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tax matters

As the Christmas season approaches we'll be having a couple of parties at our home. There are certain topics that are taboo when it comes to starting conversations with guests. Talking about the state of someone's finances, condition of their marriage, their incontinence, life expectancy or physical ailments didn't work well for me last year. And I don't like to talk much about the Income Tax Act either – particularly subsection 56(2). Not that most guests would mind having a conversation about it (I read parts of section 80.01 to guests last year), but that particular provision gets my blood boiling. Let me explain.

The law

What you should understand about subsection 56(2) of the Act is that it deals with what are called "indirect payments." The subsection is meant to catch situations where you should receive and face tax on certain amounts, but you direct the payments to someone else with the intention of avoiding tax.

If 56(2) applies, it can cause an amount, that you do not receive, to be added to your income. Specifically, you'll face tax if four conditions are met: (1) There's a payment or transfer of property to someone other than you, (2) the payment or transfer takes place at your direction or concurrence, (3) there's a benefit to you, or that you intend to confer on the other person, and (4) you would have been taxed on the amount if the payment or transfer had been made to you rather than the other person.

The examples

Okay, I get it. The subsection is important in certain situations. What if, for example, you're an independent salesperson and you're owed commissions, but you direct the payer of the commission to make payment to someone else instead – perhaps your spouse. In this case, you should pay the tax, and 56(2) will ensure that happens. Or take another example where you're the shareholder of a corporation and you cause your company to make a gift to your Aunt Bessie (who is not a shareholder or employee).

Or perhaps you own a rental property and instruct your tenant to pay the rents to your corporation even though you own the property personally. Or maybe you direct your business to pay a salary to your spouse when she didn't truly provide any services to the business. Subsection 56(2) can apply in all of these cases. The list of examples is endless.

The story

Earlier this year, a taxpayer wrote the Canada Revenue Agency a letter asking for the taxman's views on a matter that involved 56(2). Here's the story: An employee – let's call him Mr. Donor – would like to donate some of his vacation time to a co-worker – call him Mr. Friend – who is experiencing hardship and needs the additional time off to deal with personal family matters. It's clear that vacation time has monetary value. In this case, the employees have the option to take their vacation time (and be paid for it, of course) or take cash instead of the time off. It's also fair that someone should pay tax on that value received from the employer.

CRA responded to the taxpayer's letter (in document 2013-0514321E5) by suggesting that Mr. Donor would face tax on the value of the donated vacation time under 56(2). The taxman also said that it's possible that Mr. Friend would also face tax on the value of that vacation time, although they'd likely be willing to forgo taxing Mr. Friend to avoid double-taxing the amount. Given this response, I wouldn't blame Mr. Donor if he decided not to donate his vacation time after all.

The moral

You'll notice that the conditions for 56(2) to apply (noted above) say nothing about the intent to avoid tax – but really should. In the story above, Mr. Donor, who was willing to donate his vacation time to his co-worker, was not trying to avoid tax. He was trying to help a friend and co-worker. In fact, avoiding tax was not even on his radar. Yet, according to CRA, 56(2) will apply to tax Mr. Donor on the value of the vacation time. I bet the co-worker who received the vacation time would be willing to pay tax on the compensation he receives when taking those vacation days. And that would be fair. Instead, CRA plans to penalize the donor. The problem is that subsection 56(2) of our tax law isn't well-written.

So, the moral of the story? Be aware that 56(2) is out there, and be careful any time you transfer or direct payments, property, or something of value to another person, because you might just face tax.

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.