7 October 1990 Income Tax Severed Letter - Capital Gains Exemption for Qualified Farm Property

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.

Dear Sirs:

Re: Capital Gains Exemption - Qualified Farm Property

This is in reply to your letter of August 22, 1990 requesting our opinion with respect to the availability of the Capital Gains Deduction on Qualified Farm Property. Our understanding of the situation described to us in your letter follows:

• 1. Upon the death of taxpayer A in 1989 a testamentary trust was created.
• 2. Only the taxpayer's spouse (hereafter referred to as taxpayer B), is entitled to the income of the trust.
• 3. Terms of the will allow the executors to encroach on the capital of the trust as they deem necessary.
• 4. Upon the death of B the following beneficiaries are entitled to the capital of the trust:
  

  Taxpayer C - son of taxpayer A          - 23%
     "     D -  "  "     "     A          - 23%
     "     E -  "  "     "     A          - 23%
     "     F -  daughter of taxpayer A    - 23%
     "     G -  daughter of taxpayer B    -  4%
     "     H -  son of taxpayer B         -  4%

• 5. A real property was transferred to the trust upon taxpayer A's death at a cost equal to the property's adjusted cost base.
• 6. The trust proposes to rent this property to a family farm partnership consisting of taxpayers C, D, and E.
• 7. Taxpayer C will farm the property regularly and continuously for a period of at least 24 months.

Specifically, you inquired whether the property would meet the definition of qualified farm property upon a sale of the property; secondly you asked if the executors would be allowed to allocate the capital gain to the spouse in the year of the future sale in order for her to sue the enhanced capital gains deduction; lastly you inquired whether a preferred beneficiary election could be made to each of the capital beneficiaries so that they may avail themselves of the capital gains deduction for qualified farm property upon the ultimate sale of the land or death of taxpayer B.

Our Comments

Qualified farm property, as defined in subsection 110.6(1) of the Income Tax Act (the "Act") includes real property owned by an individual (including a personal trust) provided it was used in the business of farming in Canada by one of five categories. In the case you have presented, as the property will be owned by a trust, the property must be used in the business of farming by a designated beneficiary, a family farm partnership in which a designated beneficiary has an interest, or a family farm corporation in which a designated beneficiary owns shares in order for it to meet the definition of qualified farm property. This beneficiary must be one in respect of whom a designation has been made by the trust under subparagraph 104(21.2)(b)(ii) of the Act. You have stated that the trust formed would be a spouse trust. The primary question to be answered in this case is whether the property is a qualified farm property of the spouse trust. The trust as you have described it cannot designated any income or otherwise pay out any income to any beneficiary other than the spouse, taxpayer B, in order for it to qualify as a spousal trust. However the definition of qualified farm property (when the property is owned by a trust) requires that the property be used in the business of farming by a beneficiary in respect of whom an amount has been designated under subparagraph 104(21.2)(b)(ii).

You have indicated that the property was acquired after June 17, 1987 therefore it must be owned by the trust throughout a period of at least 24 months preceding its' disposition (periods of ownership by certain qualifying owners can be aggregated but this is not relevant to your scenario). The scenario presented by you appears to satisfy this "length of ownership" qualification. Additionally, in order to meet the definition of a qualified farm property, it must be shown that the property was used by a qualified user in the carrying on of the business of farming throughout a period of at least 24 months. A family farm partnership in which a qualifying individual is actively engaged on a regular and continuous basis would qualify and, subject to the remarks which follow, this condition also appears to have been met in situation described in your letter.

Provided the arrangement formed by C, D, and E is a bona fide family farm partnership, and a preferred beneficiary election were made in favour of C, the above property would meet the definition of a qualified farm property as stated in subsection 110.6(1) of the Act (but for the difficulty with the spousal trust rules outlined below). The determination of whether real property is being used by a family farm partnership in carrying on a farming business is a question of fact. When more than one party is involved, as in the case you have proposed, it is necessary to review all circumstances and any existing agreements in order to make that determination. If the relationship between C, D, and E is not a partnership, the property might still be a qualified farm property of the trust, but C would be required to meet the revenue test referred to in clause (vii)(A).

Subsection 104(21) permits a trustee to deem part of the income included in a beneficiary's income to be taxable capital gains received by the trust, provided the terms of the trust agreement allow the trustee to make a distribution on capital to that beneficiary. In this case the executors would be allowed to allocate the gain on the sale of property to taxpayer B for tax purposes, as you have indicated that the executors can encroach on capital if they deem it necessary. In the scenario presented the application of the enhanced capital gain deduction to a gain allocated to taxpayer B requires that a designation also be made to a partner of the partnership in order for the definition of qualified farm property to be met. The reply to your second question depends entirely on the property meeting the definition of qualified farm property as explained previously. In particular, in order for the property qualify it must have been used in the business of farming by a designated beneficiary or by a family farm partnership. The partners of this partnership, in turn, must be trust beneficiaries who have had capital gains designated to them under subparagraph 104(21.2)(b)(ii). If however a designation under 104(21.2) is made to the partners as required by the definition of qualified farm property, then the trust would no longer qualify as a spousal trust as described in subsection 70(6) of the Act. As a result, the situation you have presented would not be compatible with the definition of qualified farm property, because the beneficiary(ies) using the property cannot receive designations due to the fact that the spousal trust rules prohibit distributions to all except for the spouse during her lifetime.

Under subsection 104(14) the trustee is allowed to elect that a portion of the accumulating income of the trust be included in the beneficiary's income, and deducted from the trust's income, for tax purposes, only if the election is made with respect to a preferred beneficiary. In the third question you posed, the capital beneficiaries listed above would qualify as preferred beneficiaries under paragraph 108(1)(g) as they are the children of the settlor of the trust. Therefore preferred beneficiary elections could be made in respect of a capital gain realized on disposition of the qualified farm property provided that these designations are made after taxpayer B's death. As the terms of the Will provided for capital encroachments in favour of the children after the spouse's death preferred beneficiary designations could be made with respect to actual capital gains realized by the trust after B's death. Upon taxpayer B's death, gains arising on the deemed disposition of the property per paragraph 104(4) of the Act are to be taxed in the trust. Pursuant to the definition in paragraph 108(1)(a) of the Act, deemed dispositions under subsection 14(4) are specifically excluded from accumulating income, consequently these deemed gains could never be the subject of a preferred beneficiary election. Prior to taxpayer B's death, for reasons previously outlined concerning the terms of a spousal trust, preferred beneficiary elections in favour of the children could not be made.

We hope these comments are of assistance.