3 May 2022 CALU Roundtable Q. 9, 2022-0928891C6 - Subsection 104(6)

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: Question 1: Whether a deemed dividend by virtue of subsection 84(2) or (3) can be deducted by the trust where the cash received on the winding-up of the corporation or the redemption of the shares is paid by the trust to the capital beneficiaries in the year the redemption or winding up occurs.

Question 2: What powers must be contained in a trust agreement to allow the trustees to pay cash to income beneficiaries equal to phantom income in the form of a subsection 84(1) deemed dividend or FAPI and have the income allocated to the income beneficiaries.

Position: Question 1: Question of fact based on the terms of the trust agreement and the relevant trust law.

Question 2: Where an amount included in the taxable income of a trust is not recognized as income or capital for trust law purposes (referred to as “phantom income”), the terms of the trust must specifically permit an amount equivalent to the phantom income to be paid or payable or, alternatively, provide the trustees with the discretion to pay out or make payable amounts that are defined as income under the Act in order for the phantom income to become payable to any beneficiary.

Reasons: See below.

CALU Roundtable – May 2022

Question 9 – Subsection 104(6) and Trust Deemed Income Paid to Beneficiaries

PART 1

Background:

Consider the following two scenarios:

(a) A Canadian resident trust (the “trust”) is the sole shareholder of a private Canadian corporation. The corporation redeems a portion of its shares held by the trust for cash consideration with the result that the trust has taxable income in the year consisting of a deemed taxable dividend under subsection 84(3) of the Income Tax Act (the “Act”). For trust law purposes, the trust receives the cash consideration as a part of its capital (none of the provisions of the trust deem the proceeds from the redemption of shares to be ‘income’ of the trust). The trustees distribute the cash consideration as a capital distribution to the capital beneficiaries of the trust before the end of the trust’s taxation year in which the shares were redeemed.

(b) Assume the same facts as presented in (a), except that rather than redeeming its shares, the corporation winds-up in the year and distributes its assets (all cash) on the wind-up to the trust. As a result, the trust has taxable income in the year consisting of the deemed taxable dividend under subsection 84(2) of the Act. For trust law purposes, the trust receives the cash as a part of its capital (none of the provisions of the trust deem the cash received on the wind-up to be ‘income’ of the trust). The trustees distribute the full amount of the cash proceeds as a capital distribution to the capital beneficiaries of the trust before the end of the trust’s taxation year in which the shares were redeemed.

In its response to Question 2 of the 2018 APFF Conference (CRA document 2018-0768901C6), the CRA seemed to state that, in scenarios such as those described above, the terms of the trust need to include a power that permits the trustees to pay or make payable an amount equal to the deemed dividend and that a deduction under subsection 104(6) of the Act will only be permitted if the amount equivalent to the deemed dividend is not paid or made payable to the beneficiary as a capital distribution.

We question the requirement that the terms of the trust need to include a power that permits the trustees to pay or make payable an amount equal to the deemed dividend to qualify for a deduction under subsection 104(6) of the Act. We believe the provisions of the Act should apply such that the trust would be entitled to a deduction under subsection 104(6), and the beneficiary will have the amount distributed included in income pursuant to subsection 104(13) of the Act, as follows:

i. Pursuant to paragraph 104(6)(b) of the Act, the trust is entitled to a deduction in computing its income for a taxation year up to the amount not exceeding the portion of its income for the year that became ‘payable’ to a beneficiary in the year.

ii. Pursuant to paragraph 104(13)(a) of the Act, in computing the income of a beneficiary of a trust, there is to be included such part of the amount that, but for subsections 104(6) or (12) of the Act, would be the trust’s income for the year as became payable to the beneficiary.

iii. Subsection 104(24) of the Act provides that for the purposes of subsections 104(6) and (13) of the Act, an amount is deemed not to have become payable to a beneficiary in a tax year unless it was paid in the year or the beneficiary was entitled in the year to enforce payment.

Neither subsection 104(6), nor subsection 104(13) of the Act, contain any conditions for their application that have regard to the nature of the distribution from a trust law perspective. Rather, for the purposes of subsection 104(6) and 104(13) of the Act, it is the nature of the amount from a tax law perspective that is determinative. Consequently, since on the facts presented in Scenarios (a) and (b), income (as determined for tax purposes) of the trust for the year has been paid to a beneficiary before the end of the year, subsection 104(13) of the Act should apply to include such amount in the calculation of the beneficiary’s income for the year, and the trust should be permitted a deduction in calculating its income for the distributed amount pursuant to subsection 104(6) of the Act.

Question 1:

Can the CRA confirm that in the situation presented in Scenarios (a) and (b) above, the trust would be entitled to a deduction under subsection 104(6) of the Act in computing its income for the year and a similar amount would be included in the income of the capital beneficiaries for the year under subsection 104(13) of the Act.

PART 2

Background:

Consider the following four scenarios:

(c) Assume the same facts as presented in Scenario (a), except that rather than redeeming its shares, the corporation increases the stated capital of its shares with the result that the trust has taxable income for the year consisting of a deemed dividend under subsection 84(1) of the Act. Pursuant to the terms of the trust, the trustee is granted the power to make payable to its beneficiaries as income, any amounts that are deemed income under the Act and to pay the amounts with other assets of the trust (the “Deemed Income Distribution Power”). The trustee makes a distribution of trust assets (being cash) to the income beneficiaries of an amount equal to the amount of the stated capital increase before the end of the trust’s taxation year in which the stated capital increase occurred.

(d) Assume the same facts as presented in Scenario (c), except that no Deemed Income Distribution Power is contained in the terms of the trust.

(e) The trust holds shares of a corporation that is a “controlled foreign affiliate” as that term is defined in subsection 95(1) of the Act. As required under subsection 91(1) of the Act, the trust includes in its income “foreign accrual property income” (“FAPI”) of the controlled foreign affiliate in the year. Pursuant to the terms of the trust, the trustee is granted the power to make payable to its beneficiaries as income, any amounts that are included in the income of the trust under the Act and, where such income is not actual income of the trust (meaning that there is no actual return received by the trust on the property), to pay the amounts with other assets of the trust (the “Tax Income Distribution Power”). The trustee makes a distribution of trust assets (being cash) to the income beneficiaries of an amount equal to the FAPI before the end of the trust’s taxation year in which the FAPI was included in the income of the trust under subsection 91(1) of the Act.

(f) Assume the same facts as presented in Scenario(e), except that no Tax Income Distribution Power is contained in the terms of the trust.

Question 2:

Can the CRA confirm whether, in the situations presented in Scenario (c), (d), (e) and (f) above, that the trust would be entitled to a deduction under subsection 104(6) of the Act in computing its income for the year and such amounts would be included as income of the income beneficiaries under subsection 104(13) of the Act?

Response:

Question 1:

Under paragraph 104(6)(b) of the Act, a trust is generally entitled to deduct in computing its income for a taxation year such part of its income as became payable in the year to a beneficiary. The amount that became payable is generally included in the beneficiary's income under subsection 104(13) of the Act. In addition, by virtue of subsection 104(24) of the Act, 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.

To determine if the deemed dividend received by virtue of subsection 84(3) or 84(2) of the Act, as the case may be, became payable for purposes of subsections 104(6) and (13) of the Act, it is necessary to determine whether the amount paid to the beneficiary was made in accordance with the terms of the trust and the applicable trust law. If the amount cannot be paid in accordance with the terms of the trust and the relevant trust law, the amount cannot be considered to have become payable for the purposes of subsections 104(6) and (13) of the Act. Therefore, the fact that an amount has been paid in the year to a beneficiary is not determinative of whether an amount has become payable for the purposes of the application of subsections 104(6) and (13) of the Act.

Based on the facts provided, the cash consideration from the redemption or winding-up, as the case may be, formed part of the capital of the trust and was paid to the capital beneficiary in the taxation year of the trust in which the deemed dividend under subsection 84(2) or 84(3) of the Act was received. Provided the cash received as consideration from the redemption or winding-up was paid to the capital beneficiary in accordance with the terms of trust and the applicable trust law, the deemed dividend became payable to the beneficiaries for the purposes of subsections 104(6) and 104(13) of the Act.

The position described above is consistent with the response provided in CRA Document 2018-0768901C6.

Question 2:

As we have stated in the past (see CRA Document 2016-0634921C6), where an amount included in the taxable income of a trust is not recognized as income or capital for trust law purposes (referred to as “phantom income”), the terms of the trust must specifically permit an amount equivalent to the phantom income to be paid or payable or, alternatively, provide the trustees with the discretion to pay out or make payable amounts that are defined as income under the Act in order for the phantom income to become payable to any beneficiary.

Furthermore, an amount equivalent to the phantom income would become payable for income tax purposes only where the beneficiaries are entitled to enforce payment of the amount before the end of the taxation year or the trustees have paid the amount to the beneficiaries before the end of the taxation year.

Our comments are limited to circumstances where the amount is paid in cash. To the extent that any payment of the amount is made in-kind, other legal and tax considerations would need to be taken into account.

Scenarios (c) and (e)

In scenarios (c) and (e), the trustees paid the amount of the deemed dividend or FAPI, as the case may be, to the income beneficiary by way of a cash payment in the taxation year that the deemed dividend or FAPI, as the case may be, was included in the taxable income of the trust. Provided that the payment was made in accordance with the terms of the trust and the applicable trust law, the deemed dividend or FAPI became payable to the beneficiary for the purposes of subsections 104(6), (13) and (24) of the Act.

Scenario (d) and (f)

In scenarios (d) and (f), the terms of the trust do not permit an amount equivalent to the deemed dividend or FAPI, as the case may be, to be paid nor do the terms of the trust permit the trustees to pay amounts that are defined as income within the meaning of the Act. Consequently, on the basis that the deemed dividend and FAPI constitute phantom income, the deemed dividend or FAPI, as the case may be, cannot become payable for the purposes of subsections 104(6), (13), and (24) of the Act.

Katie Campbell
2022-092889
May 3, 2022