Subsection 106(1) - Income interest in trust
Cost to the beneficiary
1.20 For the purpose of determining the deduction available under subsection 106(1), the cost to a beneficiary of the income interest is generally nil, pursuant to subsection 106(1.1). This will be the case except where any part of the interest was acquired from a person who was the beneficiary in respect of the interest immediately before that acquisition or where part of the interest was at any time determined not to be nil under the taxpayer migration rules in section 128.1.
1.21 Therefore, for the purposes of subsection 106(1), the cost to a taxpayer of an income interest in a trust acquired directly from a person who was the prior beneficiary of the income interest will generally be the amount paid for it. However, if the income interest was acquired from a prior beneficiary in a non-arm's length transaction for an amount that exceeded its FMV, paragraph 69(1)(a) will deem its cost to be its FMV. If the income interest was acquired from the beneficiary by way of gift, paragraph 69(1)(c) will deem its cost to be its FMV.
…Mr. X establishes a personal trust (the Trust) in favour of his son, Mr. A, and grandson, Mr. B. He settles the Trust by transferring to the Trust, property consisting of 100 shares of XCorp and a parcel of land. Mr. A is the income beneficiary and Mr. B is the capital beneficiary. Mr. X is now deceased. …
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|Tax Topics - Income Tax Act - Section 256 - Subsection 256(7) - Paragraph 256(7)(b)||93|
|Tax Topics - Income Tax Act - Section 67.6||239|
In a particular tax year, the Trust had income of $25,000 that it allocated to Mr. A. The Trust did not have enough funds to pay that amount in that year. However, Mr. A was entitled to enforce a payment of $25,000 by the Trust. Pursuant to subsection 104(13), Mr. A included the amount of $25,000 in computing his income from the Trust for that year.
In the following year, Mr. A decides to gift his income interest to the other beneficiary, his adult son, Mr. B. This gift constitutes a disposition of Mr. A's income interest in the Trust. The FMV of Mr. A's income interest is determined to be $200,000. If the income interest disposed of includes the right to enforce payment of the $25,000 by the Trust, then the following are the tax implications on the disposition of Mr. A's income interest:
- The disposition of Mr. A's income interest triggers the application of subsection 106(2). Since it is a non-arm's length transaction, Mr. A's proceeds of disposition will be the FMV of his income interest in the trust pursuant to paragraph 69(1)(b). The income interest disposed of includes a right to enforce payment of $25,000, which was already included in Mr. A's income under subsection 104(13) in the previous year. This means that the income inclusion under subparagraph 106(2)(a)(i) will be reduced by $25,000 under subparagraph 106(2)(a)(ii). Therefore, pursuant to subsection 106(2), Mr. A will include $175,000 [$200,000-$25,000] in computing his income from the disposition of the income interest in the Trust. Any taxable capital gain or allowable capital loss for Mr. A will be deemed to be nil.
- Pursuant to subsection 106(1.1), the cost of the income interest to Mr. A is deemed to be nil.
- Pursuant to paragraph 69(1)(c), the cost of acquisition of the income interest to Mr. B is its FMV of $200,000.
Adopt the same additional facts as outlined in Scenario 2. Assume further that the Trust distributes $100,000 of income to Mr. B in the first tax year (Year 1) after he has acquired the income interest from Mr. A, and $150,000 in the second year (Year 2).
|The following table shows the tax consequences for Mr. B, with calculations shown where applicable:|
- ii) $200,000 ($200,000 - $NIL)
Lesser amount is $100,000
- ii) $100,000 ($200,000 - $100,000)
Lesser amount is $100,000
$50,000 ($150,000 - $100,000)
Therefore, at the end of Year 2, Mr. B would have fully offset the cost of acquisition of his income interest in the Trust.
IT-385R2 "Disposition of an Income Interest in a Trust"
Subsection 106(2) - Disposition by taxpayer of income interest
1.6 Pursuant to paragraph 106(2)(a), where a taxpayer disposes of an income interest in a trust that includes a right to enforce payment of an amount by the trust, the proceeds of disposition of the income interest are offset by the amount that has been included in the taxpayer's income under subsection 104(13) in respect of that right. However, where property of the trust is distributed in satisfaction of an income interest of the beneficiary, paragraph 106(2)(a) does not apply.
Meaning of disclaimer
1.10 Generally, a disclaimer is an outright refusal to accept a gift or interest. A taxpayer who executes a valid disclaimer (not in favour of any person) of an income interest in a trust will be considered not to have acquired that income interest. Therefore, in such a situation, subsection 106(2) will have no application. To be a valid disclaimer the refusal must occur:
- within a reasonable time after the recipient becomes aware of the gift or interest; and
- before the acceptance of any funds or benefits in respect of the gift or interest.
1.11 When subsection 248(8) applies (occurrences as a consequence of death) a disclaimer must meet the requirements of the definition of a disclaimer found in subsection 248(9). …
1.12 A person who has accepted any funds from the trust in respect of an income interest in the trust, or who has executed a disclaimer in respect of an income interest in the trust in favour of another person, would be considered to have acquired the income interest and therefore would be unable to execute a valid disclaimer. …
Meaning of release or surrender
1.13 A release or surrender is either an extinguishment or discharge of a legal right or claim, or a transfer of a legal right or claim to another person. Where a taxpayer formally releases or surrenders all or any part of an income interest in a particular trust in respect of future payments (amounts not due and payable at the time of the release or surrender) in favour of one or more other persons, paragraph 69(1)(b) will deem the taxpayer to have received proceeds of disposition equal to the FMV of the income interest at the time of the release or surrender. The taxpayer must include that amount in income pursuant to subsection 106(2). …
1.14 … Pursuant to paragraph 248(8)(c), a release or surrender by a beneficiary with respect to any property that was property of a deceased individual immediately before death, is not considered to be a disposition of the property by the beneficiary . However, paragraph 248(8)(c) does not apply to an income interest that arises upon the death of the deceased, as such an interest could not have been property of the deceased immediately before death.
Release or surrender for no consideration
1.15 A taxpayer who, for no consideration, validly releases or surrenders, in accordance with the terms of the trust and the relevant provincial law, an income interest in a trust in respect of future payments (amounts not due and payable at the time of the release or surrender ) and does not in any manner direct who is entitled to receive the benefits, will not be considered to have received any proceeds of disposition for the purposes of subsection 106(2). The result will be the same where the taxpayer designates or otherwise agrees which person or persons will benefit by reason of the release or surrender, if the same person or persons would be entitled to benefit in the same way under the trust without the taxpayer's designation or agreement. …
1997 Ruling 3-970604 -
Where the income beneficiary of a family trust releases and surrenders all her interests in the trust, she will be considered to have disposed of her interests for no proceeds.
ATR-3 (29 Nov. 85)
In winding-up an estate, all the estate assets would be transferred to the capital beneficiaries who would agree to give to their mother (the life tenant) $21,000 a year for life (the approximate income level she was receiving before the winding-up). The proceeds taxable under s. 106(2) would be the capitalized value of the payments expected to be made to her.
IT-385R2 "Disposition of an Income Interest in a Trust"
Elie Roth, Tim Youdan, Chris Anderson, Kim Brown, "Taxation of Beneficiaries Resident in Canada", Chapter 4 of Canadian Taxation of Trusts (Canadian Tax Foundation), 2016.
Requirements for valid disclaimer of income interest (pp. 340
A taxpayer who executes a valid disclaimer of an income interest in a trust is generally considered not to have acquired the income interest….In order-to constitute a valid disclaimer for these purposes, the CRA's position is that the refusal must occur within a reasonable time after the recipient becomes aware of the gift or interest and before the recipient accepts any funds or benefits in respect of the gift or interest. However, if die taxpayer accepts any funds from the trust in respect of die income interest or executes a disclaimer in respect of the income interest in favour of another- person, the taxpayer is considered to have acquired the income interest and therefore cannot execute a valid disclaimer. [fn 174: [S6-F2-C1], at paragraphs 1.13 to 1.15. The CRA's position in this regard appears to be inconsistent with judicial authority in Ontario. In Re Coulson, 1977 Can1.II 1060 (ONCA), the Ontario Court of Appeal held that an income beneficiary who had been receiving income from a trust on an annual basis could validly disclaim the income from her interest in the trust in a particular, taxation year, and then continue to receive the income in subsequent taxation years….]
[I]n Murphy Estate…[t]he court noted that a disclaimer is a refusal to accept an interest that has been bequeathed to a disclaiming party. Its effect is to void the gift as if the disclaiming party never received it. The gift becomes part of the estate of the deceased and the disclaiming party has no right to direct who is to receive the gift.
Effect of McKenzie: amount distributed not also proceeds (p. 345)
[McKenzie]…confirms that when property is distributed by a trust to a taxpayer in satisfaction of all or any part of the taxpayer's income interest in the trust, the amount of the proceeds of disposition of the income interest need not be included in computing the beneficiary's income for the year, because the amount distributed to the beneficiary in satisfaction of the income interest could otherwise be subject to double taxation.
Distinction between disposition and termination (p. 349)
The CRA has considered a situation in which an estate of which the deceased's wife was the income beneficiary for life and her sons-were the capital beneficiaries was wound up in accordance with a court order, her income interest was terminated prematurely, and the capital was distributed to the sons. She agreed to relinquish her income interest for consideration provided by the sons—namely, a contractual undertaking to pay her a fixed dollar amount per year for life. [fn 186: ATR-3…cancelled September 30, 2012] The CRA characterized the transaction as the disposition by the wife of her income interest for proceeds equal to the actuarial value of the agreed upon annuity. The proceeds were treated as ordinary income pursuant to subsection 106(2).
This conclusion by the CRA appears to be incorrect because it assumes that paragraph 106(2)(a) can apply to a disposition of an income interest, even though no one acquires the interest and the disposition occurs in connection with the termination of the trust…. [S]ubsection 106(2)…is intended to apply to situations in which an income beneficiary voluntarily transfers an income interest to a third party (the acquiror) for consideration (or deemed consideration in the case of a gift), following which the acquiror becomes eligible to receive the income that would otherwise have been distributed by the trust to the transferor. The provision is premised on the continuation of the income interest, the trust, and the trust capital….
Demarcation between s. 106(2) and 106(3)
[S]ubsection l06(2) … is intended to apply to situations in which an income interest is disposed of to and acquired by a third party, while subsection 106(3) deals with the situation in which an income interest is disposed of to the trust itself and thereby eliminated. As explained in McKenzie, the purpose of subsection 106(2), consistent with the general scheme of tire Act, is to tax economic gains realized by an income beneficiary on the transfer of its trust interest to a third party for consideration. A subsidiary purpose is to tax the gains as ordinary income, and not as capital gains, since the beneficiary is monetizing a future income stream that would otherwise have been taxable as ordinary income in his hands. The apparent purpose of subsection 106(3) is to assimilate the taxation of the transactions to which it applies to a gift of trust property made by the settlor to the beneficiary.
Subsection 106(3) - Proceeds of disposition of income interest
McKenzie v. The Queen, 2011 DTC 1216 [at 1274], 2011 TCC 289
The testator of a testamentary trust holding shares of a company provided that an executive employee of the company had an entitlement to the income from one-fifth of those shares until the termination of her employment. When the executive (the taxpayer) was subsequently dismissed, the taxpayer sued the capital beneficiary and the trust for wrongful dismissal, oppression and wrongful depletion and termination of her income interest. A settlement agreement provided for the payment by the trust to her of $1.7 million in satisfaction of her interest in the trust. Through a numbered company, the capital beneficiary issued a promissory note to the trust for $1.7 million in exchange for the shares held for the taxpayer. The trust issued a promissory note to the taxpayer in the same amount. The trust's law firm then gave the taxpayer a certified cheque for $1.7 million to discharge the trust's promissory note.
Boyle J. found that s. 106(3) applied to the settlement payment, and therefore that s. 106(2) did not apply. The three elements of s. 106(3), that the $1.7 million was property of the trust when paid, that the alleged trust property was distributed to a beneficiary, and that the distribution was in satisfaction of the taxpayer's income interest, were all met. Boyle J. rejected the Minister's argument that the money was never the property of the trust, but rather was property of the beneficiary's numbered company. The transfer of promissory notes was a transfer of trust property. He stated (at para. 21):
Surely [the Minister] would not seriously have contested a bill of exchange involving a bank and I have been provided with no persuasive argument that enforceable promissory notes from solvent entities should be treated any differently.
Boyle J. also found that the property had been distributed to the taxpayer. He stated (at para. 22) that "[t]here is no apparent reason put forward to suggest that the term 'distributed' should not be given its ordinary meaning." Finally, he found that the distribution was in satisfaction of an income interest. He rejected (at paras. 26-27) the Minister's argument that the lump sum payment to the taxpayer, which was contrary to the existing terms of the trust, amounted to an impermissible amendment of the trust deed. The rule in Saunders v. Vautier permitted the beneficiaries and the trust to modify the operation of the trust by entering into a termination agreement.
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|Tax Topics - General Concepts - Payment & Receipt||payment through back-to-back promissory notes||218|