2021-0883001C6 STEP 2021 – Q5 - Income Attribution from AET

Principal Issues: Application of 75(2) in three independent scenarios.

Position: General comments provided.

Reasons: See below.

Author: King, William
Section: 75(2), 96(1), 248(5)

2021 STEP CRA Roundtable – June 15, 2021

QUESTION 5. Income Attribution from Alter Ego Trust

A taxpayer settles an alter ago trust and contributes property to the trust. In general, the income of an alter ego trust attributes to the settlor because subsection 75(2) of the Income Tax Act (the “Act”) applies to the trust. 

Are there any exceptions to this (i.e. types of income that would not attribute)?  For example, consider the following independent scenarios:

a)    The property transferred is an interest in a limited partnership and the trust is allocated business income.

b)    The trust realizes a capital gain, reinvests the proceeds and realizes another capital gain.

c)    The trust earns income, reinvests the income and earns income on the reinvestment (second generation income).

For each scenario above, could the CRA comment on the possible application of subsection 75(2) to that type of income?

CRA Response

Generally, subsection 75(2) will apply to a trust that holds property on condition:

a)    that the property or property substituted for it may:

(i)   revert to the person from whom the property or property for which it was substituted was directly or indirectly received, (the “contributor”) or

(ii)  pass to persons to be determined by the contributor at a time subsequent to the creation of the trust, or

b)    during the existence of the contributor, the property shall not be disposed of except with that person’s consent or in accordance with that person’s direction.

If any of these conditions are met, any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or from property substituted for the property is attributed to the contributor while the contributor exists and is resident in Canada. 

a)    Pursuant to paragraphs 96(1)(f) and (g) of the Act, the amount of the income or loss of a partnership for a taxation year “from any source or from sources in a particular place” is generally considered to be the members’ income or loss “from that source or from sources, in the particular place” for the taxation year in which the partnership taxation year ends to the extent of the member’s share thereof (footnote 1) .  Also, paragraph 12(1)(l) of the Act provides that income from a business or property includes “any amount that is, by virtue of subdivision j, income of the taxpayer for the year from a business or property.”  Whether the income or loss of a partnership is from a source that is business, from a source that is property, or from any other source for that matter, is a question of fact.  When the partnership allocates income and losses to the partners, the income or losses keep their source identity.

The business income or loss that is allocated to the trust from the limited partnership will not be attributed to the settlor on the basis that subsection 75(2) does not attribute business income. 

However, we note that in respect of an alter ego trust, the settlor must be entitled to receive all of the income of the trust that arises before their death, and no other person may, before the settlor’s death, receive or otherwise obtain the use of any income or capital of the trust (footnote 2) .  Therefore, the business income earned by the trust will generally be included in the settlor’s income under subsection 104(13) of the Act.  Subsection 108(5) of the Act provides that except as otherwise provided in Part I, an amount included in the income of a beneficiary under inter alia subsection 104(13), shall be deemed to be income of the beneficiary from a property that is an interest in a trust and not from any other source.  Therefore, the business income allocated by the partnership will be treated as property income in the settlor’s hands.

Where the partnership earns property income, and in accordance with the partnership agreement the trust is allocated such property income, subsection 75(2) will apply, such that the income will be attributable to the person from whom the partnership interest was received (the settlor).  

b)    Pursuant to subsection 248(5) of the Act, where a trust has disposed of a particular property and acquired another property in substitution therefor and subsequently, by one or more further transactions, has effected one or more further substitutions, the property acquired by any such transaction is deemed to have been substituted for the particular property (footnote 3) .

The proceeds received in respect of the disposition of a property of a trust would be considered substituted property.  Similarly, if the proceeds were then reinvested in securities, the securities would also be considered substituted property such that any income or loss from the securities, and any taxable capital gain or allowable capital loss resulting from the disposition of the securities would also be attributed to the contributor of the original property. 

c)    Where a trust earns income from a property contributed (or property substituted therefor) by a person and reinvests that income, any income or loss derived from the reinvestment of these earnings (second generation income) from the property (or substituted property) will not be attributed to that person.

Subsection 75(2) does not apply to second generation income, as this income is not earned on property contributed to the trust.  For example, if the property received from a person is money which is deposited by the trust into a bank account, the interest on the initial deposit will attribute to that person but interest earned on the interest left to accumulate in the bank account will not attribute.

Second generation income will be taxable in the trust to the extent that it is not paid or payable to the beneficiaries of the trust in the trust’s taxation year. 

However, in the context of an alter ego trust, we would expect the second generation income earned in the trust to be payable to the beneficiary under subsection 104(13), as discussed above. Where the second generation income is payable to a beneficiary in the year, subsection 108(5) will generally apply to the income included in the beneficiary’s hands.  For certain types of income such as dividends and taxable capital gains, the trust may make a designation pursuant to subsections 104(19) or 104(21) of the Act respectively, which will result in the income retaining its character in the beneficiary’s hands.

William King
2021-088300

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  Note that allocations of partnership income are subject to subsections 103(1) and (1.1) of the Act.
2  See clause 104(4)(a)(iv)(A).
3  See also Question 11 from the 2015 STEP CRA Roundtable, document 2015-0578551C6.

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