The attribution rules that are contained in the Income Tax Act generally attribute back to the related taxpayer’s investment income from the higher rate taxpayer.  These attribution rules, therefore, attack income splitting.

Were it not for section 74.4 of the Income Tax Act, these rules could be side stepped by simply establishing a corporation, and lending a substantial sum to the corporation at no interest and then paying the resulting investment income that is earned by the corporation in the form of dividends to the related shareholders.

These rules only apply where “designated persons” benefit from such a transfer or loan and the corporation is not a small business corporation.  A designated person is the transferor’s spouse or a minor, who is either not at arm’s length with the transferor or a niece or nephew.  These “designated persons” must own at least 10% of the shares of the corporation.

Sub-section 74.4(2) applies where one of the main purposes of the transfer or loan may reasonably be considered to reduce the income of the transferor and to benefit a designated person.  If this sub-section is operative then the transferor is deemed to receive, as interest, the following amount:

1)                  Interest imputed on the outstanding amount at the prescribed rate of interest;

              less

2)                  Actual interest that is received by the transferor;

3)                  5/4 of the dividends that are received by the transferor on any shares that are received by the transferor upon the transfer, and

4)                  Any amount included in the designated person’s income or “split income” or the Kiddie Tax.
 

You will note that this deemed interest amount is reduced by income that is legitimately taxed in the hands of the transferor or is otherwise caught by the very punitive “Kiddie Tax”.  However, any excess “deemed interest” can never be deducted by the corporation as an expense.

In summary, in order to avoid any inconvenience from the application of this rule, you should, as a transferor, charge at least the provided rate of interest on any debt consideration and receive dividends on any Preferred shares consideration of at least 80% of the prescribed rate of interest.