CRA confirms that "second generation income" is not subject to s. 75(2) attribution

The settlor of an alter ego trust contributes to the trust an interest in a limited partnership that generates business income. CRA indicated that although the partnership business income (or loss) allocated to the trust would not be attributed to the settlor (s. 75(2) does not attribute business income), the settlor of an alter ego trust must be entitled to receive all of the income of the trust that arises before the settlor’s death, so that the settlor would still end up having property income in his or her hands under ss. 104(13) and 108(5).

In response to a separate question regarding how s. 75(2) would apply where proceeds or income of property of the alter ego trust was reinvested, CRA indicated that, in light of the s. 248(5) substituted-property rule, the attribution would continue to apply if securities were repeatedly sold and reinvested in other securities, so that the income including taxable capital gains arising on the substituted property would continue to be attributed to the settlor under s. 75(2). However, any income or loss derived from the reinvestment of the earnings (the "second generation income") would not be attributed to the settlor. Thus, the income earned on the substituted-property securities is attributed pursuant to s. 75(2) as first generation income, but any income earned on that income will not be attributed.

However, again, the trust would need to make the second generation income earned by it payable to the beneficiary under s. 104(13), so that s. 108(5) will generally apply to the income thereby included in the settlor’s hands subject to recharacterization under a designation such as s. 104(19) or 104(21).

Neal Armstrong. Summary of 15 June 2021 STEP Roundtable, Q.5 under s. 75(2).