30 March 1995 External T.I. 9504985 - CAPITAL GAINS ELECTION AND TRUSTS

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

		950498
XXXXXXXXXX	L. Holloway
(613) 957-8953

Attention: XXXXXXXXXX

March 30, 1995

Dear Sirs:

Re: Capital Gains Exemption and Personal Trusts

This is in reply to your letter dated February 22, 1995, concerning the methods by which a trust can flow out a deemed gain created by proposed subsection 110.6(19) of the Income Tax Act. All references to sections and parts thereof herein will be to the Income Tax Act.

Your letter presented the following hypothetical scenario:

An inter vivos trust has only three beneficiaries who have the following entitlements under the trust document:

Beneficiary A - discretionary income beneficiary,
Beneficiary B - discretionary income and capital beneficiary, and
Beneficiary C - discretionary capital beneficiary.

The trust document does not require that "deemed income" be paid to any of the beneficiaries and the trust document does not specify that capital gains are considered to be income for the purposes of the trust. The trust makes the proposed subsection 110.6(19) election to trigger a deemed capital gain in its 1994 taxation year.

In addition, we have also assumed:

a)that neither the settlor nor the settlor's spouse are beneficiaries,

b)there is power to encroach on capital for B and C, and

c)the capital interests of B and C are vested.

You asked that we confirm your understanding of the following statements:

1.The deemed capital gain created by the election can be made payable pursuant to subsection 104(24) to B and C only.

2.Such deemed gain cannot be made payable to A since capital gains arising in the trust are considered to be capital of the trust under trust law and beneficiary A is not entitled to any of the capital of the trust.

3.In order for the deemed capital gain to be considered to be payable pursuant to subsection 104(24) to B and C, the trustees must have exercised their power to encroach on capital during the trust's 1994 taxation year. Specifically, the amount must have either been:

a)paid by the trust to B and C during the year; or

b)made payable to B and C during the year such that each of B and C had a legal right to enforce payment of the amount in the trust's 1994 taxation year.

4.With respect to b) in 3 above, if the trustees intended on encroaching on capital before the end of the trust's year to make the amount payable to B and C in the event that the deemed capital gain could in fact be made payable, this intention would be sufficient for the deemed capital gain to be payable at the end of the 1994 taxation year pursuant to subsection 104(24).

5.With respect to b) in 3 above, would a demand note be required as evidence that the amount is payable to B and C?

6."Accumulating income" as defined in subsection 108(1), will include the deemed taxable capital gain created by the proposed subsection 110.6(19) election. Therefore, assuming that a preferred beneficiary election is available, A, B and C can enter into a subsection 104(14) election with the trust to include 1/3 of the deemed taxable capital gain in their respective incomes as determined under paragraph 104(15)(c) and Regulation 2800(3)(f).

7.If the trust document instead states that capital gains are considered to be income for the purposes of the trust, then:

a)The deemed capital gain created by the election can be made payable pursuant to subsection 104(24) to A and B but could not be made payable to C; and

b)Although each of the beneficiaries qualifies as a preferred beneficiary as defined in subsection 108(1), only A and B can enter into a joint subsection 104(14) election to include 1/2 of the deemed taxable capital gain in their respective incomes. C's share of the accumulating income of the trust is nil pursuant to paragraph 104(15)(d) since C is not entitled to share in the accumulating income of the trust.

Our Comments

Your letter made reference to several discussions with our office (XXXXXXXXXX/Holloway) on draft subsection 110.6(19). In particular you had mentioned that in some cases trustees did not make amounts payable before a trust's 1994 taxation year-end based on our opinion that it was doubtful that a trust could do so. Upon obtaining advice from our legal counsel (received after December 31, 1994) we maintain that deemed gains and other such "phantom income" could never be recognized as income for trust law purposes. Recognizing this, we would accept an amount as being payable for the purposes of subsections 104(24), (13), (6), (21) and (21.2) if the terms of the trust specifically require or allow an amount equivalent to the "phantom income" to be paid or payable or, alternatively, where the trustees have a discretionary power to pay to beneficiaries amounts that are defined as income under the Income Tax Act. These amounts would be paid as capital under trust law since the phantom income is still a "nothing" for trust law purposes.

Therefore, with regard to the additional assumptions we have made we offer the following comments on the statements made in your letter.

Statements 1. to 4.

We do not agree with these statements. In order for a deemed capital gain to be payable, the terms of the trust would have to allow the trustees to pay out amounts equivalent to the deemed capital gain to B and C. A power to encroach on capital is not, in and by itself, sufficient to make a deemed capital gain payable. Therefore, an amount equivalent to the deemed gain would be payable for income tax purposes only where the trustees have exercised their power to make it payable.

Statement 5.

A promissory note is ordinarily given and received as acknowledgement of the existence of a debt, but does not itself create a debt. A trustee cannot create a right of a beneficiary to enforce payment of an amount unless the terms of the trust allow or require the trustee to do so. Therefore, the trustee cannot issue a promissory note to a beneficiary for eventual payment of a deemed gain in order to make this amount payable. Where a power to pay out an amount equivalent to a deemed gain is exercised during the year and a decision is made not to pay out assets in kind or to distribute cash before year-end, then a valid payable under subsection 104(24) will have been created where the promissory note is payable on demand without restriction. There should be evidence of the exercise of the power to pay out the deemed gain (i.e. documentation creating a legally valid claim and the encumbering of assets).

Statement 6.

We do not agree with this statement. In our opinion, B and C could each elect on 1/3 of the accumulating income as calculated pursuant to paragraph 104(15)(c). The share of A is nil pursuant to paragraph 104(15)(d) because in absence of an encroachment power on A's behalf, A would never be entitled to any capital gains of the trust. However, as A, B and C "may be entitled to share in accumulating income", all are included in the divisor in Regulation 2800(3)(f).

Statement 7.

a)We do not agree with this statement for the reasons stated above. It is the terms of the trust that would dictate whether the deemed gain could be payable by the trustees, not the encroachment power.

b)We agree with this statement.

These opinions are our interpretation of the law as it applies generally. They may, however, not always be appropriate in the circumstances of a particular case. These opinions are not advance income tax rulings and, as stated in paragraph 21 of Information Circular 70-6R2, they are not binding on Revenue Canada.

We trust the foregoing clarifies our position with respect to the issues in question.

Yours truly,

for Director
Manufacturing Industries, Partnerships
and Trusts Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch