2015-0604971E5 Deemed capital gain of a trust

Principal Issues: A trust wants to make a section 48.1 election to crystallize a capital gain: 1) if the trustee’s power to encroach on capital is general, and the trustee exercises their discretion pursuant to the general power to make a payment to the beneficiaries before the end of the trust's year of an amount equal to the deemed capital gain, would the deemed capital gain be considered payable under subsection 104(24) of the Act? 2) if the answer to question 1 is yes, is there any reason why it cannot be paid in the form of shares that were the subject of the section 48.1 election?

Position: 1) It depends on the terms of the trust indenture but a general power to encroach on the capital is not sufficient. 2) It depends on the terms of the trust indenture.

Reasons: 1) The terms of the trust must specifically give the trustees the discretion to pay out or make payable an amount equivalent to a deemed capital gain, or the discretion to pay out or make payable an amount that is defined as income under the Act. 2) Where the trust makes the payment in kind, the trust must specify that such payment is in respect of the deemed taxable capital gain and not in satisfaction of a beneficiary's capital interest in the trust.

Author: White, Julie
Section: 48.1, 104(6); 104(13); 104(21); 104(24)

XXXXXXXXXX                                                                                                                           2015-060497
                                                                                                                                                   J. White
                                                                                                                                                   905 721 5202
June 8, 2016

Dear Mr. XXXXXXXXXX

This is in reply to your email dated August 21, 2015 in which you requested clarification in respect of comments made in CRA document 9816425 dated January 26, 1999.  That document discusses deemed capital gains for income tax purposes when a trust elects under section 48.1 of the Income Tax Act (Canada) (the Act) and states:

“A general power to encroach on the capital is not, in and by itself, sufficient to make a deemed capital gain payable.  For a deemed capital gain to be considered payable under subsection 104(24) of the Act, the terms of the trust must first specifically give the trustees the discretion to pay out or make payable an amount equivalent to the deemed capital gain or the discretion to pay out or make payable amounts that are defined as income under the Act.  Additionally, the trustees are required to exercise their discretion before the end of the trust’s taxation year and the exercise of such discretion must be irrevocable with no conditions attached to the beneficiaries’ entitlement to enforce payment of the amount in the year.”

You have asked the following questions in respect of the above statement:

1)    Where the power to encroach on capital is general and the trustees exercise their discretion to encroach before the end of the trust’s year to pay an amount equal to the capital gain, will that be sufficient to meet the requirement of subsection 104(24)?

2)    If so, is there any reason why it cannot be paid in the form of shares that were the subject of the 48.1 election?

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced).  It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination.  The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC70-6R7, Advance Income Tax Rulings and Technical Interpretations.

The excerpt you refer to was made in the context of whether a deemed capital gain can be flowed out of a trust to a beneficiary.  Our earlier interpretation also noted that where a deemed gain is realized in the trust because of the section 48.1 election, the deemed capital gain would be included in computing the trust’s income for tax purposes unless the deemed capital gain can be paid, or made payable to the trust beneficiaries within the meaning of subsection 104(24) of the Act.  Subsection 104(24) provides that an amount is deemed not to have become payable to a beneficiary in a taxation year unless it was paid in the year to the beneficiary or the beneficiary was entitled in the year to enforce payment of the amount.  The word “entitled” refers to a legal entitlement as would be dictated by the terms of the trust indenture.  Therefore, although a trust can elect under section 48.1, the question of whether the deemed capital gain can be flowed out to a beneficiary is one which is governed by the terms of the trust indenture.

Under trust law, capital gains would typically be considered to be part of the capital of a trust; however, a deemed capital gain created under a provision of the Act is a “nothing” for trust purposes.  It is not possible to define a deemed capital gain to be income (or a capital gain) for trust purposes. A power to encroach on capital is not in and of itself sufficient to make a deemed capital gain payable.

In order for the deemed gain to be made payable for purposes of subsection 104(24) of the Act:

*     the terms of the trust must specifically permit an amount equivalent to the deemed capital gain to be paid or payable, or

*     the trustee must have the discretionary power to pay out amounts that are defined as income under the Act.

An amount equivalent to the deemed gain would be payable for income tax purposes only where the trustees have exercised their power to make it payable.

In order for a payment in kind to be considered a payment for purposes of subsection 104(24), the trust indenture must permit the assets of the trust to be distributed to the beneficiaries as a payment in kind.  The resolution authorizing the distribution should indicate that the payment in kind is in respect of the amount of the deemed taxable capital gain and not in (partial) satisfaction of a beneficiary’s capital interest in the trust.  To the extent that the trust agreement permits such a distribution, the payment in kind will be accepted as a payment for purposes of subsection 104(24).  As a result, the distribution of the property that was the subject of the deemed gain would “flow through” the deemed gain and may be eligible for a beneficiary’s capital gains exemption, where the trust makes the appropriate designations under subsections 104(21) and (21.2) respectively.

Where the fair market value of the shares distributed exceeds the payment of the taxable capital gain the difference would represent a distribution in satisfaction of the beneficiary’s capital interest in the trust as contemplated under subsection 107(2) assuming the conditions in that provision are otherwise met and no other trust income is being distributed.

We trust our comments will be of assistance to you.

Steve Fron, CPA, CA
Manager Trust Section II
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
Canada Revenue Agency

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