Tax Planning for Dentists: Technique Approved by Tax Court
By: Bobby B. Solhi, J.D. and David Bach
The Tax Court of Canada in Gwartz allowed a tax planning technique that permitted a dentist practitioner to “split income” with his minor children and reduce his overall tax liability through the use of “high-low shares”. This was an important decision as tax planning for dentists, and other professionals for that matter, can be a means to reduce tax, protect certain assets, and begin the estate planning process.
This technique involved the use of a management company (“ManageCo”) that was incorporated to provide management services to a dental practice operated by Dr. Gwartz. The management company was wholly owned by a family trust established for the benefit of Dr. Gwartz’s two minor children. The dentist used the family trust to split his professional income with the children and to arrive at a lower overall tax liability on his earnings.
To realize the tax benefits, Dr. Gwartz entered into a series of transactions to strip the surplus out of the management company (i.e., “surplus stripping”) and into the hands of the trust, and onto his children as beneficiaries. This was accomplished by having the trust subscribe to preference shares in ManageCo with a high redemption value, which was $1 per share for 300,000 shares, with paid up capital of only $1 for all shares – i.e., high-redemption, low-PUC shares. The issuance of the new preference shares effectively shifted the value of ManageCo from the common shares to the preference shares. The preference shares were subsequently cycled through the hands of Dr. Gwartz, then to a holding company owned by his spouse, and back to the trust.
From a tax perspective, the intended result of these transactions was to have the trust earn the surplus as a capital gain – of which only 50% would be taxable – rather than a dividend, which would be entirely subject to income tax.
What was the Issue?
The main issue on appeal was whether surplus transferred from ManageCo to the children was appropriately characterized as capital gains. The Minister sought to apply the general anti-avoidance rule (“GAAR”) to re-characterize the surplus as dividend income on the basis that the series of transactions was a misuse or abuse of section 120.4 of the Income Tax Act (the “ITA”)(Canada).
Section 120.4 provides for a special tax or “kiddie tax” that is imposed on certain kinds of income received by minors from related people and companies. For the years at issue in this case, section 120.4 did not apply to income earned by way of capital gains.
For taxation years after 2010, section 120.4 was amended to include its application to capital gains. Accordingly, this type of planning is no longer viable with minor children but the principal from this case are worthy of consideration.
What happened in Gwartz?
The taxpayer’s appeal was allowed. Hogan, J. held that the transactions undertaken to generate capital gains instead of dividend income did not constitute abusive tax avoidance for the purposes of the GAAR. In his analysis, Hogan, J. set out the relevant principles application to this case:
In analyzing the object, spirit and purpose of section 120.4, Hogan J. looked to the text and context of the provision, extrinsic materials, and subsequent amendments to the provision.
He noted that section 120.4 was notable for its relative brevity and simplicity, suggesting that Parliament “was concerned with minimizing the complexity of the provision and providing certainty to taxpayers with respect to its application.”
Moreover, he pointed to a number of provisions specifically aimed at precluding surplus stripping through converting what would be dividends into capital gains (i.e., sections 84 and 84.1) that were in place prior to section 120.4, which suggested that Parliament was fully aware that taxpayers could achieve a tax benefit in such a manner when the impugned provision was enacted. He inferred that the exclusion of capital gains from s. 120.4 was an intended consequences stemming from Parliament’s preference of simplicity over complexity in respect of income splitting with minor children.
Hogan, J. also noted that subsequent amendments that broadened the scope of s. 120.4 were not determinative when examining the purpose of the provision prior to the amendment, and that by reference to the explanatory notes to the 2011 Budget he inferred that by using the words “extend” in describing that the amendments would apply to capital gains, Parliament did not intend for capital gains to apply prior to the amendment.
Importantly in this case, the capital gains were not artificially generated as the taxpayer’s could have simply sold their common shares in ManageCo and generated the same capital gains. As noted by the Court, the series of transactions that used the high-low shares may have been chosen to avoid having to do a valuation of the common shares, whereas the Class D Preferred Shares had a fixed redemption value.
It should be noted that this decision is still open to appeal by the Minister at the time of writing.
Lastly, while tax planning for dentists and this tax planning technique in particular would now be subject to the kiddie tax and thereby remove the tax benefit, it could still be a good strategy for those with adult children (over 18 years old) at the lowest marginal tax rates. It is, of course, important to exercise caution and have such plans reviewed by a tax practitioner.
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