9 March 1988 Income Tax Severed Letter 7-2417 - [Taxing of Income in a Spouse Trust]

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.

March 9, 1988

TO: KITCHENER DISTRICT OFFICE R. Beech Chief, Audit Division

S. Cohane

FROM: HEAD OFFICE Financial Industries Division G. Kauppinen (613)957-3495

RE: Taxing of Income in a Spouse Trust

This is in reply to your memorandum dated December 17, 1987. You have two separate situations relating to Spouse Trusts, as follows:

Situation A

You have had an enquiry from an accountant indicating that he wishes to make a Preferred Beneficiary Election where the Spouse Trust has realized a Capital Gain and there is no encroachment power on the capital of the trust in favour of the spouse.

The taxpayer's submission can be summarized as follows:

1. The Trust is a Spouse Trust as described in paragraph 104(4)(a) of the Income Tax Act ("Act").

2. A Taxable Capital Gain forms all of the accumulating income of the Trust as defined under paragraph 108(1)(a) of the Act.

3. The election by the Trust and the spouse preferred beneficiary is available under subsection 104(14) of the Act if made within the proper time constraints.

4. The spouse's preferred beneficiary's share of the accumulating income is set out under subparagraph 104(15)(a)(i) of the Act.

5. The Trust would be allowed the deduction of part of the accumulating income included in the preferred beneficiary's income under subsection 104(12) of the Act.

You are of the opinion that this particular Spouse Trust would not qualify for the Preferred Beneficiary Election due to the fact that the spouse is not entitled to encroach on capital. Your position appears to be supported by I.T. 394, paragraph 13. However, pages 150 and 151 of the second edition of Lloyd F. Raphael's book on the Income Taxation of Trusts appears to you to indicate that the spouse could avail herself of the Preferred Beneficiary Election where she has no power to encroach on trust capital. As there would appear to be a contradiction, you have asked our opinion as to whether we are in agreement with your interpretations

Our Opinion

Pursuant to subparagraph 104(15)(a)(i) of the Act, if the spouse of the spouse trust is alive at the end of the year, only that spouse can make a preferred beneficiary election on an amount up to the total accumulating income of the trust as defined under paragraph 108(1)(a) of the Act.

If the trust indenture specifies that capital gains are income for trust purposes, then the spouse could elect up to the full amount of the taxable portion of the capital gain, even if no encroachment power exists.

In this case we are assuming that the trust indenture does not define capital gains to be income and that there is no power of encroachment in favour of the spouse.

For purposes of subparagraph 104(4)(a)(iii) of the Act, the income of a trust is its income computed without reference to the provisions of the Act (less certain types of dividends) pursuant to subsection 108(3) of the Act. Under the foregoing assumption, trust law will normally consider capital gains to be capital and not income of the trust. Consequently, in our view, pursuant to subsection 108(3) of the Act, the taxable capital gain would not form part of the accumulating income of the trust in this situation. Therefore, while the spouse could make a preferred beneficiary election (because she is a preferred beneficiary), the maximum amount she could elect upon would be nil. The taxable capital gain must be taxed in the trust as it would accrue for the benefit of the capital beneficiaries thereof.

Situation B

Upon the date of death of the spouse beneficiary on XXXX a deemed disposition of estate assets occurred pursuant to paragraph 104(4)(a) of the Act.

When the estate return was filed for the period XXXX the deemed disposition of the estate assets was reported. However, all Capital Gains generated in the Trust were allocated out to the seven (7) residual beneficiaries. Each residual beneficiary claimed the Capital Gains Exemption to the extent allowed under section 110.6 of the Act.

You are of the opinion that the Capital Gain generated by this Trust cannot be allocated to the residual beneficiaries but must be taxed in the Trust and the Capital Gain Exemption allowed therein as calculated per subsection 110.6(12) of the Act.

Our Opinion

We agree that a deduction from the taxable capital gains caused by the deemed disposition may, to the extent available, be claimed by the trust pursuant to subsection 110.6(12) of the Act. This subsection was enacted to allow a spouse trust to claim a capital gains exemption to the extent the spouse could have claimed an exemption if eligible taxable capital gains of the trust had been realized by the spouse.

As discussed in IT-381R , paragraph 8, a spouse trust (i.e., a trust described in paragraph 104(4)(a) of the Act may not, pursuant to paragraph 104(6)(b) of the Act, deduct income payable to a beneficiary if that income arose as a result of the deemed disposition of property under subsection 104(4) of the Act on the death of the spouse. If a designation of eligible taxable capital gains is made pursuant to subsections 104(21) and 104(21.2), both the trust and the beneficiary will be taxable on the same income (unless a designation is made under subsection 104(25) of the Act to deem the taxable capital gain not to have been payable in the year to the particular beneficiary or a deduction is claimed by the trust pursuant to subsection 110.6(12) of the Act).

The practical effect of the foregoing is that the maximum capital gains exemption available to offset a deemed disposition pursuant to paragraph 104(4)(a) of the Act is that which is available to the spouse trust pursuant to the subsection 110.6(12) of the Act.

It would appear that it is technically possible to designate all or part of the taxable capital gain to a beneficiary and the beneficiary could claim a capital gains deduction himself to the extent allowable under subsection 110.6(3) of the Act. However, there does not appear to be any advantage to do so because of the restriction on the deduction to the trust under paragraph 104(6)(b) of the Act as discussed above.

Chief Deferred Income Plans & Trusts Financial Industries Division Rulings Directorate