Introduction
Subsection 104(4) of theIncome Tax Actsets out what is generally referred to as the “21-year deemed realization rule” for a trust. The purpose of subsection 104(4) is to prevent the use of trusts to defer indefinitely the recognition for tax purposes of gains accruing on certain capital property. When subsection 104(4) applies, it generally treats capital property of a trust (other than certain trusts for the benefit of the settlor, for a spouse or common-law partner of the settlor, or for their joint benefit) as having been disposed of and reacquired by the trust every 21 years at the property's fair market value.
In some situations, a transfer of the trust property to the capital beneficiaries on a tax deferred basis pursuant to subsection 107(2), prior to the 21-year deemed realization date, could be used to defer the tax consequences. Corresponding rules to subsection 104(4) for depreciable property are contained in subsection 104(5). A deferral of the 21-year deemed realization rule is generally not possible when the property is transferred from a trust (the “transferor trust”) to another trust (the “receiving trust”) since subsection 104(5.8) would apply to deem the 21-year anniversary of the receiving trust to occur no later than it would for the transferor trust.
In addition, distributions of a trust’s property (other than property described in any of subparagraphs 128.1(4)(b)(i) to (iii)) to non-resident beneficiaries will be subject to the application of subsections 107(5) and (2.1). In these circ*mstances, a rollover under subsection 107(2) is not available and the distributed property will be deemed to be disposed at fair market value.
Some taxpayers are engaging in transactions that seek to avoid or defer the 21-year deemed realization rule or that seek to avoid the rules in subsections 107(5) and (2.1) even though the property continues to be held, directly or indirectly, by a trust or by a non-resident beneficiary.
Designated Transactions
The following transactions and series of transactions are hereby designated by the Minister of National Revenue for the purposes of section 237.4 of theIncome Tax Act, effective November 1, 2023.
Indirect transfer of trust property to another trust
A Canadian resident trust (“New Trust”) holds shares of a corporation resident in Canada (“Holdco”) that is or will become a beneficiary of another Canadian resident trust (“Old Trust”) that holds property that is capital property or land included in the inventory of a business of Old Trust. At any time prior to its 21-year anniversary, Old Trust transfers the property to Holdco on a tax deferred basis pursuant to subsection 107(2).
In the result, the 21-year rule will not apply to Old Trust, and a new 21-year period will start to run with respect to New Trust, providing for a much longer period of deferral. New Trust’s assets will reflect the property formerly held by Old Trust but may have a higher tax basis than such property.
Indirect transfer of trust property to a non-resident
One or more of the non-resident beneficiaries of a Canadian resident trust hold shares of a corporation resident in Canada (“Holdco”) that is or will become a beneficiary of the trust. At any time prior to its 21-year anniversary, the trust transfers property (other than property described in any of subparagraphs 128.1(4)(b)(i) to (iii)) to Holdco on a tax deferred basis pursuant to subsection 107(2).
In the result, the 21-year rule will not apply to the trust, with the transfer of the trust’s property to Holdco providing for a much longer period of deferral. The non-resident beneficiaries of the trust hold shares of Holdco that reflect their former indirect interest in the property of the trust, possibly providing an opportunity to have such property transferred by Holdco to the non-resident beneficiaries at some future time without triggering the application of subsections 107(2.1) and 107(5).
Transfer of trust value using a dividend
A Canadian resident trust (“New Trust”) holds shares of a corporation (“Holdco”) that is or will become a beneficiary of another Canadian resident trust (“Old Trust”) that holds property that is shares in a Canadian corporation (“Opco”). At any time prior to Old Trust’s 21-year anniversary, Opco redeems shares held by Old Trust and issues a promissory note or gives cash as consideration. In so doing, Opco is deemed pursuant to subsection 84(3) to have paid, and Old Trust is deemed to have received, a dividend equal to the amount by which the amount paid by Opco on the redemption exceeds the PUC in respect of the shares. The deemed dividend is designated by Old Trust and deemed to be received by Holdco pursuant to subsection 104(19). The dividend is deductible in the hands of Holdco pursuant to subsection 112(1). The cash or the promissory note is paid or made payable in the year by Old Trust to Holdco as payment for the dividend allocated to it.
In the result, the 21-year rule will not apply to Old Trust, and a new 21-year period will start to run for New Trust, providing for a much longer period of deferral. New Trust’s assets will reflect the value of the property formerly held by Old Trust but will undoubtedly have a significantly higher tax basis than such property.
