Reduced Income by $200,000; Demolished Attempt by CRA to Double Dip on Taxing Income Distributed to Trust Beneficiaries

Case Issue

Our office was approached to represent a family trust (the “Trust”) following an incorrect audit undertaken by CRA’s Audit Division for the Trust’s 2013 to 2016 tax years. The Trust was a discretionary trust, and under the terms of the trust deed, the trustees were entitled to distribute any part or all of the Trust’s annual income and Trust capital at the trustee’s discretion to its beneficiaries (who were all the children of one of the trustees).

The Trust held dividend-paying shares in two very successful private Canadian companies. The Trust also earned business income by performing due diligence and management services for those companies and lending funds to them when necessary. From 2013 to 2016, the Trust earned substantial dividend income and business income from management fees. Further, in 2014, the Trust received payment back on a loan made to one of the companies, earning $3,000 in interest. And in 2015, the Trust sold shares in one company to an arm’s-length purchaser for substantial capital gains.

The Trust resolved (by way of a Deed of Distribution) in each tax year to allocate its income from each source fully to its beneficiaries. The Trust issued a demand promissory note to its beneficiaries totalling the income it had earned, rather than paying those amounts in cash. The Trust’s beneficiaries fully reported these amounts as personal income for their corresponding taxation years. These amounts were therefore deductible by the Trust under paragraph 104(6)(b) because they consisted of the Trust’s income “that became payable in the year to, or that was included under subsection 105(2) in computing the income of, a beneficiary.” As a result, the Trust had next to no taxable income from 2013 to 2016. In 2015, the Trust also elected to make a capital distribution of $50,000 to one beneficiary on a tax-free basis, which was made payable by way of a promissory note as well (and which was not included in any deed of distribution issued by the Trust).

Following an audit by CRA’s Audit Division, the CRA proposed and reassessed the Trust as follows:

• The auditor disallowed deductions that the Trust claimed under subsection 104(6) for: $32,234 in 2013; $19,500 in 2014; $60,000 in 2015; and $100,000 in 2016 (a total of $211,734). The auditor denied these deductions because, in his view, the demand promissory notes underlying these deductions failed to satisfy subsection 104(24), which deems an amount to not be deductible from a trust’s income unless the amount “was paid in the year to the beneficiary or the beneficiary was entitled in the year to enforce payment of it.” More specifically, the auditor compared the amounts that the Trust allocated to its beneficiaries with the Trust’s year-end bank balances. The auditor then concluded that subsection 104(24) precluded the Trust from claiming the deductions because the Trust did not maintain sufficient liquidity in its bank account to pay debts owed to its beneficiaries.
• The auditor disallowed a deduction of $41,744, which the Trust claimed for the 2014 taxation year, because the amount was paid to a non-listed beneficiary of the Trust (one of the trustee’s mother, who was not a beneficiary under the terms of the trust deed).
• The auditor assumed the $3,000 in interest income earned by the Trust was unreported dividend income, and included $4,140 in income for the Trust’s 2014 taxation year.
• The auditor disallowed a deduction for $50,000 claimed by the Trust in its 2015 tax year, on the basis the $50,000 payment to the Trust’s beneficiary could not have been a capital distribution, because the Trust’s opening and closing bank balance for 2015 were nearly identical.

By the time our office was contacted by the client, the trust’s accountant had already filed a notice of objection. Each argument presented in that objection had been flatly rejected by the CRA Appeals Division.

Approach

Our office immediately filed additional detailed submissions, and presented the following arguments to the CRA’s Appeals Division:

1. The auditor had misunderstood and misapplied the terms of subsection 104(24), which does not deny a deduction under 104(6) if “the beneficiary was entitled in the year to enforce payment of [the amount deducted under 104(6)].” Rather, because the Trust had issued demand promissory notes, each recipient beneficiary “was entitled in the year to enforce payment of” the amounts that the Trust deducted, and so the amounts were fully deductible by the Trust because they consisted of the Trust’s income “that became payable in the year to a beneficiary.” The auditor had erroneously adopted a liquidity test and conflated the beneficiary’s entitlement to payment with the Trust’s ability to pay in a given year, which flew in the face of not only a plain reading of the statutes, but also case law and the CRA’s own published views on the subject.
2. The $50,000 distribution made to a beneficiary of the Trust in 2015 was truly a capital distribution, and in effect the CRA intended to deny a deduction for a distribution by the Trust for which it did not otherwise claim a deduction. We demonstrated through analogy that the auditor’s assertion the Trust’s opening and closing bank balances alone were determinative of whether the Trust had made capital distributions was incorrect and a misapprehension of the law. Rather, by walking the CRA Appeals Division through the documentary evidence, we demonstrated that the capital distribution could be traced through the Trust’s bank balance. In fact, the auditor had arrived at the erroneous conclusion to disallow a deduction to the Trust because the auditor had actually mixed up two beneficiaries of the Trust, one of whom received a capital distribution (for which the Trust did not take a deduction) and the other who received an income distribution (and for which the Trust did take a deduction).

 

Result

The CRA Appeals Division agreed with our position and reversed the auditor’s decisions, reducing the Trust’s taxable income in 2013, 2015 and 2016 to almost nil. The Trust still recognized taxable income in 2014, in relation to distributions made to a non-beneficiary of the Trust that were erroneously deducted from its income, and for which there was no legal basis to dispute. In total, the CRA Appeals Division reduced the Trust’s taxable income by nearly $200,000 in total.