Beware the kiddie tax

One of the most popular methods of legal income splitting in the 1990s was to have a business owner issue shares directly or indirectly (via a family trust) to his or her minor children.

The company would then declare dividends on the shares owned by the minors, and since they seldom had any income, a significant amount of dividends could be paid (or made payable) to the children tax-free. This would occur since the dividends would be offset by the children’s basic personal tax credits along with the dividend tax credits.

In the more common 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.

This ended in 2000 when the government added section 120.4 to the Income Tax Act. The purpose of this section is 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 also known as the “kiddie tax.”

Under the kiddie tax rules, if a child under age 18 with a parent resident in Canada has received dividends from a private company, these dividends are taxed at the highest federal tax rate, 29%. Except for the dividend tax credit, the minor cannot use any other credits, including the basic personal amount, to reduce his or tax on these dividends.

A recent case (Jeannotte v The Queen, 2011 TCC 247) involved the application of the kiddie tax in the trust context. The plaintiff was Tenaya Jeannotte, whose grandfather Ray represented her since he had extensive knowledge about the trust that named Tenaya and her sister as beneficiaries.

The Jeannottes created the trust in 1994 on the advice of a tax accountant. An unrelated person loaned money to Tenaya, which she used to purchase shares of a private company. In 1997, 333 common shares of a second private company were transferred from the first company to Tenelle Financial Corp, a portmanteau of Tenaya’s and her sister’s names.

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 the private company shares got into the family trust, but we’ll assume the family trust owned private company shares on which a dividend was ultimately paid.)

Ray Jeannotte testified the purpose of the trust was not to split income, but rather to ensure there were funds for his granddaughters’ education. The trust was set up at the time when Tenaya’s parents were getting a divorce. It was Tenaya’s position that the funds in the trust were hers because she had borrowed the money to purchase the shares of the first company – so the traditional attribution rules should not apply.

Since in 2006 Tenaya was 15, a resident in Canada and daughter of a parent who was also a Canadian resident, the CRA reassessed her to be in receipt of a $25,000 dividend, taxable at 29%. The corporation paid this dividend to the family trust, and then the trust distributed the dividend to her as beneficiary.

The Court concluded there was no need to identify the property transferred to the trust or who made the loan to Tenaya to purchase the shares, deeming these facts irrelevant. Section 120.4 of the Act is quite clear and the kiddie tax rule applies to the dividend Tenaya received from the Canadian private corporation.

Ray Jeannotte stated the law was not fair, but the judge said 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 upheld the kiddie tax rules. If you are not careful in your tax planning, you could cause a significant tax liability on what you thought was a tax-free dividend.

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.