22 June 2004 STEP Roundtable, 2004-0069971C6 - 2004 STEP Q5. Trust Distributions

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 a non-resident trust deemed resident in Canada under 94(1)(c), or under proposed 94(3), is entitled to a deduction in computing income under 104(6) for an amount payable to a non-resident beneficiary in respect of a taxable capital gain on taxable Canadian property.

Position: No

Reasons: The taxable capital gain is included in income under 94(1)(c)(i)(A) as if the trust were non-resident. If the trust was computing its income as a non-resident, it wouldn't be entitled to a deduction under 104(6) for distributions of income to non-resident beneficiaries. Under the proposed legislation, the reduction required under 104(7.01) eliminates any deduction under 104(6).

STEP Round Table - 2004 Annual Conference

Topic 5 - Trust Distributions

A non-resident relative ("Uncle") of a Canadian resident taxpayer ("Niece") established a discretionary trust in an offshore jurisdiction several years ago. In addition, the mother of Niece (Mother) who is a resident of Canada has made contributions to the trust as well, but such contributions are insignificant in comparison to the contributions made by Uncle. The trust was established while Niece was a minor, living in a foreign country. However, Niece has since immigrated to Canada and is now resident here. The beneficiaries of the trust are Niece and her children (but not her spouse). One of the children ("Cecily") has since moved to the United States to study, and has indicated her plans to stay in the US to marry a US citizen.

The trustees of the trust are Uncle and another non-resident family friend. The trust property consists of a portfolio of investments, including shares in private and public Canadian corporations, Canadian and foreign real estate, and debt obligations of a number of governments.

Cecily has asked the trustees to distribute a portion of the trust assets to her so she can purchase a house in the United States. The trust has just sold a piece of Canadian real estate and has realized a capital gain of $300,000. The trustees are prepared to distribute the sale proceeds from this disposition to Cecily. The trustees have been advised that the trust is deemed to be resident in Canada by virtue of paragraph 94(1)(c), but that the trust may be able to avoid tax on the gain by allocating it to its beneficiaries under subsection 104(6).

A similar scenario was presented in technical interpretation 2003-002462117. In that particular case, the CRA concluded that no deduction would be allowed to the trust under subsection 104(6) in respect of the distribution of income to a non-resident beneficiary. Can you expand upon the rationale of this technical interpretation and explain whether the trust can claim a deduction under subsection 104(6) if it allocates the capital gain to Cecily? In particular, how would the introduction of proposed subparagraph 94(3)(a)(viii) affect your response?

CRA Response:

The Legislative Proposals in respect of Non-Resident Trusts and Foreign Investment Entities, most recently released by the Department of Finance in October 2003, propose to implement certain provisions of the budget tabled in Parliament on February 16, 1999 and significantly amend the rules relating to the taxation of trusts that are not otherwise considered resident in Canada. These proposals are expected to be effective for taxation years commencing after 2002. Consequently, we will first assume the question involves a taxation year commencing before 2003. We also assume that the trustees have discretion to distribute income and/or capital to any beneficiary in a particular taxation year and to simplify the example, that the only income of the trust is the taxable capital gain arising from the disposition of the Canadian real estate.

Analysis based on current legislation

We will first assume that the trustees exercise their discretion to encroach on capital of the trust and determine by written resolution that the amount of the taxable capital gain is payable to Cecily.

In this scenario, the discretionary trust is deemed resident in Canada under paragraph 94(1)(c). With respect to the computation of the trust's taxable income under paragraph 94(1)(c), the only relevant item in this scenario is clause 94(1)(c)(i)(A). That clause refers to "the amount, if any, that but for this subparagraph would be its taxable income earned in Canada for that year." Stated another way, the amount that would be the trust's taxable income earned in Canada if it were not resident in Canada for the year.

The taxable income earned in Canada would be computed under subsection 115(1).

Paragraph 115(1)(b) specifically includes in income taxable capital gains from the disposition of taxable Canadian property other than treaty-protected property. A taxable capital gain from the disposition of Canadian real property would not be treaty-protected property (since all of Canada's treaties, including the income tax convention with the United States protect Canada's right to tax the gain on the disposition of Canadian real property). Hence, the taxable capital gain from the disposition of the Canadian real property would be included in income under paragraph 115(1)(b). While a non-resident trust computing its income under section 115 would be entitled to a deduction under subsection 104(6) to the same extent as any other trust computing its income under Part I, the amount of the deduction under subsection 104(6) is limited by subsection 104(7).

Subsection 104(7) limits the deduction otherwise available under subsection 104(6) in respect of income of the trust that is payable to a designated beneficiary unless the trust was resident in Canada throughout the taxation year. When Cecily ceased to be resident in Canada, she became a designated beneficiary for the purpose of section 210 and subsection 104(7). Since the portion of the trust's taxable income as computed under clause 94(1)(c)(i)(A) is computed as if the trust were not resident in Canada, subsection 104(7) limits the amount of any deduction available under subsection 104(6) in respect of the income described in clause 94(1)(c)(i)(A) that is payable to a designated beneficiary.

Analysis based on the draft legislation released by the Department of Finance in October 2003 for a taxation year commencing after 2002

In this scenario, the trust would be deemed resident in Canada for most purposes of the Act under proposed subsection 94(3) by reason of the Mother's contribution to the trust. As a result of the Mother's contribution, the trust would have both a resident contributor and a resident beneficiary. The fact that the Mother's contribution is insignificant in respect of the total contributions made to the trust may reduce her liability for the trust's taxes under proposed subsections 94(7) and (8), but the trust would still be subject to tax as a resident of Canada and would compute its income in substantially the same manner as any other trust resident in Canada, subject to any exclusions found in proposed subsection 94(4).

Proposed subsection 104(7.01) restricts the amount that a subsection 94(3) trust can deduct under subsection 104(6) in the event that the trust has Canadian source income and makes distributions to non-resident beneficiaries. Thus, if the trustees exercise their discretion to make the income (the amount of the taxable capital gain) of the trust payable to Cecily, that income would be an amount determined under proposed paragraph 104(7.01)(b) and the amount deductible under subsection 104(6) would be nil.

Proposed subparagraph 94(3)(a)(viii) provides that a subsection 94(3) trust is deemed resident in Canada for purposes of determining the liability of the non-resident person for Part XIII tax on amounts paid or credited other than amounts referred to in proposed paragraph 104(7.01)(b). As the trust would not be entitled to a deduction under subsection 104(6) for the income that is payable to Cecily, proposed subparagraph 94(3)(a)(viii) would not be applicable to the payment and thus, the trust would not be required to withhold Part XIII tax from the payment made to Cecily.