A discretionary irrevocable personal family trust (the “Trust”), had non-resident beneficiaries (“Y” and “Z”) and held common shares of a holding company (“Holdco”). When it was approaching the 21-year deemed realization date, its trustees resolved to distribute an equal share of the Trust’s assets to each of Y and Z to the complete exclusion of any other beneficiary (the “vesting”). After the vesting, Y and Z purportedly assigned their respective capital interests in the Trust under s. 85(1) to an unlimited liability company (“ULC”) incorporated by them in exchange for ULC common shares. The Trust designated under s. 104(19) taxable dividends as those of ULC. Trust assets were transferred to ULC subsequently to this assignment.
The Directorate found that ULC did not become a beneficiary under the Trust as the Trust indenture defined “Beneficiary” to mean Y, Y’s spouse (Z) and Y’s issue, and the trustees were not empowered to vary the Trust or to add new beneficiaries.
In the Directorate’s view, this meant that the dividends were includible in the income of Y and Z, stating:
As Y and Z are the sole shareholders of ULC … ULC receives the amount for the benefit of the existing income beneficiaries of the Trust, namely Y and Z.
Accordingly, such income distribution to Y and Z was subject to Part XIII tax under s. 212(1)(c).
Similarly, “the transfer of the Trust’s assets to ULC … was for the benefit of Y and Z,” and s. 107(2.1) thereby applied to deem them to be disposed of for fair market value proceeds.
Before stating that it “would not accept that the trustees may recharacterize as capital the taxable dividend income deemed received by the Trust,” the Directorate quoted its position in 2001-0076845 “that a discretionary power granted to the trustee of a trust to distinguish income and capital items cannot change the nature of an amount of income or deductible expense into a capital receipt or expenditure and vice versa.”