22 October 1998 External T.I. 9816525 - TAXATION OF TRUSTS - GENERAL

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: General comments on taxation of income in a trust where the trust owns shares of a Canadian corporation

Position: General rules under section section 104 and attribution rules

Reasons: consistent with the Department's position on trusts

XXXXXXXXXX 5-981652
M. Lemire
Attention:XXXXXXXXXX

October 22, 1998

Dear XXXXXXXXXX:

Re: Taxation of trusts

This is in reply to your letter of June 8, 1998 in which you requested an advance tax ruling with respect to the taxation of income in a trust where the trust owns shares of a Canadian corporation. We also acknowledge receipt of your letters of August 12, August 20 and August 21, 1998.

We understand from your letter that a trust is created by an individual who is not resident of Canada for the benefit of his sister, his brother, his mother and himself. The trust is settled by way of a gift by the non-resident settlor to the trust of a gold coin. The trust is a discretionary trust. The trustees of the trust are resident of Canada. All beneficiaries under the trust are resident of Canada except for the non-resident settlor who is also a beneficiary under the trust. All the beneficiaries under the trust are adults. The trust borrows money to acquire shares of a newly incorporated Canadian corporation presently owned 50%-50% by the individual and his brother. It is expected that dividends will be paid by the corporation to the trust in the future.

As discussed (XXXXXXXXXX/Murphy), we are unable to provide an advance income tax ruling as the original request was too general and draft documents were not available. However, we can offer you the following general comments which may be of assistance although, in certain circumstances, they may not be appropriate to your specific situation.

Our comments

Existence of a trust

The existence of a trust is determined by the relationship between the settlor, the trustees and the beneficiaries. The relationship may or may not be defined by a formal written document but is codified by any applicable trust legislation and common law. It is accepted at law that a trust cannot be established unless three certainties are present. That is, the attempt to establish a trust will fail unless it is certain that the settlor intended to bring a trust relationship into existence and both the property and the beneficiaries or other objects of the trust are described with sufficient certainty. Whether the three certainties are present or not is a question of fact and particular to the circumstances of each case, however given the requirement of these three certainties, a written trust document would serve as the best evidence of their existence and would resolve any ambiguities which may otherwise arise.

The certainty of intention is established where it is clear that a trust relationship was intended as opposed to some other relationship such as an agency, or a transfer, or gift of property is intended. The property, or property substituted therefor must be clearly identifiable in order for that certainty to exist. Lastly, in creating a valid trust, the beneficiaries must be identifiable.

Our comments below are made on the assumption that a valid trust is created in the scenario described above.

The trust as a taxpayer

A trust is treated as a separate person under the Act. Generally, where property is transferred to a trust, the transferor is deemed to have received proceeds of disposition therefor equal to the fair market value of the transferred property pursuant to paragraph 69(1)(b) of the Act and thus may have a capital gain for income tax purposes. The trust is generally deemed to have acquired the property at a cost to the trust equal to its fair market value at the time of acquisition.

Residence of a trust

The Department's views with respect to this issue are contained in Interpretation Bulletin IT-447, "Residence of a Trust or Estate" (hereinafter reference being made to "trust" and "trustee"). The residence of a trust is a question of fact to be determined according to the circumstances in each case. A trust is generally considered to reside where the trustee or other legal representative who manages or controls the trust assets resides. Paragraph 2 of IT-447 outlines the powers or responsibilities which the

Department considers in determining which trustee has management and control of the trust. In this regard a determination of a trustee's powers and responsibilities as established under the terms of the trust and any other related trust document would be imperative in the determination of the trust's residence. Where an individual exercises the management and control of a trust, the residence of that individual is determined based on the normal factual tests for determining the residence of the individual.

For the purpose of this letter, we assumed that the trust in the scenario described above is resident in Canada as the trustees under the trust are resident in Canada.

Taxation of income in a discretionary trust

Under the Act, the income of a trust is generally determined the same way as the income of any other individual. The income of a trust is generally subject to tax under Part I of the Act in the hands of the trustee unless it is “paid or payable” to, and consequently taxed in the hands of, the trust’s beneficiaries according to the provisions of the trust documents.

Subsection 104(6) of the Act provides for the deduction in computing the trust’s income for any amount “paid or payable” to a beneficiary. Note, however, that in the case of a non-resident beneficiary, no deduction may be made unless the trust was resident in Canada throughout the year. Subsection 104(13) of the Act provides for the income inclusion of the beneficiary. Under this subsection, the beneficiary must generally report an amount that would be the trust’s income for the particular year as became “payable” in the particular year to the beneficiary.

Pursuant to subsection 104(24) of the Act, an amount will be considered “payable” to the beneficiary of a trust in a taxation year where either 1) it is paid in the year to the beneficiary, or 2) the beneficiary was entitled in the year to enforce payment of the amount. In order for the income of a discretionary trust to become payable in a taxation year to the beneficiaries of the trust, the trustees are required to exercise their discretion before the end of the trust's taxation year and the exercise of discretion must be irrevocable with no conditions attached to the beneficiaries' entitlement to enforce payment of the amount in the year. The apportionment of the trust's income to each beneficiary (e.g., all the income, a fixed percentage of the income, or a set amount) must also be established. Furthermore, the beneficiaries must be advised before the end of the trust's taxation year of the trustees' decision, including the apportionment of the trust's income to which the beneficiary is entitled in the year to enforce payment of (even if the actual amount is not known). Although legal rights may exist without being in writing, in our opinion, the trustees' exercise of discretion and notification given to the beneficiaries of their decision should be in writing (e.g., a resolution signed by the trustees, minutes of the trustees' meeting). Failure to do so will result in the trustees and the beneficiaries having to provide our Department with other satisfactory evidence to support their claim that amounts became payable to the beneficiaries in the year.

The fact that the actual amount of the income of a trust in a year can not be ascertained until after the end of the trust's taxation year due to administrative delays in obtaining the necessary information will not, in and by itself, result in an amount apportioned to a beneficiary in the year based on that income not being payable to the beneficiary in the year (as supported by the case Ginsburg vs M.N.R., 92 D.T.C. 1774, (T.C.C.)). However, where the income of a trust is not ascertainable at the year end because the amount of such income is dependent on some contingency or event occurring after that time, then based on our response to Question 55 of the Revenue Canada Round Table in the 1981 Conference Report, it is our view that, depending on the circumstances, a beneficiary may not have an enforceable right to demand payment of such an amount in that year.

Once the trustees have exercised their discretion and advised the beneficiaries of their decision, payment by the trust in respect of an amount payable to each beneficiary may be made by issuing a cheque to the beneficiary. That cheque must not have any conditions attached to it, such as, postdating or an arrangement that it is not to be cashed for a specific time. Where the actual amount to be paid to a beneficiary is known before the end of the trust's taxation year, a cheque for that amount should be delivered to the beneficiary before the end of the year. However, where it is not possible to determine the actual amount to be paid to a beneficiary until after the end of the trust's taxation year due to administrative delays in obtaining the necessary information, a cheque should be delivered to the beneficiary once the amount is quantified.

In some situations, payment by a trust in respect of an amount payable to each beneficiary may be made by issuing a promissory note to the beneficiary rather than a cheque. A promissory note is ordinarily given and received as acknowledgment of the existence of and/or the conditional payment of a debt and does not create the debt. It should only be issued by a trust where the trust indenture (or relevant provincial legislation where the indenture is silent on the issue) so permits. Although a promissory note issued in respect of an amount payable to a beneficiary may be non-interest bearing, it must be payable on demand without restriction. Where the actual amount that is payable to a beneficiary is known before the end of the trust's taxation year, the promissory note should also be delivered to the beneficiary before the end of the year. However, where it is not possible to determine the actual amount that is payable to a beneficiary until after the end of the trust's taxation year due to administrative delays in obtaining the necessary information, the promissory note should be delivered to the beneficiary as soon as the amount is quantified.

As indicated above, the exercise of discretion by the trustees of a discretionary trust must be irrevocable with no conditions attached to a beneficiary's entitlement to enforce payment of an amount in the year. Conversely, where the discretion exercised is revocable or there are conditions attached to the beneficiary's entitlement to enforce payment of an amount in the year, the amount will not be considered payable in the year to the beneficiary. Where such is the case and subsection 104(14) of the Act does not apply, the amount must be reported in the trust's income for that year since there will be no deduction from the trust's income available under subsection 104(6) of the Act in respect of the amount. If the amount is paid to the beneficiary in a subsequent year, it would not be included in the beneficiary's income in that year since the amount has already been included in the trust's income in a prior year.

21-year rule

Generally, a trust (other than a spousal trust) is deemed by subsections 104(4), (5) and (5.2) of the Act to dispose of its capital property, land inventory and resource properties every 21 years, the first deemed disposition occurring 21 years after the creation of the trust.

Trust tax rates under Part I

The taxable income of a trust (other than a testamentary trust) is subject to income tax at the top personal income tax rate whereas a testamentary trust is subject under Part I of the Act to the graduated income tax rates applicable to individuals.

Flow-through of dividends/taxable capital gains to a beneficiary

Subsection 108(5) of the Act provides that, except as otherwise provided in Part I of the Act, an amount included in computing the income for a taxation year of a beneficiary of a trust under subsection 104(13) or (14) or section 105 of the Act shall be deemed to be income of the beneficiary for the year from a property that is an interest in the trust and not from any other source. However, subsections 104(19) and (21) permit a trustee of a trust resident in Canada throughout the year to designate that a portion of the taxable dividends and taxable capital gains, respectively, of the trust in the year, as may reasonably be considered to have been part of the income included in a beneficiary’s income, is deemed to be received by the beneficiary as taxable dividends or taxable capital gains, as the case may be, within certain limits. Whether it is reasonable to consider that a taxable capital gain realized by a trust was part of the income that was included in a beneficiary’s income in the year will depend upon the terms of the trust.

Part XIII tax - withholding tax

Subsection 212(11) of the Act is similar to subsection 108(5) of the Act in that for the purposes of the withholding tax under Part XIII of the Act, any amount paid or credited by a trust to a non-resident beneficiary is deemed to have been paid or credited as income of the trust, regardless of the source from which the trust derived such amount. Paragraph 212(1)(c) of the Act provides that a withholding tax at the rate of 25% (or such lower rate as set by treaty) will be exigible under Part XIII on any amount that is paid by the trust to the non-resident beneficiary and that would have been subject to tax under Part I if it had been paid to a person resident in Canada to whom Part I was applicable. An exception to paragraph 212(1)(c) of the Act is made for amounts deemed by subsection 104(21) of the Act to be taxable capital gains. However, there is no exception under paragraph 212(1)(c) of the Act made for amounts deemed by subsection 104(19) of the Act to be taxable dividends.

Part XII.2 tax

A trust (other than a testamentary trust) resident in Canada with non-resident beneficiaries may also be subject to a tax under Part XII.2 of the Act at the rate of 36% on its income when income is distributed to non-resident beneficiaries and the distribution is out of the trust’s designated income (e.g. income from carrying on a business in Canada, from Canadian real estate, resource properties and from dispositions of taxable Canadian property).

Attribution rules

One of the main attribution provisions contained in the Act that is relevant with respect to transfers of property, including gifts, to trusts is contained in subsection 75(2) of the Act. The provisions of subsection 75(2) of the Act essentially provide that any income or loss from property, as well as any taxable capital gain or allowable capital loss from the disposition of the property, is attributed to the person from whom the property was directly or indirectly received during the lifetime of the person while the person is resident in Canada if the terms of the trust are such that the property may revert to that person, may be distributed to beneficiaries determined by that person at a time after the trust was created or may only be disposed of with the consent of, or at the disposition of, that person. We refer you to the comments found in the enclosed Interpretation Bulletin IT-369R which discusses the application of subsection 75(2) of the Act.

Subsection 56(4.1) of the Act sets out an anti-avoidance rule that applies where an individual or a trust in which the individual is beneficially interested becomes indebted, directly or indirectly, to another individual with whom the individual is not dealing at arm's length. For this subsection to apply, one of the main reasons for incurring the

indebtedness must be to reduce or avoid tax by having income included in the hands of the individual which would otherwise be included in the hands of the creditor individual. If subsection 56(4.1) applies, income included in the hands of the individual for a taxation year that relates to the period or periods in the year throughout which the creditor individual was resident in Canada is deemed to be income or loss of the creditor individual for the year.

We are enclosing Interpretation Bulletins IT-286R2, IT-342R, IT-369R, IT-381R3,

IT-447, IT-465R, and IT-524 that provide general comments on the taxation of trusts. We are also enclosing a copy of the T3 Guide and Trust Return.

As indicated in paragraph 22 of Information Circular 70-6R3 dated December 30, 1996, this opinion is not a ruling and accordingly, is not binding on the Department.

We hope this will be of assistance to you. Your deposit will be returned in another letter.

Yours truly,

for Director
Resources, Partnerships & Trusts Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch

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