Principal Issues: Where a first trust makes a designation pursuant to subsection 104(21.2) with respect to an amount paid to a second trust, whether the second trust can make a designation pursuant to subsection 104(21.2) with respect to the same amount paid to its own beneficiaries to allow them to claim the capital gains deduction under subsection 110.6(2.1)?
Position: Yes.
Reasons: To determine the "eligible taxable capital gains", as defined in subsection 108(1), of the second trust, it is necessary to take into account the effect of the designation under subsection 104(21.2) that the first trust has made in respect of its beneficiary, the second trust. The effect of paragraph 104(21.2)(b) is that, for the purposes of sections 3, 74.3 and 111 as they apply for the purposes of section 110.6, the beneficiary, the second trust, is deemed to have disposed of capital property that is qualified small business corporation shares, and have a taxable capital gain from such disposition equal to the amount determined by the formula set out in clause 104(21.2)(b)(ii)(B). Therefore, the second trust will be able to make a designation under subsection 104(21.2) in respect of its own beneficiaries as its "eligible taxable capital gains" include the amount designated by the first trust under subsection 104(21.2). This will allow the second trust’s beneficiaries, who are individuals other than trusts, to claim the capital gains deduction under subsection 110.6(2.1), provided all the other conditions are met. As a result of the above, the position set out in document 2016-0667361E5 no longer represents the position of the CRA.
August 13, 2020
Tax Avoidance Division Income Tac Rulings Directorate International and Large Nathalie Boyer, Advocate, Business Directorate M. Fisc.
Attention: Suzanne Saydeh 2019-081830
Subject: XXXXXXXXXX
This is further to your correspondence of July 31, 2019, in which you asked our opinion regarding the ability of beneficiaries of two trusts to claim the capital gains deduction in the circumstances described below.
Unless otherwise indicated, all legislative references cited herein are to the provisions of the Income Tax Act (the "Act").
Party Designations and Abbreviations
"CRA" Canada Revenue Agency
"Beneficiary A" XXXXXXXXXX
"Beneficiary B" XXXXXXXXXX
"Beneficiary C" XXXXXXXXXX
"Beneficiary D" XXXXXXXXXX
"TSO" XXXXXXXXXX Tax Services Office
"Canco” XXXXXXXXXX
“Trust 1” XXXXXXXXXX
"Trust 2" XXXXXXXXXX
"Trust 3” XXXXXXXXXX
Facts
Our understanding of the relevant facts can be summarized as follows:
1. XXXXXXXXXX, Trust 1, a personal trust resident in Canada, disposed of XXXXXXXXXX common shares it held in the capital stock of Canco to an unrelated third party. These shares qualified as qualified small business corporation shares ("QSBCS") within the meaning of subsection 110.6(1). As a result of this disposition, Trust 1 realized a capital gain, from which it claimed a deduction for a reserve under subparagraph 40(1)(a)(iii) in computing its capital gain within the meaning of subsection 39(1).
2. Pursuant to subparagraph 40(1)(a)(ii), an amount of $XXXXXXXXXX, claimed by Trust 1 as a reserve for the taxation year XXXXXXXXXX, was included in computing its capital gain in the subsequent XXXXXXXXXX year, resulting in a taxable capital gain under paragraph 38(1)(a) of $XXXXXXXXXX for XXXXXXXXXX.
3. On XXXXXXXXXX in accordance with the Trust Indenture, the $XXXXXXXXXX taxable capital gain of $XXXXXXXXXX from Trust 1 was distributed and designated to two beneficiaries that were Canadian-resident personal trusts, namely, $XXXXXXXXXX to Trust 2 and $XXXXXXXXXX to Trust 3.
4. On XXXXXXXXXX, Trust 2 realized a taxable capital gain of $XXXXXXXXXX (footnote 1), of which $XXXXXXXXXX came from the distribution and designation of income from Trust 1. Trust 2 distributed and designated all of its taxable capital gain to two beneficiaries who were individuals resident in Canada, namely $XXXXXXXXXX to Beneficiary A and $XXXXXXXXXX to Beneficiary B.
5. For the XXXXXXXXXX taxation year, Beneficiary A and Beneficiary B each reported a taxable capital gain of $XXXXXXXXXX, of which $XXXXXXXXXX was from the designation of Trust 1 income. A capital gains deduction by virtue of subsection 110.6(2.1) was claimed by each of Beneficiary A and Beneficiary B.
6. On XXXXXXXXXX, Trust 3 realized a taxable capital gain of $XXXXXXXXXX (footnote 2), of which $XXXXXXXXXX came from the distribution and designation of income from Trust 1. Trust 3 distributed and designated a taxable capital gain of $XXXXXXXXXX to Beneficiary C and a taxable capital gain of $XXXXXXXXXX to Beneficiary D, who were individuals resident in Canada.
7. For its XXXXXXXXXX taxation year, Beneficiary C and Beneficiary D each reported a taxable capital gain of $XXXXXXXXX, of which $XXXXXXXXXX was from the designation of Trust 1 income. A capital gains deduction by virtue of subsection 110.6(2.1) was claimed by each of Beneficiary C and Beneficiary D.
8. For each of the XXXXXXXXXX and XXXXXXXXXX taxation years, Trust 1 also included an amount of $XXXXXXXXXX pursuant to subparagraph 40(1)(a)(ii) in computing its capital gain, resulting in a taxable capital gain of $XXXXXXXXXX, which it distributed and designated to its two beneficiaries, Trust 2 and Trust 3, who then distributed and designated this taxable capital gain to their respective beneficiaries.
9. For the XXXXXXXXXX and XXXXXXXXXX taxation years, the beneficiaries of Trust 2 and Trust 3 also claimed the capital gains deduction by virtue of subsection 110.6(2.1) against taxable capital gains arising from the designation of income from Trust 1 to its beneficiaries Trust 2 and Trust 3.
10. For each of the taxation years in question, the amounts designated and paid by the trusts were retained in the hands of each of the beneficiaries. In other words, Beneficiary A, Beneficiary B, Beneficiary C and Beneficiary D were the true beneficiaries of the amounts distributed and designated to them.
Your Question
Can Trust 2 and Trust 3, to which Trust 1 has designated amounts in respect of its eligible taxable capital gains under subsection 104(21.2), make a designation under subsection 104(21.2) to allow their respective beneficiaries, A, B, C and D, to claim the capital gains deduction under subsection 110.6(2.1)?
Position of the TSO
The TSO is of the view that beneficiaries of Trust 2 and Trust 3 are not entitled to the capital gains deduction under subsection 110.6(2.1) based on Technical Interpretation 2016-0667361E5.
Position of the Representative of the Taxpayers
The representative is of the view that once a subsection 104(21) designation is made by the trust, the second step is to determine whether subsection 104(21.2) will permit the net taxable capital gains of the trust to be designated as eligible taxable capital gains as well.
While the effect of subsection 104(21) is that the amount in respect of the trust's net taxable capital gains retains its nature as a taxable capital gain, subsection 104(21.2) deems the beneficiary to have disposed of the capital property that is a QSBC for the purposes of the application of sections 3, 74.3 and 111 in relation to section 110.6.
Consequently, for the purposes of determining A in the calculation of the "annual earnings limit" as defined in subsection 110.6(1), clause 104(21.2)(b)(ii)(B) must be considered. Clause 104(21.2)(b)(ii)(B) confirms that the beneficiary is, for the purposes of sections 3, 74.3 and 111, for the purposes of section 110.6, deemed to have a taxable capital gain from the disposition of a capital property that is a QSBC. Under subparagraph 104(21.2)(b)(i), for the purposes of section 110.6, the beneficiary is deemed to have disposed of a capital property that is a QSBC.
As a result, Trust 2 and Trust 3 were able to include, for the purposes of calculating their "annual gains limit" and "cumulative gains limit" under subsection 110.6(1), amounts in respect of Trust 1's eligible taxable capital gains designated to them by Trust 1 under subsection 104(21.2). Such amounts were therefore required to be taken into account in determining the eligible taxable capital gains of Trust 2 and Trust 3. This allowed Trust 2 and Trust 3 to make a subsection 104(21.2) designation in respect of their eligible taxable capital gains to their respective beneficiaries and allowed their beneficiaries to claim the capital gains deduction under subsection 110.6(2.1).
Our Comments
Where all of the conditions set out in subsection 104(21) are met, this subsection provides that for the purposes of sections 3 and 111, except as they apply for the purposes of section 110.6, an amount in respect of a trust’s net taxable capital gains, as defined in subsection 104(21.3), for a particular taxation year of the trust is deemed to be a taxable capital gain of the recipient beneficiary from the disposition of a capital property, for the taxation year of the beneficiary in which the particular taxation year of the trust ends.
Subsection 104(21) does not apply for the purposes of section 110.6. Accordingly, a designation under subsection 104(21.2) is also required in respect of the trust’s eligible taxable capital gains, in order for the beneficiaries to be able to claim the capital gains deduction under subsection 110.6(2.1).
Where a personal trust designates an amount to a beneficiary under subsection 104(21) in respect of its net taxable capital gains for a particular taxation year, paragraph 104(21.2)(a) provides that the trust must also designate an amount in its income tax return for the year, in respect of its eligible taxable capital gains, if any, in respect of the beneficiary equal to the amount calculated under subparagraphs 104(21.2)(b)(i) and (ii).
Subsection 108(1) defines “eligible taxable capital gains” of a trust as the lesser of its “annual gains limit” (footnote 4) and the amount of its “cumulative gains limit” (footnote 5) at the end of the year less the total of all amounts designated under subsection 104(21.2) by the trust in respect of beneficiaries for taxation years before that year.
Where an amount is designated under subsection 104(21.2), paragraph 104(21.2)(b) provides that, for the purposes of section 120.4 and for the purposes of sections 3, 74.3 and 111 as they apply for the purposes of section 110.6, the beneficiary is deemed to have disposed of a capital property that is either a qualified farm or fishing property or a QSBC share, as the case may be (footnote 6), as defined in subsection 110.6(1), and to realize a taxable capital gain equal from such disposition equal to the amount determined by the formula set out in clause 104(21.2)(b)(ii)(A) or (B).
The result is that for the purposes of calculating the “annual gains limit” of the beneficiary, the amount calculated in element A takes into consideration the taxable capital gain designated by the trust under subsection 104(21.2) in order to permit the beneficiary to claim the capital gains deduction under subsection 110.6(2.1).
In the situation described, in determining A in the computation of the “annual gains limit” of each of Trust 2 and Trust 3, it is necessary to take into account the amount designated by Trust 1 under subsection 104(21.2) to them. Paragraph 104(21.2)(b) provides that for the purposes of sections 3, 74.3 and 111 as they apply for the purposes of section 110.6, the beneficiaries, Trust 2 and Trust 3, shall be deemed to have disposed of capital property that is a QSBC share, and to realize a taxable capital gain from such disposition equal to the amount determined by the formula in clause 104(21.2)(b)(ii)(B).
Consequently, where Trust 1 has made designations under subsections 104(21) and (21.2) in respect of amounts distributed to Trust 2 and Trust 3, Trust 2 and Trust 3 can also rely on 104(21.2) to enable their respective beneficiaries to claim the capital gains deduction under subsection 110.6(2.1). The designations made under subsection 104(21.2) by Trust 1 must be taken into consideration in order to determine the eligible taxable capital gains of Trust 2 and Trust 3. In light of these comments, the position set out in Technical Interpretation 2016-0667361E5 no longer represents the CRA's position.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the taxpayer.
Best regards,
Mélanie Beaulieu
Manager
For the Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
c.c. Jean Bilodeau
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 Information regarding the difference between $XXXXXXXXXX and $XXXXXXXXXX has not been provided and does not form part of this interpretation. Consequently, no comment will be made with respect to this portion of the taxable capital gain realized by Trust 2.
2 Information regarding the difference between $XXXXXXXXXX and $XXXXXXXXXX has not been provided and does not form part of this interpretation. Consequently, no comment will be made with respect to this portion of the taxable capital gain realized by Trust 3.
3 Within the meaning of subsection 104(21.3).
4 Within the meaning of subsection 110.6(1).
5 Within the meaning of subsection 110.6(1).
6 Either of the types of capital property referred to in clauses 104(21.2)(b)(ii)(A) or (B).