2016-0669301C6 2016 CTF - Q1 - GAAR & 21-year rule planning

Principal Issues: Implications of a transfer of property from a discretionary trust to a Canadian corporation wholly owned by a new discretionary trust

Position: CRA will typically apply GAAR in this situation.

Reasons: The transaction described circumvents the application of subsection 104(5.8), paragraph 104(4)(b) and the Act as a whole.

Author: Panourgias, Marina
Section: 104(4); 104(5.8); 107(2); 245

2016 CTF Annual Conference
CRA Roundtable

Question 1:  Application of GAAR to Transactions Involving Discretionary Family Trusts and the Application of the 21 Year Deemed Disposition Rule

A number of Canadian resident discretionary family trusts are currently approaching their 21st anniversary.  Accordingly, trustees are considering planning alternatives to avoid the 21-year deemed disposition pursuant to subsection 104(4) of the Income Tax Act (Canada) (the “Act”).  A common method of avoiding the 21-year deemed disposition involves the distribution of property with an unrealized gain to a Canadian resident beneficiary on a tax-deferred basis pursuant to subsection 107(2) of the Act.  Where the beneficiary is a natural person, the realization of any capital gains inherent in the property distributed will be deferred and (absent a spousal rollover) realized at the earlier of the date that the individual actually disposes of the property, or the date that the individual dies.  However, a distribution to a beneficiary that is a natural person in advance of the 21st anniversary of the trust may not always be the desired course of action.   Where the tax-deferred distribution is instead made to a beneficiary that is another Canadian resident discretionary trust, subsection 104(5.8) of the Act would apply to prevent a deferral of the 21-year deemed disposition date. The trustees of the recipient trust would then be faced with the transferor trust’s approaching 21-year deemed disposition.

Consider a situation where a Canadian resident discretionary trust (Old Trust) that is approaching its 21st anniversary distributes property with an unrealized gain to a Canadian resident corporate beneficiary (Canco) that is wholly owned by a newly established discretionary trust resident in Canada (New Trust) on a tax-deferred basis pursuant to subsection 107(2) of the Act.  Canco would be a beneficiary of Old Trust pursuant to its trust indenture.    

As a result of this tax-deferred distribution to Canco, Old Trust will not hold the property on its 21st anniversary.  In addition, subsection 104(5.8) of the Act should not be applicable to affect the timing of the 21st anniversary of New Trust since the property was not transferred directly from Old Trust to New Trust. 

Can the CRA comment on whether it agrees with this conclusion?

CRA Response

The transactions described effectively result in Old Trust indirectly transferring property to New Trust on a tax deferred basis, thereby avoiding the application of the anti-avoidance provision in subsection 104(5.8) of the Act and restarting the 21-year clock.  Thus, the capital gains that would otherwise be realized by Old Trust would be deferred beyond its 21st anniversary while the property continues to be held in a discretionary trust arrangement.  Furthermore, the New Trust is provided with another 21 years to decide who from the potential beneficiaries will receive the property which could result in deferring the unrealized gain beyond the lifetime of the individual beneficiaries alive on the date of the Old Trust’s 21st anniversary.

Generally, it is the CRA’s view that such planning circumvents the anti-avoidance rule in subsection 104(5.8) of the Act in a manner that frustrates the object, spirit and purpose of that provision, the deemed disposition rule in paragraph 104(4)(b) and the scheme of the Act as a whole as it relates to the taxation of capital gains.  It is also the CRA’s view that if a distribution is made by an existing discretionary trust to a Canadian resident corporation wholly owned by a new discretionary trust resident in Canada, it will generally be inferred that the primary purpose of such distribution is to defer the income tax otherwise applicable in respect of the 21-year deemed disposition pursuant to subsection 104(4) of the Act.  The CRA has significant concerns regarding these transactions and will apply GAAR when faced with a similar set of transactions unless substantial evidence supporting its non-application is provided.

The CRA is also concerned that the proposed transactions may be repeated where the terms of New Trust are similar to those of Old Trust. Thus the realization of the capital gains inherent in the property could be deferred for several generations or indefinitely. This contravenes one of the underlying principles in the taxation of capital gains regime, which is to prevent the indefinite deferral of tax on capital gains.

The CRA is currently considering whether GAAR should apply to a situation involving a distribution from a discretionary family trust to a Canco that is wholly owned by a newly established discretionary family trust in which the deferral of capital gains is extended beyond the 21-year deemed disposition in paragraph 104(4)(b); however, the realization of the gain occurs within the lifetime of the existing beneficiaries of Old Trust.

Finally, unless substantial evidence supporting the non-application of GAAR is provided, the CRA will not provide any Advance Income Tax Ruling where such a structure is proposed to be put in place.

Marina Panourgias
Mélanie Beaulieu
2016-066930
November 29, 2016

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