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ARCHIVED - Trusts -- Capital Gains and Losses and the Flow-Through of Taxable Capital Gains to Beneficiaries

From: Canada Revenue Agency

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What the "Archived Content" notice means for interpretation bulletins

NO: IT-381R3

DATE: February 14, 1997

SUBJECT: INCOME TAX ACT
Trusts -- Capital Gains and Losses and the Flow-Through of Taxable Capital Gains to Beneficiaries

REFERENCE: Subsections 104(21), (21.2) and (21.3) (also sections 3, 105, 110.6 and 111; subsections 104(4), (5), (5.3), (6), (7.1), (12), (13), (13.1), (13.2), (14), (18) and (24) and 107(4); the definitions of "accumulating income," "eligible taxable capital gains," "pre-1972 spousal trust," "preferred beneficiary" and "testamentary trust" in subsection 108(1) and the definition of "personal trust" in subsection 248(1); and paragraphs 53(2)(h) and 122(2)(d))

Notice -- Bulletins do not have the force of law

This document is also available for download in PDF format.

Contents

Application

This bulletin cancels and replaces Interpretation Bulletin IT-381R2 dated November 29, 1991.

Summary

This bulletin discusses rules for determining a beneficiary's income for tax purposes from a trust as well as the deductions available to the trust for its income distributions and allocations to beneficiaries. The discussion of these rules serves as the background for the main topics of the bulletin, which are

Related subjects that are covered in the bulletin include

The provisions discussed in the bulletin are intended

It should be noted that a discussion of the application of the 21-year deemed realization rule for trusts, as well as related rules, is outside the scope of this bulletin.

Discussion and Interpretation

Income of a Beneficiary of a Trust

¶ 1. The income, for income tax purposes, of a beneficiary of a trust for a particular taxation year may include the following:

(a) the share of an amount included in the income of the trust that is paid or payable to the beneficiary in the year under the terms of the trust, to the extent that it was not included in the beneficiary's income in a previous year (see subsection 104(13) and also subsections 104(18) and (24));

(b) that part of the "accumulating income" of the trust that is designated to the beneficiary in a preferred beneficiary election (see subsection 104(14) and related provisions, including the definitions of "preferred beneficiary" and "accumulating income" in subsection 108(1); see also the current version of IT-394, Preferred Beneficiary Election);

(c) a benefit conferred on the beneficiary resulting from the maintenance, out of income of the trust, of a property for the beneficiary's use (subsection 105(2)); or

(d) any other benefit to the beneficiary in the year from or under the trust, except to the extent that it

(Such other benefits are included in the beneficiary's income under subsection 105(1)).

Deductions in Computing Income of a Trust

¶ 2. As a general rule, amounts included in the income of a trust's beneficiary under subsections 104(13), 104(14) or 105(2) (described in ¶s 1(a) to 1(c) above) are deductible by the trust under subsection 104(6) or 104(12), as applicable, in computing its income. A trust's deduction under subsection 104(12) pertains to that part of the trust's "accumulating income" that is included in a beneficiary's income under a subsection 104(14) preferred beneficiary election. Paragraph 104(6)(b) generally provides for a deduction by a trust of the following amounts:

A paragraph 104(6)(b) deduction is available to a trust if one of the other paragraphs in subsection 104(6) does not apply to it (these other paragraphs in subsection 104(6) pertain to certain special types of trusts, e.g., an employee trust or a trust governed by an employee benefit plan). There are certain restrictions on the amounts that a trust may deduct under paragraph 104(6)(b) or subsection 104(12). Restrictions that can apply with respect to capital gains (the main subject of this bulletin) are discussed in ¶s 11 through 16 below. Also, if a trust is entitled to a deduction under paragraph 104(6)(b), it may choose to deduct an amount that is less than the amount of its income distributions. This may be done, for example, to enable the trust to utilize, in a particular year, losses from prior years without affecting the ability of the trust to distribute its income currently. If a trust is precluded from deducting an amount or if a trust chooses to deduct an amount that is less than the amount of its income distributions, designations to prevent double taxation are available as discussed in ¶s 17 to 19 below.

Capital Gains of a Trust

¶ 3. Under trust law, a capital gain realized by a trust is generally considered to be part of the capital of the trust. For income tax purposes, however, a taxable capital gain realized by a trust is included in computing its income. All or part of the amount of a taxable capital gain realized by a trust may, under certain circumstances, be included in the income of one or more of its beneficiaries under one of the provisions discussed in ¶ 1 above (note that, since such an amount included in the income of a beneficiary will also have been included in the trust's income, a corresponding deduction could then be claimed by the trust as discussed in ¶ 2 above).

Any amount of a taxable capital gain realized by a trust that is paid or payable to a beneficiary is included in the beneficiary's income under subsection 104(13) (see ¶ 1(a) above). This could occur, for example, where the terms of the trust allow for an encroachment on the capital of the trust and the trustees determine by written resolution that an amount of a taxable capital gain realized by the trust will be paid or payable to a beneficiary.

Also, although a taxable capital gain may not form part of trust income under trust law, it does enter into the calculation of "accumulating income" (as defined in subsection 108(1) of the Income Tax Act) and thus an amount of a taxable capital gain can be included in the income of a preferred beneficiary by means of a subsection 104(14) preferred beneficiary election (see ¶ 1(b) above).

The actions taken by the trustees of the trust that cause an amount of a taxable capital gain to be included in the income of a beneficiary under subsection 104(13) or (14) should not contravene the terms of the trust indenture. Finally, it should be noted that when an amount of a trust's taxable capital gain is included in the income of a beneficiary under subsection 104(13) or (14), neither of those provisions deems the amount to be a taxable capital gain of the beneficiary (see, instead, the discussion of subsection 104(21) below).

Flow-through of Taxable Capital Gains to a Beneficiary

¶ 4. For the "net taxable capital gains" (see ¶ 5 below) of a trust for a taxation year throughout which it was resident in Canada, provision is made in subsection 104(21) to preserve the character of such gains flowing through the trust to its beneficiaries resident in Canada and, if the trust is a mutual fund trust, to its non-resident beneficiaries. This flow-through of net taxable capital gains applies for purposes of sections 3 and 111 in determining a beneficiary's income for the year and the amounts of losses from other years which the beneficiary may deduct in determining taxable income for the year, but not for purposes of a capital gains deduction in section 110.6 (in the case of a beneficiary of a personal trust, however, see ¶s 6 and 7 below).

¶ 5. A trust that has realized taxable capital gains in a particular taxation year may, within the limits of subsection 104(21), designate in its return of income for the year all or part of the amount of those gains as a taxable capital gain for the year of one or more beneficiaries. An amount designated to a beneficiary under subsection 104(21) must reasonably be considered to be part of the amount included in the beneficiary's income for that year under any of the provisions referred to in ¶ 1 above (see also ¶ 3 above). The total of the amounts designated under subsection 104(21) may not exceed the amount of the trust's "net taxable capital gains" for the year. For this purpose, subsection 104(21.3) provides that the amount of the trust's net taxable capital gains equals the amount (if any) by which the trust's taxable capital gains for the year exceed the total of

(a) its allowable capital losses for the year, and

(b) the amount of net capital losses of other years that are deducted by it in determining its taxable income for the year.

As indicated in ¶ 18 below, the amount of taxable capital gains otherwise included in a beneficiary's income for the year by reason of subsection 104(21) is reduced by any amount designated to the beneficiary for the year under subsection 104(13.2).

Capital Gains Deduction Claims by a Beneficiary of a Personal Trust

¶ 6. If a "personal trust," as defined in subsection 248(1) of the Act, designates to a beneficiary an amount under subsection 104(21) in respect of its net taxable capital gains for a taxation year (see ¶s 4 and 5 above), subsection 104(21.2) provides that the trust shall also designate to the beneficiary an amount or amounts in respect of its eligible taxable capital gains, if any, for the year. (The calculation of a personal trust's "eligible taxable capital gains" is discussed in ¶ 8 below.) A subsection 104(21.2) designation can occur only if the amount designated to the beneficiary under subsection 104(21) pertains to net taxable capital gains of the trust from the disposition of qualified farm property or qualified small business corporation shares. These are the two types of property that qualify for a section 110.6 capital gains deduction. There is a formula for each of these types of property in subsection 104(21.2). The effect of each of these formulas is that the amount designated to a particular beneficiary is equal to the beneficiary's proportionate share of

all the trust's subsection 104(21) designations for the year to its beneficiaries in respect of its net taxable capital gains for the year
minus
all the trust's subsection 104(13.2) designations for the year to its beneficiaries (see ¶ 18 below),

to the extent that the amount so calculated represents eligible taxable capital gains of the trust for the year from the disposition of qualified farm property or qualified small business corporation shares (depending on which formula is being applied).

¶ 7. An amount designated to a beneficiary by a personal trust under either formula in subsection 104(21.2) is deemed to be a taxable capital gain of the beneficiary from a disposition (by the beneficiary) of his or her qualified farm property or qualified small business corporation shares (depending on which formula is being applied). The beneficiary's deemed taxable capital gain occurs in the beneficiary's taxation year in which the taxation year of the trust (for which the subsection 104(21) designation was made) ends. This deeming rule in the subsection 104(21.2) formulas applies only for purposes of the beneficiary's claiming a section 110.6 capital gains deduction. It is important to note that the beneficiary must still meet all of the requirements of section 110.6 in order to claim a capital gains deduction. For example, a beneficiary who has already claimed the full $500,000 capital gains exemption in prior years would not be able to use a subsection 104(21.2) designation to claim any further capital gains deduction.

¶ 8. The amount of a personal trust's "eligible taxable capital gains" for a particular taxation year is defined in subsection 108(1) as the lesser of two amounts:

(a) the trust's "annual gains limit" for the year (as determined under subsection 110.6(1)); and

(b) the trust's "cumulative gains limit" at the end of the year (as determined under subsection 110.6(1)) less the total of all amounts designated by the trust to beneficiaries under subsection 104(21.2) for prior taxation years.

Taxation of Trust on Taxable Capital Gains Not Included in Income of Beneficiary

¶ 9. Any portion of the amount of a taxable capital gain realized in a taxation year by a trust that is not included in the incomes of beneficiaries for that year (see ¶ 1 and also ¶ 3 above) is taxable in the hands of the trust. Such portion of the taxable capital gain, net after tax, remains as trust capital pending its distribution as such in accordance with the terms of the trust.

Capital Losses

¶ 10. As indicated in ¶ 5 above, a trust's allowable capital losses for a particular taxation year are netted against its taxable capital gains for the year when calculating its "net taxable capital gains" that can be designated to beneficiaries under subsection 104(21). However, if the trust's allowable capital losses are greater than its taxable capital gains for the year, the resulting net allowable capital loss

Instead, such net allowable capital loss is included in the trust's "net capital loss" for the year. A trust's net capital loss for a particular year

If a trust's net capital loss is carried back to an earlier year, the following should be noted:

Restrictions on Deductions by Spousal Trusts

¶ 11. As indicated in ¶ 2 above, an amount of income of a trust that is paid or becomes payable to a beneficiary is generally deductible by the trust under paragraph 104(6)(b). However, a spousal trust as described in paragraph 104(4)(a) (sometimes referred to as a "post-1971 spousal trust") may not deduct under paragraph 104(6)(b) the amount of any taxable capital gains arising in the year from deemed dispositions of trust property that occur

(a) under subsection 104(4) or 104(5) on the day on which the life tenant spouse dies (see also ¶ 14 below), or

(b) under subsection 107(4) when the property is distributed to a beneficiary other than the life tenant spouse and the spouse is alive on the day the property is distributed.

¶ 12. Also, a spousal trust as described in paragraph 104(4)(a) may not deduct under paragraph 104(6)(b) an amount of income, including a taxable capital gain (if not already disallowed by the rule described in ¶ 11(b) above), that is paid or payable to a beneficiary other than the life tenant spouse if the spouse is still alive throughout the year in which the amount was so paid or payable. This restriction does not apply, however, if the trust altered its terms and conditions on or before December 20, 1991 to permit such a distribution.

¶ 13. By virtue of the definition of "accumulating income" in subsection 108(1), taxable capital gains of

that result from deemed dispositions of trust property under subsection 104(4), 104(5) or 107(4) are excluded from the trust's "accumulating income" for the year. As a result, they do not qualify for inclusion in a beneficiary's income under a preferred beneficiary election as described in ¶ 1(b) above or for a deduction by the trust under subsection 104(12) as described in ¶ 2 above.

¶ 14. If the life tenant spouse of a spousal trust as described in paragraph 104(4)(a) dies during the trust's taxation year, the following rules apply with respect to the trust's taxable capital gains for the year if it ends after July 19, 1995:

¶ 15. The restrictions discussed above cause the spousal trust itself to be taxable on a taxable capital gain described above, even if the amount of the taxable capital gain is otherwise payable by the trust to a beneficiary and to be included in the beneficiary's income under subsection 104(13) (see ¶ 1(a) above). However, rules to eliminate double taxation of such income are discussed in ¶s 17 to 19 below. It should also be noted that a spousal trust may be able to claim a capital gains deduction under subsection 110.6(12) for its eligible taxable capital gains (see ¶ 8 above) for its taxation year that includes the day on which the life tenant spouse dies. Subsection 110.6(12) essentially makes available to the spousal trust after the spouse dies, subject to certain limitations, the spouse's unused capital gains exemption.

Anti-avoidance Rule

¶ 16. A deduction by a trust under paragraph 104(6)(b) for an amount of trust income paid or payable to a beneficiary may be disallowed by an anti-avoidance rule relating to the improper allocation of income to beneficiaries that is contained in subsection 104(7.1). Should such a disallowance of a paragraph 104(6)(b) deduction occur, the rules for the elimination of double taxation, as discussed in ¶s 17 to 19 below, can be used.

Double Taxation Relief

¶ 17. Generally, under the provisions of subsection 104(13) and paragraph 104(6)(b), the amount of income of a trust for a taxation year that is paid or becomes payable, within the meaning of subsections 104(18) and (24), to a beneficiary is subject to tax as income in the beneficiary's hands and not in the hands of the trust (see ¶s 1(a) and 2 above). However, if a trust is prevented from deducting an amount of income that is paid or payable to a beneficiary (see ¶s 11 to 16 above) or if a trust chooses to deduct an amount that is less than the amount of its income distributions (see ¶ 2 above), such amount is also subject to tax in the hands of the trust. To eliminate this double taxation, designations may be made under subsections 104(13.1) or 104(13.2).

¶ 18. Subsections 104(13.1) and (13.2) can be used by a trust for any taxation year throughout which it is resident in Canada and not exempt from Part I tax by reason of subsection 149(1). Subsection 104(13.1) provides the mechanism for the trust to designate to its beneficiaries their respective shares of that portion of the trust's income distributions that has not been deducted in computing its income for the year. The amount of trust income designated to a beneficiary under subsection 104(13.1) will be deemed, for the purposes of subsections 104(13) and 105(2), not to have been paid or to have become payable in the year to or for the benefit of the beneficiary or out of income of the trust. In other words, the amount will not be required to be included in the beneficiary's income under subsection 104(13) or 105(2). A subsection 104(13.2) designation contemplates the situation in which a trust has a non-capital loss carry-forward from a prior taxation year and current taxable capital gains. In such circumstances, as indicated in ¶ 2 above, the trust may choose not to deduct the full amount to which it is entitled under paragraph 104(6)(b) in order to allow the non-capital loss carry-forward to absorb the current taxable capital gains. The designation in subsection 104(13.2) allows the trust to designate to its capital beneficiaries their respective shares (based on the trust's subsection 104(21) designations) of the portion of the potential deduction under subsection 104(6) that has not been deducted under that subsection or used in a designation under subsection 104(13.1). An amount designated to a beneficiary for the year under subsection 104(13.2)

The provision in subsection 104(13.2) for the above-mentioned reduction of the subsection 104(21) amount does not apply, however, for purposes of applying the rules in subsection 104(21.2). Instead, subsection 104(21.2), in its own calculation, provides for a reduction of the subsection 104(21) amount by an amount designated under subsection 104(13.2). By virtue of paragraph 53(2)(h), an amount designated to a beneficiary by a trust under subsection 104(13.l) or (13.2) will generally reduce the adjusted cost base ("ACB") of the beneficiary's capital interest in the trust. However, if the beneficiary's capital interest is an interest in a "personal trust" (as defined in subsection 248(1) of the Act) and the interest was acquired by the beneficiary for no consideration, there is no such ACB reduction under paragraph 53(2)(h). An amount designated under subsection 104(13.1) or (13.2) and included in the computation of the trust's income will not be subject to tax in the hands of a beneficiary when that amount, net after tax, is paid out to the beneficiary. The designation of an amount as provided by subsections 104(13.1) and (13.2) is to be made by a trust in its return of income for the year under Part I of the Act.

¶ 19. An income beneficiary may agree to pay a trust's tax liability arising from a designation under subsection 104(13.1) or (13.2). Often this is done because the payment of tax by the trust would reduce the value of the capital interests held by other beneficiaries. The payment of tax by the income beneficiary is not a contribution for the purpose of paragraph (b) or (c) in the subsection 108(1) definition of "testamentary trust," nor is it a gift for the purposes of paragraph 122(2)(d). The payment must equal the tax payable by the trust on the income that is deemed not to have been paid or payable to the beneficiary because of the designation. The payment can be made by

(a) reimbursing the trustee,

(b) providing a cheque payable to the taxing authority, or

(c) receiving a net amount from the trustee reflecting the beneficiary's share of income less the relevant taxes payable by the trust.

Explanation of Changes

Introduction

The purpose of the Explanation of Changes is to give the reasons for the revisions to an interpretation bulletin. It outlines revisions that we have made as a result of changes to the law, as well as changes reflecting new or revised departmental interpretations.

Reasons for the Revision

This bulletin has been revised because of amendments to the Income Tax Act that were enacted by the 5th Supplement to the Revised Statutes of Canada, 1985; S.C. 1994, c. 7 (formerly Bill C-15); S.C. 1995, c. 3 (formerly Bill C-59) and S.C. 1996, c. 21 (formerly Bill C-36). The comments in the bulletin are not affected by any draft legislation released before January 1, 1997.

Legislative and Other Changes

New ¶s 6 and 7 (replacing former ¶s 5, 6 and 7) reflect an amendment to subsection 104(21.2) that took effect for taxation years of trusts beginning after February 22, 1994. The amendment to subsection 104(21.2) changed the formulas for determining the amount designated to a particular beneficiary in respect of the disposition of qualified farm property and qualified small business corporation shares and eliminated the formula in respect of the disposition of other types of property. These changes were made as a consequence of the elimination of the $100,000 capital gains exemption (in section 110.6) for dispositions of the above-mentioned "other" types of property after February 22, 1994. Because the $500,000 capital gains exemption in respect of qualified farm property or qualified small business corporation shares

the amendment to subsection 104(21.2) also narrowed the person making a designation under that subsection from a "trust" to a "personal trust."

New ¶ 8 (replacing former ¶ 9) is revised to reflect an amendment to the definition of "eligible taxable capital gains" in subsection 108(1), which took effect for taxation years beginning after February 22, 1994. The amended definition ties in with the rules in section 110.6 (as amended to discontinue the $100,000 capital gains exemption for dispositions of property after February 22, 1994). Also, the amended definition of "eligible taxable capital gains" is narrowed in its application from a "trust" to a "personal trust" for essentially the same reason as was done with respect to the person making a designation under subsection 104(21.2) (see explanation for new ¶s 6 and 7 above).

The definitions of "accumulating income," "eligible taxable capital gains" and "testamentary trust" were removed from paragraphs 108(1)(a), (d.2) and (i) of the Act, respectively, and instead placed (along with other definitions) in alphabetical order in subsection 108(1). These structural changes in the revised Act are reflected in new ¶s 8, 13 and 19 (which replace former ¶s 9, 15 and 21, respectively).

New ¶ 10 replaces and clarifies former ¶s 11, 12 and 13. New ¶ 10 clarifies that carrying back a net capital loss to a particular year will not cause any reduction to the amounts originally included in the income of the beneficiaries under subsection 104(13) or 104(14) or section 105 with respect to that year.

In new ¶ 11 (replacing all but the last three lines of former ¶ 15), the former references to "income gains" and to "subsection 104(5.2)" are removed because the bulletin is essentially concerned with the tax treatment, particularly the flow-through, of a trust's taxable capital gains.

New ¶ 12 has been added to the bulletin to describe rules that took effect for taxation years of trusts ending after December 20, 1991 (subject to the exception mentioned in new ¶ 12).

In new ¶ 13 (replacing the last three lines former ¶ 15), references to the trusts described in the first and third bullets were added to the subsection 108(1) definition of "accumulating income" for the 1991 and subsequent taxation years.

New ¶ 14 has been added to the bulletin to describe rules that took effect for taxation years of trusts (i.e., spousal trusts as described in paragraph 104(4)(a)) ending after July 19, 1995.

In new ¶ 15 (replacing former ¶ 16), a reference to subsection 110.6(12) is now given as additional information. (This provision was first added to the Act for the 1985 and subsequent taxation years and it has been amended from time to time as a consequence of amendments to the section 110.6 capital gains exemption rules.)

Former ¶ 17 is discontinued in the new bulletin because it has had no basis in law since the amendment to paragraph 104(6)(b) that took effect for the 1991 and subsequent taxation years. (It should be noted, however, that if a trust made a charitable gift to a person described in parts (a) to (g) of the definition of "total charitable gifts" in section 118.1 or made a gift to Her Majesty in right of Canada or a province, a tax credit to the trust under section 118.1 would be possible.)

In addition to the changes described above, other changes in the new bulletin include:

Notice -- Bulletins do not have the force of law

Interpretation bulletins (ITs) provide Revenue Canada's technical interpretations of income tax law. Due to their technical nature, ITs are used primarily by departmental staff, tax specialists, and other individuals who have an interest in tax matters. For those readers who prefer a less technical explanation of the law, the Department offers other publications, such as tax guides and pamphlets.

While the ITs do not have the force of law, they can generally be relied upon as reflecting the Department's interpretation of the law to be applied on a consistent basis by departmental staff. In cases where an IT has not yet been revised to reflect legislative changes, readers should refer to the amended legislation and its effective date. Similarly, court decisions subsequent to the date of the IT should be considered when determining the relevancy of the comments in the IT.

An interpretation described in an IT applies as of the date the IT is published, unless otherwise specified. When there is a change in a previous interpretation and the change is beneficial to taxpayers, it is usually effective for all future assessments and reassessments. If the change is not favourable to taxpayers, it will normally be effective for the current and subsequent taxation years or for transactions entered into after the date of the IT.

A change in a departmental interpretation may also be announced in the Income Tax Technical News.

If you have any comments regarding matters discussed
in this IT, please send them to:

Director, Business and Publications Division
Income Tax Rulings Directorate
Policy and Legislation Branch
Revenue Canada
Ottawa ON K1A 0L5

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