This blog has been written by Pritika Deepak, Associate at Fasken LLP.

As we leave another year behind, it’s a fitting time to reflect on what tax and trust practitioners may often perceive as a period that often raises questions about the distribution of income from trusts to beneficiaries. To better understand this, it’s helpful to review the role trusts play as conduits or flow-through entities.

Part I of this blog post provided an overview of trust taxation in Canada, outlining the fundamental principles governing trusts and their tax obligations. Part II explores the “flow-through” functionality of trusts and the rules for deducting trust income, which are primarily outlined in sections 104 to 108 of the Income Tax Act (Canada) (“ITA”).

Note: This blog post presents a high-level overview of the flow-through rules and is not intended to be exhaustive or a substitute for consulting a qualified advisor for legal or tax advice.

The Conduit Principle

A trust may serve as a ‘conduit’ for tax purposes by allocating and distributing income[1] earned by the trust to one or more of its beneficiaries. This mechanism enables the trust to deduct the allocated income from its taxable income under subsection 104(6) of the ITA and allows the same income to be taxed in the hands of the recipient beneficiaries under subsection 104(13).

The conduit principle also allows a trust to distribute income to a beneficiary while making an election to designate the income in a way that retains its original tax character.[2] For example, consider a fully discretionary family trust that receives an eligible dividend from a taxable Canadian corporation. Eligible dividends benefit from more favourable effective tax rates. The trustees can designate the eligible dividend to be treated as an eligible dividend in the hands of the recipient beneficiary, thereby preserving its tax treatment.

“Paid or Payable”: Key Requirements

To utilize the conduit function, a trust must ensure that income is “paid or payable” to beneficiaries, as defined in subsection 104(24) of the ITA. This does not require the beneficiary to physically receive the income during the year; rather, the beneficiary must have a legal right to enforce payment of the allocated income.

Continuing with the example above, the trustees of a discretionary trust may choose to distribute the eligible dividend by paying cash or, alternatively, by issuing a promissory note to the beneficiary. While the promissory note does not need to be called upon or paid during the calendar year, the beneficiary must have the legal right to enforce payment of the full amount of the note in the year the trust deducts the associated income. Consequently, for an amount to be considered “payable,” trustees must notify the beneficiary of their entitlement to such income.

It is important to note that a trust can only make amounts payable to the extent that it is solvent. In other words, the trust cannot make an amount payable if it does not have sufficient assets to satisfy the obligation within the relevant calendar year.

Additionally, trustees are required to report income allocations and designations on T3 slips issued to beneficiaries. This ensures proper tax treatment in the beneficiaries’ personal tax returns and allows trustees to substantiate the allocation if questioned by the Canada Revenue Agency.

Deduction of Income

Under subsection 104(6) of the ITA, a trust may deduct amounts that are “paid or payable” to beneficiaries from its taxable income. This deduction effectively shifts the tax burden from the trust to the recipient beneficiaries. Any income that is not allocated or distributed (i.e., retained within the trust) is taxed at the highest marginal tax rate applicable to individuals, unless the trust qualifies as a Graduated Rate Estate or a Qualified Disability Trust (QDT), which benefit from graduated tax rates under subsection 122(1) of the ITA.

Exceptions to the Conduit Principle

While the conduit principle is broadly applicable, there are some important exceptions, including:

• Loss Carryforwards: A trust with unused losses from prior years may wish to have income or capital gains taxed within the trust itself, rather than in the hands of the beneficiaries, in order to utilize the unused losses.
• Attribution Rules: If tax on split income rules or the attribution rules apply, such as those outlined in subsection 75(2) of the ITA, income paid or payable to a beneficiary may be taxed in the hands of another person instead of the beneficiary receiving the income.

This serves as a timely reminder for trustees to thoughtfully manage trust income to ensure it is “paid or payable” to beneficiaries within the year, where advantageous. Effective planning and execution can help avoid the unnecessary taxation of trust income at the highest marginal rates.

[1]           For the purposes of this blog, the term ‘income’ refers to income determined in accordance with the ITA, which may differ from ‘income’ for trust law purposes. This does not apply to all types of trusts and a professional advisor should be consulted to determine the application of the ITA rules for specific circumstances.

[2]           Income that flows through a trust typically retains its original tax character. The classification of receipts by a trust for trust law and tax law purposes, which are not always aligned, as well as the retention of the income’s original characterization, is a complex topic worthy of its own separate discussion. While this blog does not explore these details, readers may find further insights in resources such as Canadian Taxation of Trusts (2nd Edition) by Elie Roth, Chris Anderson, Kim Brown, Rhonda Rudick, and Ryan Wolfe, and Income and Payment: Key Trust Law Income Tax Differences, by Joan E. Jung.