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.
Principal Issues: Where a trust makes a section 48.1 election can the phantom income created by the election be taxed in the hands of a beneficiary? If so, how does the trust meet the requirement that the income is paid or payable to the beneficiary by the end of the year? Assuming the trust meets this requirement; can the payment be made "in kind" by distributing the shares that were the subject of the section 48.1 election?
Position: It depends on the terms of the trust indenture.
Reasons: The terms of the trust must specifically give the trustees the discretion to pay out or make payable an amount equivalent to a deemed capital gain or the discretion to pay out or make payable an amount that is defined as income under the Act. Where the trust makes the payment in kind, the trust must specify that such payment is in respect of the deemed taxable capital gain and not in satisfaction of a beneficiary's capital interest in the trust.
STEP CRA Roundtable – June 10, 2016
Question 12 – Amounts Payable and Phantom Income
In certain circumstances, a trust may realize income for income tax purposes without receiving a payment, or even having a transaction. Such income is sometimes called “phantom income”. One example might be where a trust owns shares of a Canadian controlled private corporation which is a small business corporation, which then becomes publically listed. An election can be made under section 48.1 to realize a capital gain. The trust itself has no transaction and no economic realization, yet income is deemed to arise for tax purposes.
Our question is whether phantom income of this kind can be taxed in the hands of a beneficiary and, if so, how does the trust meet the requirement that the income is paid or made payable to the beneficiary by the end of the year? Assuming the trust meets this requirement, can the payment be made ‘in kind’ by distributing the shares that were the subject of the section 48.1 election?
It is our understanding that a deemed capital gain for purposes of the Act is not recognized as income or capital for trust law purposes. A deemed capital gain is a “nothing” for trust law purposes. Where a trust elects under section 48.1, the taxable capital gain resulting from the deemed disposition would be taxed in the trust, unless the deemed taxable capital gain is paid or payable to the trust beneficiaries within the meaning of subsection 104(24) and the requirements of subsection 104(6) are met.
Subsection 104(24) provides that an amount is deemed not to have become payable to a beneficiary in a taxation year unless it was paid in the year to the beneficiary or the beneficiary was entitled in the year to enforce payment of the amount. The word “entitled” refers to a legal entitlement as would be dictated by the terms of the trust indenture. A power to encroach on capital is not in and of itself sufficient to make a deemed capital gain payable for purposes of subsection 104(24). Instead, the terms of the trust must specifically permit an amount equivalent to the deemed taxable capital gain to be paid or payable, or the trustee must have the discretionary power to pay out amounts that are defined as income under the Act.
For a discretionary trust, an amount equivalent to the deemed taxable capital gain would be payable for income tax purposes only where the trustees have exercised their power to make it payable. The trustees must exercise their discretion before the end of the trust’s taxation year and the exercise must be irrevocable with no conditions attached to the beneficiaries’ entitlements to enforce payment of the amount in the year. Furthermore, the beneficiaries must be advised before the end of the trust’s taxation year. The trustees’ exercise of discretion and notification to the beneficiaries should be in writing (e.g. in a resolution signed by the trustees, minutes of a trustees’ meeting). Where a trust is non-discretionary, the trust indenture must provide that the amount equivalent to the deemed taxable capital gain is to be paid or payable to the beneficiaries by the end of the trust’s taxation year.
In order for a deemed taxable capital gain to be distributed by way of a payment in-kind, the trust indenture must also permit the assets of the trust to be distributed to the beneficiaries as a payment in-kind. The resolution authorizing the distribution should indicate that the payment is in respect of the amount of the deemed taxable capital gain and not in satisfaction of a beneficiary’s capital interest in the trust. Where the fair market value of the property distributed in-kind exceeds the amount of the deemed taxable capital gain, the difference would represent a distribution in satisfaction of the beneficiary’s capital interest in the trust as contemplated under subsection 107(2) assuming the conditions in that provision are otherwise met and no other trust income is being distributed.
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