000, thinking he can avoid estate taxes and reduce capital gains tax liability, as the property would no longer be part of his estate. The testator assumes he has a capital gain of $200,000 ($500,000 sale price minus $300,000 original cost), half of which is taxable, so he expects to pay tax on merely $20,000+ in capital gains to CRA. 

However, in reality, the Canada Revenue Agency (CRA) will consider the property to have been sold at its FMV of $1 million. This means the testator has a capital gain of $700,000 ($1 million FMV minus $300,000 original cost), and he will owe CRA a much higher tax bill of $140,000 in the year of disposition. 

Transfer to a Trust
Under s.75(2) ITA, if an individual transfers property to a trust and retains the ability to benefit from that trust (e.g., receiving income or capital), all income and capital gains generated by the trust will be attributed back to the original transferor. This means the transferor, not the trust or beneficiaries, will be liable for taxes on the trust’s income and gains.

For example, imagine a person creates a trust and transfers rental property to it but retains the right to live in the property. Any rental income or capital gain from the property, even though it is now in the trust, will be attributed back to the original owner for tax purposes. The transferor will be taxed on the rental income and any gains on the sale of the property, not the trust.

Transfer to a Corporation

Under s.74.4 ITA, 

IF

  • an individual transfers property or loans money to a corporation, which is not a CCPC (Canadian-Controlled Private Corporation earning active business income, and
  • the main purpose of reducing their taxable income, and
  • the transferor’s spouse or a non-arm’s length minor holds more than 10% of the company’s shares

THEN

  • The income from that corporation will be assumed (deemed) to be transferor’s income and taxed at a prescribed rate

Since 2018, the CRA introduced new rules to prevent income splitting, which previously allowed business owners to reduce their tax liability by distributing income to family members in lower tax brackets. Under these rules, any dividends or business income paid to family members, such as a spouse or minor children, who do not actively participate in the business, are taxed at the 53% top marginal rate. This effectively eliminates the tax benefit of splitting income with family members.

Important Notice:

This blog series provides readers with a basic and general understanding of estate tax issues. If you encounter estate tax matters in your personal situation, it is crucial to consult with your lawyer or accountant. As always, it’s better to leave professional matters to the professionals.