Section 132

The capital gains refund rules in s. 132(1) and following permit a mutual fund trust such as a REIT to retain rather than distribute part (or in some circumstances, all) of the capital gains realized by it in the year in reliance on generating a refund under s. 132(1) that offsets the capital gains tax to which it otherwise would have been subject on that undistributed capital gain.

The amount of this refund is based in part on the amount paid in the year by such trust in the year “on the redemption” of units of the Trust (under the definition in s. 132(1) of “capital gains redemptions.”) In light of the introduction of s. 132(5.3), there is a strong implication that a purchase for cancellation of units will qualify as a unit “redemption” for these purposes, since otherwise it would be possible to avoid this rule (which is intended to avoid a disproportionate allocation of capital gains to the units of a redeemed unitholder) by treating a purchase for cancellation of that unitholder’s units as not constituting their “redemption.” Accordingly, purchasing units of a listed REIT pursuant to a special or normal course issuer bid should qualify as a redemption for purposes of the s. 132(1) refund rules.

The example below shows a simplified calculation of the generation of a refund of capital gains tax to a REIT as a result of purchase for cancellation of some of its outstanding units for $90M pursuant to an issuer bid made in the same year as it realized capital gains and recapture of depreciation of $80M and $20M, respectively from the disposition of buildings having a capital cost and undepreciated capital cost of $120M and $100M, respectively (land is ignored). It is assumed that, but for these dispositions, the REIT would have had a market cap at the end of that year of $1B and would have had an aggregate cost amount for its assets of $1.2B.

Conveniently, s. 770 of the Taxation Act (Quebec) provides that no Quebec income tax is imposed on a REIT that has undistributed capital gains in a year. Accordingly, the spreadsheet assumes that the REIT is not potentially subject to provincial income tax otherwise than in Quebec, so that it addresses only federal capital gains tax.

The capital gains tax that is refunded to the trust under s. 132(1) is equal to the lesser of two amounts (Lines Z and AA). The first amount is the “refundable capital gains tax on hand amount” (RCGTH) in Line V; and the second is the capital gains refund (CGR) in Line Y multiplied by the capital gains tax rate of 16.5%.

In general terms, the RCGTH (i.e., the first of these two amounts) is the lesser of (i) the tax that would otherwise have been payable by the REIT on its undistributed income (including net taxable capital gains) for the year in the absence of receiving the capital gains refund (Line S), and (ii) the tax that would be applicable to the taxable capital gains realized by it in the year (net of any allowable capital losses that are deductible therefrom) if it had not made any distributions in the year (Line T). In other words, the second (Line T) component computes tax at a 33% rate on the taxable capital gains that were realized in the year on the basis that this taxable income was not reduced by any distributions that were made payable by the trust in the year. Given that, in fact, significant distributions might be made by the trust in the year, it may be unnecessary for the trust to try to generate a refund under s. 132(1) equal to this large theoretical amount of tax, because, in fact, the distributions made in the year “shelter” (i.e., reduce) not only the ordinary income realized in the year by the trust (from which the trust distributions made in the year effectively are applied first) but, also, part of that taxable capital gain. However, in this example, the distributions made in the year were not large enough to generate this effect (The RCGTH is computed on a cumulative basis, i.e., it takes into account any positive balance from a previous year - a situation which the trust would generally seek to avoid.)

In contrast, the income for the purposes of the first (Line S) component of the RCGTH amount is in fact reduced by the distributions made payable in the year. Thus, where there are significant distributions in the year, the RCGTH may be based on the first rather than the second of these two components. In addition to the taxable capital gains realized in the year, this first (Line S) component reflects the additions to the REIT’s income for the year as a result of net rental income and recapture of depreciation realized in the year, as well as reductions for the ordinary and special distributions made payable in the year.

The CGR (Line Y) effectively computes the total of the accrued capital gains in the REIT’s portfolio at year end (computed on the assumption that such portfolio’s value equals the year-end fair market value of its units plus its outstanding debts) (Line X) and the capital gains realized in the year to the extent that they have not been sheltered by the distributions made in the year (Line W), and then determines what pro rata portion of this total is represented by the units that were redeemed in the year (Line Y). Thus the CGR does not recognize capital gains tax except to the extent that the net taxable capital gains for the year have not been reduced by distributions made in the year. Accordingly, in order to generate a capital gains refund under s. 132(1), it is necessary to leave an amount of undistributed taxable capital gains “in” the trust for the year rather than fully distributing the trust’s realized taxable capital gains for the year – or, to put it another way, this refund mechanism permits the trust in various circumstances to reduce the amount of the special distribution (Line U) that it might otherwise have been required to make payable by year end in order to instead fully distribute its net realized taxable capital gains for the year.

However, the capital gains refund is the lesser of (a) the RCGTH and (b) 16.5% (the effective tax rate on capital gains) of the CGR (Line W). As discussed above, in most circumstances, the RCGTH effectively represents the tax that the trust would be subject to in the absence of generating a refund. Accordingly, to the extent that (a) exceeds (b), the trust will have to pay tax equal to that excess. Thus, in order that the REIT not be subject to any capital gains liability, the latter (b) amount must not be less than the former (a) amount. Depending on the quantum of the recapture of depreciation and capital gains to be recognized in the year of the redemption transactions, this may requires choosing a combination of an aggregate issuer-bid redemption amount (Line R) and a special distribution amount (Line U) in order to produce this result – although in the above example, this dilemma does not arise.

The “capital gains redemption” amount as defined in s. 132(4) is reduced by twice the amount designated under s. 104(21) respecting units of the trust that were redeemed in the year. In light of draft s. 132(5.3) it generally will now be rare for an exchange-traded mutual fund trust such as a REIT to “push out” capital gains on redemptions of its units, so that this adjustment to the capital gains redemption amount formula typically will not be relevant to such listed funds. This adjustment does not produce an adverse effect respecting s. 104(21) designations that are made respecting taxable capital gains that have been distributed pursuant to a regular or special cash distribution made by the mutual fund (otherwise than in respect of a distribution).

Accordingly, in the case of an exchange-traded REIT, there does not appear to be a reason why it could not make a s. 104(21) designation equal to ½ (and likely all) of the excess of the distributions (including special distribution) made by it in a year over its ordinary income (including recapture of depreciation) for that year, assuming that the net capital gains realized in the year were more than twice this excess. Conceptually, this seems to make sense. It is only the capital gain that has not been distributed that generates the s. 132(1) refund. Accordingly, it appears to be appropriate that there is permitted to be a flow-through of capital gains treatment (through the making of the s. 104(21) designation), respecting the taxable capital gains that have been distributed, rather than being retained with a view to generating a s. 132(1) refund.

To expand on a point adverted to in the previous paragraph, there does not appear to be any prohibition against the trustees treating all, rather than only ½, of the distributions made by them in the year, in excess of the trust ordinary income for the year, as being a distribution of a taxable capital gain – rather than being forced to treat ½ of such distribution as in effect being a capital distribution (i.e., of the untaxed ½ of the relevant portion of the capital gains realized in the year.

Utilizing the capital gains redemption rules may help a mutual fund trust to address a "dry income " issue, i.e., a situation where, absent such refund, its distributions in they year would be insufficient to fully distribute all of the income (including a substantial taxable capital gain) realized by it in the year. Those rules also may permit the trust to reduce the discretionary deductions claimed by it in they year (such as for capital cost allowance), thereby preserving those deductions for the future. They also possibly would effectively permit the transfer a deduction into a future year under ss. 132.11(6) and (7) provided that doing so would not be conrary to s. 132.11(8).

In order for a unit trust to qualify as a mutual fund trust, its only undertaking must be the investing of its funds in property or a real estate undertaking described in s. 132(6)(b)(ii). In addition, it must satisfy the requirements of Regulation 4801 respecting sufficient dispersal in the ownership of its units.

Meaning of “undertaking”

The word “undertaking” likely was used because use of the word “business” would have raised the usual issues as to whether a passive operation of earning income from property, or a non-commercial operation, was included, and use of the word “enterprise” (which appears in dictionary definitions of “undertaking”) might have raised similar difficulties. Although, use of “business” or “enterprise” for this reason might have been inappropriate, “undertaking” likely has the same sense of a set of activities constituting an integrated operation, business or enterprise and, except potentially where there is an adventure in the nature of trade (as discussed below) likely does not include isolated activities. The contrary interpretation would undercut the likely purpose of the provision. For example, charitable givings or tax or regulatory filings by a mutual fund trust would not by themselves be an activity of investing funds, but would generally be considered to be part and parcel of its undertaking of investing.

The word “undertaking” in s. 132(6) contrasts to the word "activity" in s. 149(1)(o.2). The French version uses the word "activité" in both provisions – a word which is similar to “activity” but which, depending on the context, can be translated as “operation,” “practice,” or “business” (which are also senses in which the word “activity” can be used.)

In Income Tax Technical News No. 34 (27 April 2006) CRA cited some of the Canadian constitutional case law on the meaning of “undertaking (including Beauport, Lount and Northern Telecom), which generally treats an undertaking as comprising all the activities that comprise the working of the undertaking. See, for example, Lount where an installation for the transmission of TV signals to hotel guests was not an "undertaking" because no separate charge was made for this service. See also Baytrust. This approach is consistent with the definition in s. 248(1) of “business,” which refers inter alia to a profession, calling, trade, manufacture “or undertaking of any kind whatever.” This definition implicitly treats the concept of undertaking as being approximately coterminous with that of “business.” (See also Drumheller and Timmins.)

Inclusion of adventures in the nature of trade

The definition of “business” also includes an adventure or concern in the nature of trade. This may represent the principal or only exception to the proposition that an undertaking represents an aggregation of related or linked activities making up a collective whole. A single “adventure” of earning a fee or profit can constitute an adventure in the nature of trade and, thus, a (deemed) business (see e.g., Manley). There is a concern that an activity that is thereby deemed to be a business could consequently be considered to represent an undertaking that was separate from a (more passive) investment undertaking. In Income Tax Technical News No. 34 (27 April 2006), CRA states that the payment of a guarantee fee by a subsidiary to the parent mutual fund trust might give rise to a non-qualifying undertaking of the trust.

Guarantees

CRA considers that while the provision of guarantees for a fee would represent a services activity that was inconsistent with having only an investment undertaking, a unit trust generally can still satisfy the investment undertaking requirement if the provision of a guarantee is an integral part of the trust's investment undertaking. This requirement generally will be satisfied where the trust guarantees obligations of a direct or "grandchild" subsidiary in order to assist the subsidiary in financing its business. In 2004-0068221E5, 2008-0273501R3 and 2010-0386081R3, CRA countenanced guarantees respecting obligations of grandchild or great-grandchild entities where the indirect interest of the mutual fund trust was less than 100%.

In Income Tax Technical News No. 34 and in other interpretations, CRA effectively indicated that there should be a high degree of integration between the giving by the mooted mutual fund trust of a guarantee and its investing undertaking. Depending on what is meant by “high,” this very well may be articulating a standard that is too stringent. A guarantee that is given without a fee likely could not constitute an adventure in the nature of trade or an undertaking by itself, so that the relevant question would almost always be whether the giving of the guarantee occurred as part of the investment undertaking (or real estate undertaking described in s. 132(6)(b)(ii)) of the mooted mutual fund trust, or instead occurred as part of some other enterprise or integrated operation of the trust.

In order for the giving of a guarantee to form a part of a non-permitted undertaking of the mooted mutual fund trust, it would not be sufficient to find that its giving was not highly integrated with the trust’s “good” investing (or real estate) undertaking: the guarantee would also need to have a sufficient connection with the non-qualifying undertaking. Furthermore, this way of looking at the question assumes a negative answer to the very issue at hand, i.e., it assumes that there already is some other non-qualifying undertaking to which the giving of the guarantee could be assimilated. Obviously, if the mooted mutual fund trust instead gives a guarantee to support the expansion of a sardine plant carried on by it through a general partnership (i.e., a partnership that cannot benefit from the insulating effect of s. 253.1), that guarantee would relate to what is already by assumption a non-qualifying undertaking of the trust. However, in the situation where the only mooted activities of the trust are the giving of guarantees for obligations incurred by entities in which it is invested, it is difficult to conceive of how that would give rise to a separate enterprise or other undertaking – so that in default of any other reasonable alternative, the giving of the guarantees would form part of the investing undertaking.

Directors of subsidiaries

Although CRA has not stated that a unit trust through its trustees will be considered to be engaged in the non-qualifying undertaking of a corporate subsidiary where its trustees are identical to the directors of that subsidiary, it has required in the context of various rulings that a majority of the directors of the subsidiary not be trustees of the trust (see e.g., Income Tax Technical News No. 34 and 2013-0492731R3).

Speculative trading

The entering into of futures contracts and forward purchase contracts can constitute investing even if these transactions are on income account.