Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: When should the guidance in paragraph 6 of IT-286R2 apply to the income of a graduated rate estate (GRE)?
Position: Whether paragraph 6 can be applied in a given situation depends on the terms of the will, and whether the final year of the GRE ends after the executor's year.
Reasons: See detailed discussion.
Author: Fron, Steve
Section: 104(6), 104(13), 104(24)
2020 STEP CRA Roundtable – November 26, 2020
QUESTION 1. Application of the Executor’s Year to a Graduated Rate Estate
Paragraph 6 of IT-286R2 notes that under common law rules, the initial 12 month period for a testamentary trust, commencing with the date of the settlor's death, is referred to as the "executor's year" and the right to income of the trust is, during the executor's year, unenforceable by a beneficiary of the trust. In spite of such common law rules, where the initial taxation year of a testamentary trust coincides with the executor's year and where the sole reason for the rights of a beneficiary being unenforceable is the existence of an executor's year, the CRA appears to consider the income of the trust for that year to be payable to the beneficiary or beneficiaries of the trust pursuant to subsection 104(24). However, if even one beneficiary of the trust objects to this treatment with respect to the executor's year, the income of the trust for that year, to the extent that it was not actually disbursed during that year, will be taxed in the hands of the trust.
In any case where the trust has been wound-up and the final T3 return is filed for a period which terminates before the end of the executor's year, the income of the trust (including taxable capital gains) earned for that period is considered to have been paid to the beneficiaries of the trust in the calendar year in which that period ends, except for any part of the trust's income that was disbursed by the trustee to persons other than beneficiaries pursuant to the deceased's will or the operation of law (e.g., the will stipulated that debts are to be paid out of income).
Assume an estate qualifies as a graduated rate estate (“GRE”). Could the CRA clarify whether, in the final year of the estate, income should be taxed in the estate or in the beneficiaries’ hands, where the final year: a) ends after the executor’s year; b) ends during the executor’s year and c) coincides with the end of the executor’s year?
Firstly, we note that paragraph 6 of archived Interpretation Bulletin IT-286R2 Trusts – Amounts Payable, (“the Bulletin”, issued April 1988), is substantively reproduced in the first two paragraphs of the question. Since that time, several technical interpretations (footnote 1) have discussed paragraph 6, including document 2005-0116041E5, which provided further context in respect of the executor’s year:
On the death of an individual, the individual’s property comes under the control of an executor or other personal representative and thus the property is held in an estate, which is treated as a type of trust for purposes of the Income Tax Act. It is the executor’s role to administer the estate, which involves determining and paying creditors and distributing the remaining assets of the estate to the beneficiaries as soon as possible. Generally, the law provides the executor with a year (often referred to as the executor’s year) to administer an estate, during which time the beneficiaries cannot demand the distribution of property held by the executor. After this time, it is a question of fact as to whether the executor is able to distribute property and whether the income of the estate is payable to the beneficiaries.
Paragraph 6 of Interpretation Bulletin IT-286R2, Trusts – Amounts Payable, states that the income earned in the first 12 months of the estate will be considered payable to the beneficiaries, even though the estate is still under administration and the beneficiaries are not able to enforce payment of such income, provided that none of the beneficiaries object to such treatment. Note that this position only applies to the executor’s year. That is to say, where the only reason that an amount of income is not payable to the beneficiaries is that it was earned in the initial 12 months of the estate, the income can be considered payable to the beneficiaries provided that all beneficiaries agree to such treatment. This would not apply to any other situation in which the amount was not payable to the beneficiaries because the terms of the will did not provide for such a distribution or in which the income was not allocated to the beneficiaries in proportion to their respective shares of the estate.
As stated in a paper, Post Mortem Tax Planning, presented by Mary Louise Dickenson at the 1984 Canadian Tax Foundation:
“Generally, beneficiaries are entitled to the income of the estate according to the terms of the will. If under the will income is payable to beneficiaries, the income must also be allocated by the personal representatives. If, on the other hand, income is not payable to beneficiaries, it must be included in computing the estate’s income for tax purposes. If the personal representatives have discretion regarding the payment of income and can pay or accumulate it, the personal representatives have considerable flexibility, subject to the even-hand principle and other fiduciary considerations.”
Thus, if the terms of the will provide that the income is payable to beneficiaries, the income is allocated to them by the executor unless a designation is made under subsection 104(13.1) or (13.2). If, on the other hand, income is not payable to beneficiaries, it must be included in computing the estate’s income for tax purposes.
Before it can be concluded that an amount is payable within the meaning of subsection 104(13), subsection 104(24) must be considered. Subsection 104(24) applies for the purposes of inter alia subsections 104(6) and 104(13), and deems an amount that has otherwise become payable to a beneficiary, not to have become payable to a beneficiary in a taxation year unless the amount is paid in the taxation year to the beneficiary or the beneficiary was entitled in the taxation year to enforce payment of the amount.
The above principles are reflected in the T3 Trust Guide which states, “generally, you allocate income to the trust’s beneficiaries according to the terms of the will or trust document”. The T3 Trust Guide further points out that an amount can only be allocated to a beneficiary if one of the following applies:
* the beneficiary is entitled to the income in the year that it is earned by the trust, under the trust document;
* the trust makes a preferred beneficiary election to include the trust income in the beneficiary’s income; or
* the beneficiary is paid income in the year that is earned by the trust, at the discretion of the trustee.
The entire context of paragraph 6 of the Bulletin contemplates a situation in which the income of the estate is otherwise payable to the beneficiaries. However, this may not always be the case; therefore, one must look to the terms of the Will to determine whether paragraph 6 is relevant in a particular situation. For example, the terms of the Will may:
* require the payment of income to the beneficiaries;
* provide the executor with discretion to pay income to the beneficiaries (in that case, whether the discretion is exercised is relevant), or to accumulate the income in the estate;
* direct the executor to use the income for some other purpose (or to not pay the income to the beneficiaries); or
* provide very little indication as to whether the income or capital of the estate should be used to make distributions to residual beneficiaries. (footnote 2)
Accordingly, there are situations where the guidance in paragraph 6 does not apply, for example, where the Will provides the executor with the discretion to distribute the income to the beneficiaries or accumulate the income in the estate and the executor chooses the latter.
In our view, paragraph 6 of IT-286R2 considers the treatment of income in the executor’s year where: a) the initial taxation year of an estate coincides with the executor’s year such that the administration of the estate is not completed until after the executor’s year, or b) the estate is administered and wound up in its first year.
Response for a) – where the estate is wound up after the executor’s year
Our understanding is that the greater need for clarification is in respect of the final year of the estate, and the discussion in the latter part of paragraph 6. Nonetheless, it is important to note that the treatment discussed in the first part of paragraph 6 which allows income in the executor’s year to be considered as payable to the beneficiaries (if all of the beneficiaries agree to the treatment) relates only to situations where the estate has not been wound up in the executor’s year such that the estate administration continues beyond the first year. Also the income must otherwise be payable to the beneficiaries.
Whether the income earned in the estate’s final year which falls beyond the executor’s year should be taxed in the estate or in the beneficiaries’ hands also depends on the terms of the trust as discussed above. Where the income is distributed or made payable to the beneficiaries pursuant to the terms of the Will, the amount must be included in the beneficiaries’ income, unless a valid subsection 104(13.1) or (13.2) designation is made (see below).
Response for b) and c) – where the estate is wound up before or at the end of the executor’s year
The latter part of paragraph 6 is framed under the assumption that where the estate is wound up prior to the end of the executor’s year, amounts will have been distributed to, or will have become payable to the beneficiaries. As noted above, this may not always be the case; as the determination of whether the distributed or payable amounts are income or capital of the estate depends on whether the terms of the Will and any other laws that impact the administration of the estate allow for the distribution of income to beneficiaries.
For example, document 2016-0669871C6 considers a situation in which a simple will provided minimal direction to an executor. The question was, where all of the debts and specific bequests have been paid, whether an executor can pay or make payable taxable income of an estate to the residual beneficiaries of the estate and thus satisfy subsection 104(24) such that a deduction under subsection 104(6) could be claimed. The CRA response noted in part:
While the issue of whether a deduction pursuant to subsection 104(6) of the Act will ultimately depend on the terms of the Will and any other laws that impact the administration of the estate, in our view, the following key concepts will be useful in determining how to treat testamentary gifts for tax purposes:
1. Where there is no indication in the Will from which assets the gift is to be paid, generally the Executor can make the payment as they wish as long as they act impartially (the even-hand rule), they follow the classification of gifts (and, as is noted in the question posed, they have paid the liabilities of the testator and the estate). The residue of the Estate can include income and the residue of an estate is not necessarily comprised only of after tax amounts. Accordingly, in such instances, the income of the estate may be paid or made payable to a residual beneficiary, and a deduction pursuant to subsection 104(6) may be taken by the estate (if no other provision of the Act prohibits such a deduction).
2. However, depending on the wording of the Will, after the debts and specific bequests of the estate have been paid, the Executor may be required to pay the taxes owing on the income generated by the Estate and distribute the after tax “residue” to the residual beneficiaries. In such cases distributions to residual beneficiaries could not be considered to be income payable to a beneficiary for purposes of subsections 104(6) and 104(13). Accordingly, the estate would be precluded from claiming a deduction under subsection 104(6) in respect of the distribution. Instead, the income would be taxed in the estate, and the residual beneficiaries would receive capital distributions, comprised of after tax paid capital of the estate.
Accordingly, the guidance provided in the latter part of paragraph 6 does not apply to every situation.
Further, we note that although the discussion in the latter part of paragraph 6 refers to “a period which terminates before the end of the executor’s year”, in our view, the guidance would also apply where the end of the estate’s tax year coincides with the end of the executor’s year and only one T3 return is being filed which covers the time from the establishment of the estate to the final distribution of the property of the estate and its wind-up.
Designations under subsections 104(13.1) and (13.2)
We have noted in the past (for example in the 2005 document above) that a designation under subsection 104(13.1) or (13.2) may be utilized to have income that is otherwise paid or payable to beneficiaries taxed in the estate. It is important to note that since 2016, the application of these two subsections has been limited by subsection 104(13.3).
The Department of Finance's Explanatory Notes indicate that subsection 104(13.3) ensures that subsection 104(13.1) or (13.2) designations “are made only to the extent that the trust's tax balances (e.g., loss carry-forwards) are applied, under the rules that apply in Division C, against all of the trust's income for the year determined after the trust claims the maximum amount deductible by it under subsection 104(6).” Therefore, where an estate’s taxable income would be greater than nil after a subsection 104(13.1) or (13.2) designation is made, subsection 104(13.3) will render the designation invalid. Subsection 104(13.3) may impact the ability to make a subsection 104(13.1) or (13.2) designation in any year of the estate.
Dawn Dannehl / Steve Fron
November 26, 2020
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 Several documents are discussed in the response. See also documents 2007-0259841E5 and 2016-0630781E5.
2 See document 2016-0669871C6 – Question 14 from the 2016 CTF Annual Conference Roundtable which provides further discussion in respect of the last two bullets above.
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