The Income-Diversion Rules: Section 56 Of The Income Tax Act—A Canadian Tax Lawyer's Analysis

Introduction: Income-Diversion Arrangements

A taxpayer might try to reduce his or her taxable income by diverting an incoming payment to another party. For example, an employee might direct her employer to pay a portion of the employee's salary directly to a creditor of the employee. Similarly, a creditor might direct his debtor to make interest payments to the creditor's mother.

Of course, these sorts of arrangements may serve legitimate non-tax purposes, and they may be perfectly legal and enforceable under private law. But Canada's tax law will sometimes ignore legally effective arrangements when discerning the proper taxable recipient of income.

The income-diversion rules in section 56 of the Income Tax Act identify several cases where tax law will ignore a transaction that private law might see as valid. (The attribution rules also illustrate this same principle. For more on the attribution rules, see here)

This article looks at three income-diversion rules:

the indirect-payment rule in subsection 56(2); the income-assignment rule in subsection 56(4); and the rule applying to interest-free or low-interest loans in subsection 56(4.1). Indirect Payments—Subsection 56(2) of the Income Tax Act

Subsection 56(2) will include in a taxpayer's income a payment that was:

made to a person other than the taxpayer; made pursuant to the direction of, or with the concurrence of, the taxpayer; made for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person; and would have been included in the taxpayer's income if it had been made to the taxpayer. Put differently, when 56(2) applies, it renders a diverted payment ineffective for tax purposes. So, if (as in our previous example) an employee directs her employer to pay a portion of the employee's salary directly to a creditor of the employee, then the employee must still pay tax on that income. Likewise, a creditor is still taxed on interest income where the creditor directs his debtor to pay the loan interest to the creditor's mother. In each case, the taxpayer would have to report the income even though she or he didn't actually directly receive it.

Subsection 56(2) doesn't apply to preferential dividend declarations. For instance, in R v McClurg, [1990] 3 SCR 1020, a closely held corporation had four shareholders: the taxpayer, his business partner, and each of their wives. The husbands held one class of shares; the wives held another class. In...