Published: December 23, 2022
Introduction – Taxation of Trusts and Trust Distributions in Canada
The trust is a legal concept with deep roots in the Canadian common law, specifically the rules of equity, the body of law developed by the English Court of Chancery. Equity distinguishes between the legal ownership and beneficial ownership of property. The legal owner of property holds the legal title to a particular property in that owner’s name. In turn, the beneficial owner is entitled to benefit and enjoy the property. This separation between legal and beneficial ownership allows for the creation of personal trusts under the common law.
A personal trust is not a legal entity or a legal person, like an individual or a corporation. Rather, a trust is better described as a legal relationship concerning property. In a typical trust arrangement, legal title to property is transferred by the settlor of the trust to a trustee for the benefit of the beneficiaries of the trust, in accordance with the terms of the trust arrangement. While the trustee holds legal title to the property, the beneficiaries of the trust become the beneficial owners of the property. The terms of the trust are typically included in a written Trust Deed (also called indenture), setting out the property to be held in trust and the rights and obligations of the trust’s various trustees and beneficiaries. The trust itself cannot own property or enter into contracts because it does not have the powers of a legal person. Instead, the trustee has the power and authority, and responsibility, to represent the trust. Further, the Trust Deed will typically give the trustee the power to distribute income earned by the trust to its beneficiaries at the trustee’s sole discretion, at a fixed rate, or under some other conditions as defined by the Trust Deed as well as to dispose of the capital when the trust terminates.
For Canadian tax purposes, the trust is treated as a separate taxpayer from the trustee under subsection 104(2) of the Canadian Income Tax Act. Further, personal trusts in Canada are subject to tax at the highest marginal rate for individuals on taxable income. Taxable income earned by a trust in Canada is thus treated much more unfavourably than if that same income were earned in the hands of natural persons.
The beneficiaries of a trust will not pay tax on distributions made by that trust, so long as those distributions are made on income in respect of which tax was paid by the trust. In turn, should the trust make distributions of income to beneficiaries before tax is paid, that income will be taxable in the hands of the beneficiaries. Under paragraph 104(6)(b) of the Canadian Income Tax Act, a trust may take a corresponding deduction from its own taxable income in the year that an amount became “payable” to a beneficiary. This presents a significant tax planning opportunity for Canadian trusts by allowing trusts to allocate income to beneficiaries who may pay tax on that income according to Canada’s marginal tax rates, as opposed to at the highest marginal rate.
This article will first discuss the rules concerning subsections 104(6) and 104(24) of the Income Tax Act and the ability to deduct from trust income amounts made payable to beneficiaries. Afterwards, this article will discuss the ability of a trust to use a promissory note to evidence an amount made payable, but not paid, to a beneficiary, and the conditions under which the Canada Revenue Agency (“CRA”) will accept such an arrangement. Finally, we will provide some pro tax tips and some frequently asked questions concerning taxation of trusts and trust distributions. Should you or anyone you know be investigating the merits of setting up a personal trust for tax planning purposes, you should consult with an expert tax law firm in Toronto to ensure that income distributions and deductions are appropriately handled.
Determining Whether a Distribution is “Payable” Under Subsection 104(6) of the Income Tax Act
In order for an amount to qualify as “payable” for purposes of subsection 104(6) of the Canadian Income Tax Act, that amount must satisfy the conditions of subsection 104(24). In order for an amount to qualify under subsection 104(24) of the Canadian Income Tax Act as “payable”, the amount must be paid in that tax year to the beneficiary, or the beneficiary must be entitled in the year to enforce payment of the amount.
The first condition is self-explanatory. Where an amount is actually paid to a beneficiary, then it will be considered “payable”, and the trust will be entitled to deduct that distribution from its taxable income. Where an amount is not actually paid to a beneficiary, determining whether the beneficiary is entitled to enforce payment is more difficult to determine.
There is good reason to exercise caution when evaluating how to distribute the income of a trust to beneficiaries. Although the Canadian Income Tax Act has been found by the courts to have a general policy against double taxation, this principle only extends to cases where the same income is unexpectedly taxed twice in the hands of a single taxpayer. In the immortal words of Justice Le Dain, writing for the Federal Court of Appeal in Perrault v The Queen,  1 FC 155, “the incidence of taxation depends on the matter in which a taxpayer arranges his affairs. Just as he may arrange them to attract as little taxation as possible, so he may unfortunately arrange them in such a manner as to attract more than is necessary.” Double taxation on trust distributions are not protected under the rule against double taxation. If a trust distributes an amount to a beneficiary, and that trust fails to make that amount payable for purposes of subsection 104(6), then that amount may be taxed in the hands of both the trust and the beneficiary.
Using Promissory Notes for Trust Distributions under Subsection 104(6) of the Income Tax Act
A promissory note is a written instrument often used by professionals, including Canadian tax lawyers, to evidence a debt between two parties. A promissory note is often given to acknowledge the existence or conditions for payment of a debt. A promissory note does not create the debt. A demand promissory note, for example, may express that payment of the debt will only come due when the debtor demands payment from the borrower in a prescribed form. A promissory note may also indicate that interest will begin accruing on the principal of a debt starting on a specific date, or once payment of the debt is demanded.
A debt between a trust and beneficiary evidenced by a promissory note may intuitively satisfy the conditions of subsection 104(24). Presumably, the beneficiary holding the promissory note is entitled to enforce payment of a debt owed by the trust. Intuition alone is of little aid to a taxpayer when faced with the Canada Revenue Agency and its own reading of the law, however. And in the case of distributions of a trust made payable by promissory notes, the courts have not yet ruled on a case involving these issues and facts. While the CRA’s own published interpretations of Canadian tax law do not have force of law in Canada, they have been recognized by Canadian courts as fundamental tools for the interpretation and application of Canada’s tax laws to other taxpayers and should not be ignored.
The CRA’s Technical Interpretations on Enforceability of Payment by Trust Beneficiaries
As a matter of administrative policy and taxpayer education, the CRA maintains an Income Tax Rulings Directorate. Through the Directorate, the CRA maintains a team of professionals responsible for the interpretation of various provisions of Canada’s taxation statutes, both for the Canadian government and for individual taxpayers and their Canadian tax lawyers. Canadian taxpayers and Canadian tax lawyers may apply to the CRA for an advance income tax ruling to be issued by the Directorate, based on the particular taxpayer and facts involved in a scenario, to obtain a binding opinion on the CRA’s treatment of that scenario.
On February 26, 1997, the CRA released Technical Interpretation 9529647, “Promissory Note – Discretionary Trust Amount Payable”. The CRA was asked to express its view on whether a promissory note issued to the beneficiary of a discretionary trust could qualify as sufficient evidence that an amount was made “payable” by that trust to a beneficiary for purposes of subsection 104(24) of the Canadian Income Tax Act. The CRA concluded that a promissory note could suffice, so long as the note met certain qualifying conditions:
- The trustees must exercise their discretion to make the amounts payable to the beneficiaries before the trust’s year-end. That exercise of discretion must be irrevocable, and cannot impose any conditions on the beneficiaries’ entitlement to enforce payment of those amounts by the trust.
- The trust must establish how the trust’s income is apportioned to its beneficiaries, whether it be a fixed amount, a percentage of income, or all of its income.
- The beneficiaries must be notified before the end of the trust’s taxation year that the trustees have elected to make that income payable and how the income of the trust was apportioned.
- Any promissory note evidencing the amount payable to that particular beneficiary should be delivered to the beneficiary before the trust’s taxation year end, or where the amount payable cannot be ascertained until after the trust’s taxation year end, as soon as the amount is quantified.
The CRA has since re-affirmed this view in several more recent Technical Interpretations. Thus, a debt payable by a trust to a beneficiary may be treated by the CRA as an amount made payable for purposes of subsection 104(24), so long as certain conditions are observed. Not all promissory notes will meet these conditions. Any arrangement distributing payable amounts to beneficiaries of a trust must be documented in a careful and deliberate way and should observe each condition above to avoid those deductions being disallowed by the CRA.
Pro Tax Tip – Document Your Reliance on CRA’s Published Tax Interpretations
As mentioned before, the CRA’s Technical Interpretations do not have force of law in Canada, but should not be ignored as they are often given weight by the courts as interpretive guides for Canadian tax laws. As well, those published views form a fundamental part of the due diligence required of taxpayers and Canadian tax lawyers when confronted with uncertain tax consequences for a particular transaction or series of transactions. Reliance on the CRA’s published interpretations of a particular tax provision is a substantial factor in satisfying the due diligence required of a taxpayer when preparing and filing a tax return.
Once the CRA has prepared and mailed a notice of assessment for a taxpayer, there is a limited window of time for the CRA to reassess a taxpayer’s taxes payable should it discover any issues on a taxpayer’s filed return. Under subsection 152(3.1) of the Canadian Income Tax Act, that “normal reassessment period” can vary depending on the taxpayer:
- For mutual funds and corporations other than Canadian-controlled private corporations (“CCPCs”), a period of four years; and
- For all other individual taxpayers, as well as for CCPCs, a period of three years.
Once the normal reassessment period has expired, the taxpayer’s tax year is statute-barred from reassessment. The CRA must justify any reassessment for a tax year beyond the normal reassessment period under the applicable conditions of the Canadian Income Tax Act. Under subparagraph 152(4)(a)(i) of the Canadian Income Tax Act, the CRA may reassess a statute-barred tax year where it can establish that the taxpayer or the taxpayer’s representative “has made any misrepresentation that is attributable to neglect, carelessness or wilful default… in filing the return or in supplying any information.”
Should the CRA choose to re-assess a taxpayer beyond the normal reassessment period, and that taxpayer filed in accordance with the CRA’s published views, the CRA will have a substantial hurdle demonstrating neglect, carelessness, or wilful default. The CRA would, in effect, have to argue the taxpayer was negligent by filing taxes in accordance with the CRA’s own published views of how that income should be reported. The courts have also, and quite fortunately, recognized the same.
It is therefore crucial, when confronted with an uncertain tax situation, that everything be recorded. Should the CRA audit a taxpayer and adopt the position that there was a misrepresentation, documentation showing reasonable reliance on the CRA’s own published views will provide a substantial asset for that taxpayer.
- How is a trust taxed for Canadian tax law purposes?
Under subsection 104(2) of the Canadian Income Tax Act, a trust is treated as an individual for purposes of determining taxes payable on income earned in the trust. The trustees and administrators of the trust will be responsible for determining the trust’s taxable income and remitting those taxes payable. The trustees and beneficiaries who receive distributions from the trust may become personally liable for any unpaid taxes of the trust.
- Can a trust deduct income paid to a beneficiary from its taxable income?
A trust that distributes income earned to a beneficiary may be able to deduct those amounts from its taxable income under subsection 104(6) of the Canadian Income Tax Act, if that amount was made “payable” to the beneficiary in that given tax year. Under subsection 104(24) of the Canadian Income Tax Act, an amount is deemed to not be payable to a beneficiary “unless it was paid in the year to the beneficiary, or the beneficiary was entitled in the year to enforce payment of it.” Whether a beneficiary was entitled to enforce payment of an amount is a fact-driven analysis. You should always engage an expert Canadian tax lawyer to ensure any income distributions made to a trust beneficiary will be treated as payable and deductible from that trust’s income.
- Can a promissory note make an amount payable to a beneficiary for purposes of subsection 104(24) of the Canadian Income Tax Act?
On February 26, 1997, the CRA released Technical Interpretation 9529647, “Promissory Note – Discretionary Trust Amount Payable”. The CRA has expressed that it will accept that a promissory note issued to the beneficiary of a discretionary trust can qualify as sufficient evidence that an amount was made “payable” by that trust to a beneficiary for purposes of subsection 104(24) of the Canadian Income Tax Act. In order to qualify, a number of other conditions must be met, including that the trustees irrevocably use their discretion to make the amount payable to the beneficiary, and that the beneficiary’s entitlement to enforce payment be unrestricted.
"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."