Beware the kiddie tax
In the 1990s, one of the most popular methods of legally income splitting was to have a business owner issue shares directly, or more commonly indirectly via a family trust, to his or her minor children. Dividends would then be declared on the shares owned by the minors (or the trust) and since they seldom had any income, a significant amount of dividends could be paid (or made payable) to the children tax-free owing to the use of the children’s basic personal tax credits along with the dividend tax credits.
In the family trust context, the dividends declared and paid on the shares held by the family trust would simply be used to pay all the children’s expenses, such as private school tuition, summer camp and extracurricular activities, thus effectively making them payable to the children with, in most cases, no tax owing on the amounts paid on their behalf.
Of course, this all ended back in 2000 when section 120.4 was added to the Income Tax Act which was introduced to prevent high-income individuals from being able to reduce their taxes by income splitting private company dividends with their minor children. The tax levied by this section is more commonly known as the "kiddie tax.”
In a nutshell, under the kiddie tax rules, if an individual under age 18 who has a parent who is a resident in Canada has received dividends from a private company, these dividends are taxed at the highest tax rate or 29% federally. The minor cannot use any credits, including the basic personal amount, to reduce his or tax on these dividends other than the dividend tax credit.
A recent case (Jeannotte v The Queen, 2011 TCC 247) involved the application of the kiddie tax in the trust context. Tenaya Jeannotte was represented in court by her grandfather Ray Jeannotte who had extensive knowledge about the trust which had been created with Tenaya and her sister as beneficiaries.
The trust was created in 1994 on the advice of a tax accountant. Tenaya was loaned money by an unrelated person which she used to purchase shares of a private company. In 1997, 333 common shares of second private company were transferred from the first company to Tenelle Financial Corp, the name of which was composed of Tenaya’s and her sister's name. On April 30, 1997, the Vaughn Jeannotte Financial Trust was created with Tenaya’s father as the trustee. (It is unclear from the Court transcript how exactly the private company shares got into the family trust, but for our purpose, we’ll assume that the family trust owned private company shares on which a dividend was ultimately paid.)
Mr. Jeannotte testified that the purpose of the trust was not to split income but rather to ensure that there were funds for his granddaughters' education, the trust having been set up at the time when Tenaya’s parents were getting a divorce.
It was her position that the funds in the trust were her funds because she had borrowed the money to purchase the shares of the first company and thus the traditional attribution rules should not apply.
Since in 2006, Tenaya was 15, was a resident in Canada and had a parent who was also a resident in Canada, the Canada Revenue Agency reassessed her to tax a $25,000 dividend paid by the corporation to the family trust and then distributed to her as a beneficiary of the family trust at the 29% tax rate.
The Court concluded that there was no need to identify the property transferred to the trust or who made the loan to the Tenaya to purchase the shares since this was irrelevant. In other words, section 120.4 of the Act is quite clear and the kiddie tax applies to the dividend Tenaya received from the Canadian private corporation.
Mr. Jeannotte stated that the law was not fair, but the Judge said that the Court must interpret the section “as it finds it.” Quoting an earlier case:
The applicant says that the law is unfair and he asks the Court to make an exception for him. However the Court does not have that power. The Court must take the statute as it finds it. It is not open to the Court to make exceptions to statutory provisions on the grounds of fairness or equity. If the applicant considers the law unfair, his remedy is with Parliament, not with the Court.
As a result, the Tax Court dismissed Tenaya’s appeal and the kiddie tax was upheld. This case should serve as an important reminder that this rule is out there and occasionally, if you are not careful in your tax planning, could end up causing a significant tax liability on what you might have otherwise thought was a tax-free dividend.