Principal Issues: (1) Whether a qualified disability trust ("QDT") is subject to the recovery tax imposed under paragraph 122(1)(c) when an amount is paid or distributed out of the taxable income of the trust for a year that precedes the particular taxation year to the estate of the last electing beneficiary of the trust? (2) Whether the trustee of a QDT is jointly and severally, or solidarily, liable with the trust to pay the recovery tax payable under paragraph 122(1)(c)? (3) Whether the estate of the deceased electing beneficiary of a QDT is jointly and severally, or solidarily, liable with the trust to pay the recovery tax payable under paragraph 122(1)(c)?
Position: (1) Yes. (2) Application of section 159. (3) Possible application of section 160.
Reasons: (1) The QDT is subject to the recovery tax under paragraph 122(1)(c), as none of the beneficiaries under the trust at the end of the particular year was an electing beneficiary of the trust for a preceding year, and the total taxable income for the years that precede the particular taxation year has not been paid or distributed to an electing beneficiary. (2) and (3) As no specific provisions have been released in relation to the responsibility of the recovery tax payable by a QDT, general principles stated in sections 159 and 160 may apply.
TAXATION OF FINANCIAL STRATEGIES AND INSTRUMENTS ROUNDTABLE, OCTOBER 7, 2016
2016 APFF CONFERENCE
Question 7
Testamentary Trusts for Persons with Disabilities
A testator created a trust for his son who was mentally incompetent from birth, which rendered him incapable of work and eligible for the disability tax credit. At the time of his death, he bequeathed substantial capital to the trust whose sole beneficiary was the disabled child. The trustees are authorized to use the income of the trust on a discretionary basis for the benefit of the son for the rest of his life. The trustees are also permitted to encroach on capital for special needs of the beneficiary in their sole discretion. In fact, the trustees used the income and a good proportion of the capital to meet the growing needs of the beneficiary.
At the time of the disabled beneficiary's death, the trust held a sum which it would be reasonable to consider had not become payable or been distributed out of the taxable income of the trust for a taxation year preceding that of death.
Questions to the CRA
(a) If the balance of the taxable income of the trust for a taxation year prior to the year of death is paid to the estate of the disabled beneficiary in the year of his decease (if permitted under the trust deed), would paragraph 122(1)(c) apply to retroactively impose tax at the high marginal rate?
(b) Would the trustee be personally liable for this tax?
(c) Would the estate of the handicapped beneficiary be liable for the payment of such tax if the trust did not hold sufficient assets to satisfy the tax due by it as a result of previous distributions made to the beneficiary?
CRA response to Q.7(a)
Paragraph 122(2)(a) applies to a trust for a particular taxation year if the trust was a QDT for a preceding taxation year and none of the beneficiaries under the trust at the end of the particular year was an "electing beneficiary" of the trust for a preceding taxation year. The taxation year referred to in paragraph 122(2)(a) may be the year in which the electing beneficiary died or, if the QDT has various electing beneficiaries, the year in which the last of its electing beneficiaries died.
The CRA is of the view that the estate of a disabled beneficiary cannot qualify as an "electing beneficiary" for a particular taxation year. Indeed, paragraphs 118.3(1)(a) and (b) cannot apply to an estate, as required by the provisions of paragraph (b) of the definition of that expression in subsection 122(3) and by subparagraph (b)(i) of the definition of QDT in subsection 122(3).
In the example provided, paragraph 122(1)(c) applies since none of the beneficiaries under the trust at the end of the year of death was an electing beneficiary of the trust for a preceding taxation year, as required under paragraph 122(2)(a). Furthermore, a recovery tax is payable by the trust in the year of the death of the disabled beneficiary since the entire taxable income of the trust for the taxation years during which it was a QDT was not paid or distributed to an electing beneficiary.
It should be noted that the recovery tax does not apply in respect of a distribution or repayment of a capital contribution.
CRA response to Q.7(b)
Generally, pursuant to subparagraph 159(1)(a)(i), the legal representative of a taxpayer is solidarily liable with the taxpayer to pay each amount payable under the Income Tax Act by the taxpayer to the extent that the legal representative is at that time in possession or control, in the capacity of legal representative, of property that belongs or belonged to, or that is or was held for the benefit of, the taxpayer.
Subsection 159(2) provides that, before distributing any property in the possession or control of a legal representative, the legal representative of a taxpayer must obtain a certificate certifying that all amounts for which the taxpayer is or can reasonably be expected to become liable under the Income Tax Act have been paid. This certificate must also confirm, as required, that all amounts for the payment of which the legal representative, in that capacity, is or can reasonably be expected to become liable, have been paid. Finally, if security for the payment of the such tax amounts has been accepted by the Minister, the certificate must certify as to such acceptance of this security.
If the legal representative proceeds with a distribution of property in his or her possession or control without obtaining a certificate under subsection 159(2), the legal representative could be personally liable for these amounts, up to the value of the property distributed. This rule is provided in subsection 159(3).
In the situation provided, the trustee of the QDT, in his or her capacity of legal representative as defined in subsection 248(1), is therefore subject to the above rules, and could be solidarily liable with the trust for the payment of the taxes imposed under paragraph 122(1)(c).
CRA response to Q.7(c)
Under subsection 160(1), where a person is liable to pay tax under the Income Tax Act and the person transfers property, directly or indirectly, to a person with whom the person was not dealing at arm's length, the transferee and the transferor generally are solidarily liable to pay the amount by which the FMV of the transferred property exceeds the FMV at the time of the consideration given for the property, up to the amount of the tax liability of the transferor for the year of the transfer or for a preceding taxation year.
If, at the time of the transfer of the property to the estate by the trust, they were not dealing with each other at arm’s length within the meaning of subsection 251(1), it is possible that the rules in subsection 160(1) would apply. In the current situation, the information available to the CRA does not permit a conclusion as to the application of this provision.
Marie-Claude Routhier
(613) 670-8921
October 7, 2016
2016-065175
FOOTNOTES
Due to our system requirements, the footnotes contained in the original document are reproduced below:
1 For the purposes of the definition of this expression in subsection 122 (3).