CRA indicates that the eligibility of a gain for the capital gains deduction is lost when it is distributed by a lower-tier to upper-tier trust

S. 104(21), which indicates that, in specified circumstances, taxable income distributed by a trust can be designated as being a taxable capital gain of the recipient beneficiary from a disposition, states that it does not apply for purposes of s. 110.6.

CRA considers that this means that where Trust 1 has realized a capital gain from the disposition of qualified small business corporation shares, and distributes that capital gain to a second beneficiary trust (Trust 2), and makes a s. 104(21) designation, the resulting deemed capital gain of Trust 2 is not also deemed to be a capital gain from the disposition of QSBC for capital gains exemption purposes. This, in turn, means that Trust 2 cannot make a s. 104(21.2) designation respecting that capital gain where it is distributed by it, in turn, to its individual beneficiaries, so that they cannot benefit from the capital gains deduction.

Neal Armstrong. Summary of 6 December 2017 External T.I. 2016-0667361E5 F under s. 104(21.2).