9 November 1990 Ministerial Correspondence 901334 F - Use of Preferred Beneficiary Elections

SUBJECT:  Paragraph 104(15) of the Income Tax Act (the "Act") and paragraph 2800(3)(f) of the Income Tax Regulations (the "Regulations")             

This is in reply to your memorandum of June 19, 1990 concerning the use of preferred beneficiary elections.

You describe 2 situations:

Situation 1

24(1)

You inquire as to whom can elect on the 24(1). The remaindermen are all children of the testator. Does the spouse have to be alive at the April 10th year end to elect? If there are discretionary powers for the children, does the situation change?

Situation 2

This is a trust set up in 1973. The testator died on May 11th. The will allocates 60% of the revenue to the spouse and 40% of the revenue to the daughter. Both the spouse and daughter can encroach on capital.

You ask who can elect or, the capital gains?

It is your opinion that in situation 1, the allocation of the actual gains of 24(1) in the trust before the spouse's death would depend upon the wording of the will. If all the accumulating income for the benefit of the spouse up to her death, then it would appear the 24(1) should be taxed in the trust.

As for situation 2, it is your opinion that the trust is not a spousal trust and the accumulation income is accumulating for both the spouse and the daughter; hence both can elect on the capital gains.

Our Comments

Situation 1

Assuming that the trust does not specify that capital gains are income for income tax purposes, under trust law and the definition of income contained in subsection 108(3) of the Act, taxable capital gains would not form a part of the income of the trust for the purpose of subparagraph 104(4)(a)(iii) of the Act (subject to the existence of a capital encroachment power).

If capital encroachments have been made to the spouse prior to her death, it is our opinion that these payments would be considered, for the purposes of subsection 104(13) and subparagraph 104(4)(a)(iii) of the Act, to be paid first out of the taxable capital gain generated in the trust on the actual disposition of capital property by the trust. Furthermore, a designation could be made pursuant to subsection 104(21) of the Act on the spouse's final tax return. However, if no capital encroachments were made in favour of the spouse prior to her death, the capital gain realized by the trust cannot be flowed through to her final tax return.

After the spouse's death, the trust will still have its regular testamentary year-end. The will presumably provides for an immediate or future winding-up of the trust and distribution of assets to the children, who are assumed to be now both income and capital beneficiaries. The will could provide for discretionary or non-discretionary payments of income and/or capital to the children. These provisions and the exercise or non-exercise of trustee discretion will determine whether the taxable capital gain must be taxed in the trust, in the hands of the children, or in either, depending upon the powers granted to the trustees by the Will.

If the terms of the will provided for capital encroachments in favour of the children after the spouse's death, then a preferred beneficiary election could be made pursuant to subsection 104(14) of the Act with respect to the actual capital gains realized by the trust. Even though the capital gain occurred prior to the spouse's death it still occurred during the taxation year of the trust. Since the children are capital beneficiaries of the trust at the year- end of the trust, it is our opinion that a designation could also be made pursuant to subsection 104(21) of the Act to flow the character of the taxable capital gain to the children.

If no preferred beneficiary elections were made, a designation pursuant to subsection 104(21) of the Act in favour of the children can only be made if the actual capital gain can reasonably be considered (having regard to all the circumstances including the terms of the trust) to have been paid or payable to the children as of the year-end of the trust. Assuming that the trust does not specify that taxable capital gains were income for trust law purposes, and no capital encroachments in favour of the children were actually made during the period from the date of death of the spouse until the year-end of the trust, then the taxable capital gain realized by the trust must be taxed in the trust since that gain could never be paid or payable to the children pursuant to subsections 104(13) and (24) of the Act as of the year-end of the trust.

There is no practical reason to flow a deemed taxable capital gain under subsection 104(4) of the Act to a beneficiary because of the denial of the deduction to the trust pursuant to subsection 104(6) of the Act.

Pursuant to the definition of "accumulating income" in paragraph 108(1)(a) of the Act, deemed dispositions under subsection 104(4) of the Act are specifically exclude from accumulating income. Consequently, these deemed gains could never be the subject of a preferred beneficiary election.

Situation 2

In our opinion the preferred beneficiaries who can make a preferred beneficiary election with respect to the trust's accumulating income for the taxation year are beneficiaries who have a right at the end of the particular taxation year, to share in the accumulating income of the trust, either due to the power of the trustee to encroach on capital on their behalf or pursuant to the terms of the will, notwithstanding that this right could be extinguished if they should die before their interest in the trust has been vested absolutely.

In this particular situation, the will allocates 60% of the revenue to the spouse and 40% to the daughter. Both can share in the taxable capital gain of the trust due to their power of encroachment on capital. They are therefore capital as well as income beneficiaries.

In view of the above, both the spouse and daughter could make a preferred beneficiary election pursuant to paragraph 104(15)(c) of the Act and paragraph 2800(3)(f) of the Regulations.

We trust the above comments will be of assistance to you.

ChiefDeferred Income Plans andTrusts SectionRulings Directorate