Co-author: Rock Lapalme, CPA, CA, TEP (Associate Director of Tax – Baker Tilly Canada)

Most practitioners are aware that subsection 75(2) of the Income Tax Act (ITA) may apply to a trust and will attribute all income or loss from a trust’s property back to the person (transferor) from whom the property (or substituted property) was directly or indirectly received if the property may revert to the transferor[i].

In addition to the attribution of income, if subsection 75(2) applies at any point in time, subsection 107(4.1) denies the usual tax-deferred rollover available under subsection 107(2) for distributions of property out of the trust to beneficiaries while this transferor is alive. As a result, subsection 107(2.1) applies, deeming the distribution of property to occur at fair market value.

A typical corporate structure

A typical corporate structure seen in practice is one where a discretionary family trust owns the common shares of both the operating and holding companies. The holding company would be named as an income and capital beneficiary of the trust, allowing dividends paid by the operating company to the trust to be allocated and paid to the holding company. This structure may provide a way to achieve asset protection and preserve small business corporation status for the operating company.

Assuming that the trust was set-up correctly, then dividends paid by the operating company to the holding company through the trust will not be subject to attribution under subsection 75(2). These dividends would typically be invested and retained in the holding company until a future date when the holding company would pay a dividend to the trust for distribution to the trust’s beneficiaries.

The technicality

When a dividend is paid by the holding company to the trust, the trustees would normally distribute the dividend to other beneficiaries but could, in theory and depending on the terms of the trust, allocate the dividend back to the holding company as a beneficiary. The property that was received by the trust as payment for the dividend may therefore revert to the person from whom it was received, being the holding company. The question is: does this result in the application of subsection 75(2) and, by extension, subsection 107(4.1)?

Subsection 75(2) applies if a trust holds property on condition that the property (or property substituted therefor) may revert to the person from whom the property was received. The current case law supports that a dividend is a transfer of property, and if that property is held by the trust on condition that it may revert to the payor of the dividend (transferor), then presumably subsection 75(2) could apply.

Attribution of income

If subsection 75(2) applies in the situation above, it will only apply to attribute income earned from the property received by the trust; however, attribution would not apply to the dividend itself. Typically, the property received by the trust as payment for the dividend would be distributed by the trust to its other beneficiaries before any further income could be earned by the trust, and thus the attribution rule in subsection 75(2), while technically applicable to the trust, would not result in any attribution of income.

Denial of tax-deferred rollout

The potential issue with the application of 75(2) in this scenario is therefore not the attribution rule itself; rather, it is the resulting denial of the tax-deferred rollout of the trust’s property pursuant to subsection 107(4.1).

Prevent the reversion

Justice Miller in Sommerer vs. The Queen[ii], applied a textual interpretation to the opening words of subsection 75(2) inferring that the subsection is to be discerned at the time of the trust’s creation. These opening words were slightly modified for taxation years that end after March 20, 2013, which may or may not alter Justice Miller’s textual interpretation. Without certainty as to the textual interpretation of the opening words to subsection 75(2), it would be prudent to insert a clause into the trust indenture preventing the possibility that any dividend received by the trust may revert back to the payor of that dividend. This preventative measure eliminates the need to ascertain any textual interpretation.

If the trust has already been created, the trustees may want to consider amending the trust indenture prior to any dividends being paid to the trust by a corporate beneficiary.

[i] More specifically subsection 75(2) deems income or losses and taxable capital gains or allowable capital losses from property, or property substituted for the property, directly or indirectly transferred to a Canadian resident trust by a person to be income, gains or losses of the person transferring the property instead of income, gains or losses of the trust while the person is alive and resident in Canada if:

• The property may revert to the transferor,
• The property may pass to persons to be determined at some future time by the transferor, or
• The property cannot be disposed of during the lifetime of the transferor without his or her consent or in accordance with his or her direction.

[ii] Sommerer vs. The Queen, 2011 TCC 212