15 June 2022 STEP Roundtable Q. 5, 2022-0928231C6 - Trust and Debt Forgiveness

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 an in specie capital or income distribution by a personal trust will give rise to a forgiven amount for the purposes of section 80 in the described situation.

Position: Generally no.

Reasons: Based on the CRA’s long-standing position on debt settlement in various factual situations relevant to this issue.

2022 STEP CRA Roundtable – June 15, 2022

QUESTION 5. Trust and Debt Forgiveness

A Canadian resident trust makes a loan (the “Loan”) to a beneficiary. The beneficiary uses the Loan proceeds for investment. Later the trust distributes the Loan as an in specie capital or income distribution to the beneficiary.

Is the distribution of the Loan to the beneficiary a settlement of debt? If so, do the debt forgiveness rules under section 80 of the Income Tax Act (the “Act”) apply to the beneficiary for the “forgiven amount”?

If the beneficiary used the loan proceeds for personal purposes (e.g. to buy a principal residence), is the answer different?

CRA Response

For the purposes of our response, we have assumed that the trust qualifies as a “personal trust” within the meaning of that term in subsection 248(1) of the Act and that the trust’s taxation year ends on December 31, which coincides with the taxation year-end of the beneficiary. We have further assumed that the beneficiary of the trust is resident in Canada for the purposes of the Act.

We understand that the in specie capital or income distribution, as the case may be, is legally effective and is made to a capital or income beneficiary of the trust, as the case may be, in accordance with the terms of the trust indenture.

We also understand that the Loan is a bona fide loan made by the trust to the beneficiary and is capital in nature at the time of the distribution. We understand that the amount of principal and fair market value of the Loan is equal to the capital or income distribution, as the case may be.

The meaning of a settlement or extinguishment of an obligation is not defined in the Act. The determination of whether an obligation is settled or extinguished, whether there is payment and whether there is a forgiven amount resulting from its settlement or the extinguishment is a mixed question of fact and law and can only be determined on a case-by-case basis. Generally, where the qualities of creditor and debtor are united in the same person, the obligation would be extinguished under the doctrine of “merger” under the Common Law (or “confusion” under article 1683 of the Civil Code of Quebec), and thus would generally constitute a settlement of the obligation for the purposes of section 80 of the Act.

For the purposes of our response, we understand that the Loan is extinguished in accordance with the applicable law as a result of the distribution of the Loan to the beneficiary under the doctrine of “merger” (or “confusion”, as applicable) and that the settlement of the Loan in such a manner does not constitute a “payment” by the beneficiary in satisfaction of the principal of the Loan within the meaning of the applicable law.

The “forgiven amount” defined in subsection 80(1) of the Act applies to a “commercial obligation” issued by a debtor. A “commercial obligation” issued by a debtor means (a) a commercial debt obligation issued by the debtor or (b) a distress preferred share issued by the debtor. A “commercial debt obligation” is a debt obligation for which an amount relating to interest paid or payable on the debt obligation, if any, is or would be deductible in computing the debtor’s income, taxable income or taxable income earned in Canada. In the present question, if the proceeds from the Loan are used by the beneficiary for investment purposes that meet the criteria for interest deductibility, the Loan would qualify as a “commercial debt obligation”. If the proceeds of the Loan are used by the beneficiary for personal use such as to buy a personal residence, the Loan would not be considered as a “commercial debt obligation”, so that the definition of the “forgiven amount” would not apply to the settlement of the Loan.

When a “commercial obligation” is settled, it must be determined whether it gives rise to a “forgiven amount”. A “forgiven amount” at any time is determined by the formula “A-B” under that definition in subsection 80(1) of the Act. The element “A” of the formula is the lesser of the amount for which the obligation was issued and the principal amount of the obligation. The element “B” of the formula is the total of the amounts described in paragraphs (a) to (l) of that element “B”. Paragraph (a) of the element “B” includes any amount paid at the time the obligation is settled in satisfaction of its principal amount. In the fact situation described in your question, as we understand it, a settlement of the Loan does not constitute a payment in satisfaction of the principal amount of the obligation and would not constitute an amount described in paragraph (a), nor in any other paragraphs (b) to (l) of the element “B”. Therefore, a settlement of the obligation without any payment could give rise to a forgiven amount equal to element “A” in the said formula “A-B”.

In some specific situations, when a “commercial obligation” is extinguished under the doctrine of “merger” (or “confusion” as applicable) and it does not constitute a payment under the applicable law, the CRA adopts a long-standing position to consider that those situations will not give rise to a “forgiven amount” for the purposes of section 80 of the Act. Based on the facts and assumptions as we understand them, we are of the view that the CRA’s long standing position would apply to the extinguishment of the Loan described in the present question.

Finally, we would like to point out that the taxpayer could structure the transactions in such a way that the legal documentation clearly demonstrates the payment of the Loan, so that the transactions do not raise uncertainty as to the application of section 80 of the Act in similar situations.

Nathalie Aubin
2022-092823