Principal Issues: 1. Whether subsections 107(1) and 107(2) will apply when a discretionary personal trust makes a distribution partly by way of cash and partly issues a promissory note representing an equivalent to a certain percentage of its capital to a beneficiary?
2. Whether the definition of cost amount pursuant to paragraph 108(1)a) apply in that context?
3. Whether the interest payable on a note issued by a trust in satisfaction of the capital interest of a beneficiary is deductible under paragraph 20(1)c).
Position: 1. If conditions are otherwise satisfied, subsections 107(1) and 107(2) apply to a cash distribution but not to the issuance of a promissory note by the trust to the beneficiary.
2. Subparagraph 108(1)a)(i) (definition of cost amount) applies to a cash distribution but paragraph 108(1)a) (definition of cost amount) does not apply to the issuance of promissory note by the trust to its beneficiary.
3. No.
Reasons: 1. Wording of subsections 107(2). Meaning of "a property of a personal trust... distributed by the trust..."
2. Wording of paragraph 108(1)a).
3. See IT-533 and jurisprudence.
FEDERAL TAXATION ROUNDTABLE 10 OCTOBER 2014
2014 APFF CONFERENCE
Question 9
Disposition of capital interest in a discretionary family trust
Particular situation
A discretionary family trust (personal trust) owns rental properties. The trust derives property income from these properties annually. The trust wishes to settle the capital interest of one of its principal beneficiaries for an amount of $200,000. The $200,000 amount was obtained as a result of an agreement between the beneficiary and the trustees. The recipient is related to the trustees pursuant to subsection 251(2).
Although the trust is a discretionary trust, the trustees would like to distribute a 20% interest in the trust to this beneficiary for a value of $200,000. The trust proposes to settle all of this 20% interest in the principal amount by paying a portion in cash ($50,000) and by issuing a $150,000 promissory note payable over a five-year period with interest at the rate of 5% paid on the balance owing. In consideration, the beneficiary will renounce all rights as beneficiary in the trust.
Questions to the CRA
a) Can subsections 107(1) and (2) be applied so that there is no capital gain or loss to the beneficiary?
b) Would the cost amount of such interest be equal to the total redemption value of $200,000 (in cash and promissory note) pursuant to paragraph (a) of the cost amount definition in 108(1)?
c) Would the interest payable by the trust on the promissory note be deductible in computing the trust's income in accordance with paragraph 20(1)(c)?
CRA Response to Questions 9(a) and 9(b)
The determination of the tax consequences in respect of a transaction between a beneficiary and a trust depends on an analysis of all the facts, the trust deed, and any relevant documentation including, in this case the wording of the promissory note and the beneficiary's renunciation of its rights in the trust.
Subsection 107(2) applies in particular where a personal trust makes a distribution of property to a beneficiary that results in the disposition of all or a portion of the beneficiary's interest in the capital of the trust. In addition, subsection 107(2) will apply only if subsections 107(2.001), 107(2.002) and 107(4) to 107(5) do not apply.
In order for subsection 107(2) to apply, there must be a distribution of property by the trust that results in a disposition of a capital interest in a trust, or a part of that interest, under paragraph (d) of the definition of disposition in subsection 248(1).
In Mai Tai Chan v. The Queen (footnote 1), which was upheld by the Federal Court of Appeal, the Tax Court of Canada defined the term "distribution" as an action taken by the trustee in response to fiduciary duty in accordance with a provision in the trust deed.
Furthermore, in Chan (footnote 2), the Federal Court of Appeal stated, inter alia, that in order for subsection 107(2) to apply, it is necessary for the taxpayer to demonstrate that the property which was transferred to the taxpayer was indeed property distributed out of the trust assets.
Consequently, we are of the view that the issuance of a note by a trust does not result in the beneficiary having ownership of property, which belonged to the trust and to which he or she had a right as a beneficiary, immediately before its distribution. Therefore subsection 107(2) cannot apply respecting the note for $150,000.
Under paragraph 107(1)(a), for the purpose of calculating capital gains, the ACB to the taxpayer of all or part of the capital interest in the trust is generally deemed to be equal to the greater of the ACB, otherwise determined, to the taxpayer immediately before the disposition and the cost amount of the taxpayer's interest, as defined in subsection 108(1).
Where any money or other property of the trust has been distributed to the beneficiary in satisfaction of all or part of the capital interest, paragraph (a) of the definition of cost amount in subsection 108(1) provides that the cost amount is equal to the money distributed by the trust or, where the interest or part of the interest is settled by the distribution of property other than money, to all amounts each of which is the cost amount to the trust of each such other property.
In our view, the issuance of a note does not constitute the distribution of property of a trust to a beneficiary for purposes of paragraph (a) of the definition of cost amount in subsection 108(1).
CRA Response to Question 9(c)
Subparagraph 20(1)(c)(i) allows deductibility in the computation of a taxpayer's income, of interest paid or payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.
Subparagraph 20(1)(c)(ii) provides for the deductibility of interest paid or payable pursuant to a legal obligation to pay interest on an amount payable for property acquired for the purpose of gaining or producing income from a business.
The interest calculated on the $150,000 note would not be deductible in accordance with the provisions of subparagraph 20(1)(c)(i) as there is no borrowed money in connection with this transaction.
To conclude that the conditions set out in subparagraph 20(1)(c)(ii) are satisfied, it must be possible to show, among other things, that the issuance of the note represents "an amount payable for property acquired". Even if it were possible from a legal perspective to conclude that the note issued by the trust represented "an amount payable for property acquired", it should also be demonstrated that the "amount payable for property acquired" by the trust was "for the purpose of gaining or producing income from a business". In this regard, we are of the view that it would not be possible to conclude in the present situation that any "amount payable for property acquired", to the extent this were the case, was "for the purpose of gaining or producing income from a business".
Some may be tempted to draw parallels with Penn Ventilator Canada Ltd. v. The Queen, 2002 DTC 1498 (TCC), where a deduction under subparagraph 20(1)(c)(ii) was accorded for interest on a note issued as consideration for the redemption of shares by a corporation, but we are of the view that the reasoning in that decision does not apply here.
We also refer to the comments of the Supreme Court of Canada in The Queen v. Bronfman Trust, 87 DTC 5059, where, in circumstances similar to those described in this question, the Court refused to consider the indirect use criterion in its decision.
Lucie Allaire
(613) 957-8962
October 10, 2014
2014-053826
Marc Séguin
(514) 620-8562
October 10, 2014
2014-053834
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 99 DTC 1215 (« Chan »)
2 2001 FCA 302