21 June 2004 STEP Roundtable Q. 3, 2004-0069951C6 - Phantom Income

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: Whether amounts included in a trust's income under 12(4) or 48.1 can be made payable to a beneficiary and deducted by the trust under 104(6).

Position: It depends on the terms of the trust indenture.

Reasons: Previous positions.

STEP Round Table - 2004 Annual Conference

Question 3 - Allocation of Trust "Phantom Income"

Can a trust allocate "phantom income"? Consider a situation where a family trust has advanced funds to a corporation owned by family members (some of whom are contingent beneficiaries of the trust) which is in financial distress. The loan bears interest which accrues, but which is payable only if the corporation survives a restructuring. This loan would constitute an "investment contract" under subsection 12(11). Consequently, under subsection 12(4), the trust must include the accruing interest in income. However, no amount will be payable to the trust until the conditions are satisfied. In such circumstances, the trust will have a tax liability without any cash to pay the tax. However, if the trust could allocate this "phantom" income to the beneficiaries, they could pay the tax from their resources. In these circumstances, can the trust make an amount payable to the beneficiaries to accomplish this result? What if the accruing interest is never paid (i.e. the business fails) - can the beneficiaries claim a deduction for the interest included in income which was never received?

Note this problem could also arise where a trust held shares of a QSBC that "went public" and made the election under section 48.1 to crystallize the capital gain.

CRA response:

While a trust's income is determined in accordance with the provisions of the Income Act, the amount payable to the beneficiary is determined in accordance with the trust indenture. It is our understanding that so-called phantom income, such as that arising from the accrual of interest income, would not be defined as income for trust law purposes. Hence, at first glance, it is unlikely that such phantom income would be payable in the year to a beneficiary.

We dealt with a similar issue in a Round Table that was held on February 16, 1995 (document number 9503120), wherein we were asked to comment on distributions of deemed taxable capital gains that were triggered as a result of an election made according to subsection 110.6(19) of the Act. That provision was introduced in connection with the elimination of the $100,000 lifetime capital gains exemption and permitted certain personal trusts to elect to have a deemed disposition of capital property on February 22, 1994. The election would give rise to a deemed capital gain in the trust and a corresponding "bump" to the tax basis of the assets to the fair market value on that date. However, there remained the issue of whether the deemed gain could be made payable to the beneficiary in order for the gain to be designated in favor of the beneficiary under subsections 104(21) and 104(21.2) and thus enabling the beneficiary to claim the unused portion of his or her capital gains exemption.

In our response we stated that because a deemed taxable capital gain is a "nothing" under trust law, in order for it to be payable to any beneficiary the terms of the trust must first specifically give the trustees the discretion to pay out or make payable an amount equivalent to the deemed capital gain or the discretion to pay out or make payable amounts that are defined as income under the Act.

The same comments would be applicable to the situation described in this question where an amount is included in the computation of income according to subsection 12(4) of the Act but no property is received by the trust and it is not considered to have received income at law.

Where the trust has accrued and reported interest on a debt obligation and has at any particular time disposed of the obligation for consideration equal to its fair market value at the time of disposition, the trust may, by virtue of subsection 20(21) of the Act, deduct in computing income for the year of disposition the over accrued amount; that is the amount, if any, by which the aggregate of the amounts of interest on that debt obligation that were included in the trust's income for the year of disposition and all previous years exceeds the total interest actually received thereon. There is no provision to allocate the subsection 20(21) of the Act deduction to beneficiaries.

On the disposition of the investment contract, a capital loss could result if the proceeds of disposition are less than the adjusted cost base of the investment contract.

The comments made above in respect of subsection 110.6(19) and 12(4) of the Act also apply in respect of a capital gain deemed to have been realized by a trust on shares of a small business corporation as a result of an election made under section 48.1 of the Act (document 9816425).

Yves Moreno