Trust Tax Planning: Strategic Use of a Trust’s Tax Loss Carryovers—A Canadian Tax Lawyer’s Analysis
Introduction: Basics of Canadian Tax on Trusts & The Income Designations
Canada taxes a trust’s income only to the extent that the income remains in the trust. The trust can deduct from its income any amount that it pays to a beneficiary. The beneficiary then pays tax on amounts received from the trust.
Subsections 104(13.1) and 104(13.2s) of Canada’s Income Tax Act, however, permit a trust to designate an amount that, although paid to the beneficiary, will be taxed as if it remained in the trust. In other words, these income designations allow a beneficiary to receive tax-paid income from a trust.
Subsections 104(13.1) and 104(13.2) basically allow the trust to use its losses to the advantage of its beneficiaries. A trust can’t transfer tax losses to beneficiaries, but, using the income designation, it can use its own tax losses to shelter a beneficiary’s trust receipts from tax.
In fact, the Income Tax Act restricts the income designations to ensure that they can only be used in relation to the trust’s loss carryovers or other income deductions. In particular, an income designation under either subsection 104(13.1) or 104(13.2) is invalid if the trust’s taxable income for the year is greater than nil.
Using a Trust’s Non-Capital Losses: Subsection 104(13.1) of the Income Tax Act
Subsection 104(13.1) allows the trust beneficiary to take advantage of the trust’s non-capital losses—i.e., losses relating to business income or income from property.
Subsection 104(13.1) gives a formula to compute the maximum amount that the trust can designate per beneficiary. Here is a simplified version of this formula:
(A ÷ B) x C, where
- A = the particular beneficiary’s share of the trust’s income
- B = the total of each beneficiaries’ share of the trust’s income
- C = the trust’s non-capital losses
In other words, a beneficiary can only take advantage of the trust’s non-capital losses to the extent of his or her proportionate income interest in the trust.
For example: Trust earns $100,000 in business income, and it has a non-capital loss of $80,000. Trust has two beneficiaries, B and C. Each are equally entitled to the trust’s income. Trust pays all $100,000 to B despite C’s entitlement. Under subsection 104(13.1), the maximum amount that Trust may designate for B is $40,000 (50/100 x 80,000). So, of its $100,000 in business income, Trust notionally retains $40,000 as income per subsection 104(13.1), and Trust deducts $60,000 as payable to B. Trust uses $40,000 of its non-capital loss to reduce its income to nil. (Trust still has $40,000 non-capital loss remaining.) B’s taxable income from the trust is $60,000 despite, in fact, receiving $100,000. In sum, despite receiving all Trust’s income, B could only benefit from half of Trust’s loss carryovers.
Using a Trust’s Net Capital Losses: Subsection 104(13.2) of the Income Tax Act
Subsection 104(13.2) allows a beneficiary to take advantage of a trust’s net capital losses—i.e., a loss from disposing of a capital property.
Subsection 104(13.2) gives a formula to compute the maximum amount that the trust can designate per beneficiary. Here is a simplified version of this formula:
(A ÷ B) x C, where
- A = the amount that the trust designated as a taxable capital gain under subsection 104(21) for a particular beneficiary
- B = the total of all amounts that the trust designated as taxable capital gains under subsection 104(21)
- C = the trust’s net capital losses
Notably, the formula in subsection 104(13.2) refers to subsection 104(21), which is an income-characterization rule. Trust distributions to a beneficiary are generally characterized as the beneficiary’s income from property. Yet certain provisions of the Income Tax Act, when invoked by the trustee, preserve the character of income flowing through the trust to the beneficiary. In particular, if the trust realizes a capital gain and pays that amount to a beneficiary, subsection 104(21) preserves the capital gain’s character in the hands of the beneficiary. So, the beneficiary incurs tax on only half of the distribution from the trust.
Unlike subsection 104(13.1), subsection 104(13.2) allows the trust to use the full designation in favour of one beneficiary despite the proportionate capital interests of another beneficiary. This result stems from subsection 104(13.2)’s reference to subsection 104(21).
For example: Trust has two beneficiaries, C and D, each equally entitled to Trust’s capital. Trust realizes a taxable capital gain of $100,000. Trust also has a net capital loss of $80,000. Trust designates the full $100,000 as a taxable capital gain under 104(21), and pays all $100,000 to C despite D’s entitlement. Under 104(13.2), the maximum amount that Trust may designate for C is $80,000 (100/100 x 80,000). So, of its $100,000 taxable capital gain, Trust notionally retains $80,000 per subsection 104 (13.2), and Trust deducts $20,000 as payable to C. Trust uses the full $80,000 of its net capital loss to reduce its income to nil. C’s tax able capital gain from the trust is $20,000 despite, in fact, receiving $100,000. In sum, Trust can allocate its full net capital loss to a s ingle beneficiary despite another beneficiary’s capital interest. (The trustee’s ability to do this without liability, however, may turn on th e contents of the trust instrument.)
Although a trust beneficiary cannot directly benefit from the trust’s loss carryovers, the trust can use its loss carryovers to shelter the beneficiary’s trust income.
The trust cannot preferentially shelter one beneficiary’s trust income if the trust must distribute its income to multiple beneficiaries in equal portions. If you wish to set up a trust, speak with an experienced Canadian tax lawyer for tax-planning advice. You should review your tax goals in light of the beneficiary entitlements that you want to establish.
The trust may preferentially shelter one beneficiary’s capital receipts from the trust even where multiple beneficiaries have equal entitlement to the trust’s capital. The trust instrument, however, may preclude this sort of tax planning. An experienced Canadian tax lawyer should prepare or review the trust deed to ensure that the intended tax benefits are available.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."