Loss carryforwards and other tax attributes, such as scientific research and experimental development (“SR & ED”) expenditures, investment tax credits (“ITCs”), resource pools, are valuable assets because they can shelter taxes. As such, loss utilization has always been a staple of good tax planning. The Income Tax Act (the “Act”) and the CRA’s administrative policies have generally accepted loss utilization planning within affiliated and related parties.1 On the other hand, the Act has always had provisions against arm’s length loss trading transactions whereby one taxpayer in effect makes use of another’s unused tax attributes. Prior to March 21, 2013, these rules were referred to as the “acquisition of control” rules and they applied only to corporations. However, in recent years, there are a proliferation of non-corporate vehicles that carry on substantial activities traditionally undertaken only by corporations. In response, the Department of Finance introduced a new “loss restriction event” concept in new section 251.2 that essentially expands the old acquisition of control regime to partnerships and trusts. These rules came into force on March 21, 2013.
Whereas the old rules look solely to changes in corporate control to determine when an acquisition of control has occurred, the new rules, as they relate to trusts, look to changes in beneficiaries as the triggering event:
For the purposes of this Act, a taxpayer is at any time subject to a loss restriction event if …
(b) the taxpayer is a trust and
(i) that time is after March 20, 2013 and after the time at which the trust is created, and
(ii) at that time a person becomes a majority-interest beneficiary, or a group of persons becomes a majority-interest group of beneficiaries, of the trust.2
A “majority-interest beneficiary” is defined as a person whose interest as a beneficiary has, together with the beneficiary interests of all persons with whom the person is affiliated, a fair market value (“FMV”) that is greater than 50 percent of the FMV of all beneficiary interests in the trust.3
Similar to the acquisition of control regime, once a loss restriction event is triggered, the affected entity would be subject to a number of, mostly adverse, implications. The consequences for a trust subject to a loss restriction event may, among other consequences, include:
- expiry of all net capital loss carry forwards;4
- mandatory write-down of all non-depreciable capital property with accrued losses (and immediate expiry of the resulting capital losses);5
- streaming of non-capital loss carryforwards, resource pools, SR & ED expenditures, and ITCs;6 and
- a deemed year-end (a provision was subsequently added to extend the filing and tax payment due dates to the trust’s ordinary due dates, but does not negate the actual stub year’s filing requirement or tax owing).7
Trusts that would particularly be affected would be those holding properties with large accrued losses (e.g. an underwater stock investment), or those that have significant loss carryforwards from either business, property, or capital losses. Whereas the business losses would be streamed to same or similar business income, property and capital losses would immediately expire.8
There are complex exceptions, deeming rules, and anti-avoidance rules within new section 251.2. For example, one of the exceptions provides that a person generally is deemed not to become a majority-interest beneficiary solely because of the acquisition of equity in a trust by a person from an affiliated person, or by a person who was affiliated with the trust. Variation in trust terms or redemption, surrender or termination in trust equity would also not cause a person to have become a majority-interest beneficiary if each majority-interest beneficiary or group of beneficiaries afterwards were affiliated with the trust before the event.9
A key deeming provision within the new section is the expansion of the concept of “affiliated persons” in respect of natural persons. Ordinarily, natural persons may be affiliated only if they are spouses or common-law partners.10 However, for purpose of applying section 251.2, the concept of “affiliated persons” is expanded to include those connected by blood relationship, marriage or common-law partnership, or adoption.11 Without this deeming provision, any changes to the beneficiaries beyond spouses and common-law partners could trigger the loss restriction event. Also, subsequent revisions by the Department of Finance to section 251.2 provided important carve-outs for mutual fund trusts and quasi-mutual fund trusts.
At first glance, the rules in section 251.2 appears to be of limited relevance to ordinary trust and estate planning due to the affiliated person exceptions provided. However, there are traps for the unwary contained in these rules.
A deeming rule in the Act deems each discretionary beneficiary to be entitled to the maximum amount of income or capital that such beneficiary might receive under the terms of the trust.12 As a result, if a discretionary beneficiary who might receive more than 50 percent of the income or capital is added to a trust and none of the exceptions are met, the trust would be subject to a loss restriction event. Most trusts we see in the private context are discretionary trusts where each beneficiary may potentially be entitled to all of the income or capital of the trust. It is also not uncommon to name a class of beneficiaries such as “all my children, nephew and nieces”. In this situation, each time a nephew or niece is added by birth, the new beneficiary automatically becomes a majority-interest beneficiary causing the trust to be inadvertently subject to a loss restriction event (nephews, nieces and cousins do not fall within the expanded definition of affiliated persons).13 Similar results arise if any new unaffiliated beneficiaries (natural persons or otherwise) are added to the discretionary trust.
Exacerbating this is the definition of majority-interest beneficiary itself, which looks to a person’s interest, together with the beneficiary interests of all persons with whom the person is affiliated. The CRA recently confirmed that it views this definition to mean that a person who does not have an interest in a trust is nonetheless a majority-interest beneficiary of the trust if the person is affiliated with another person who is a majority-interest beneficiary of the trust.14 This implies that every time a beneficiary of a discretionary trust has a new affiliate (new spouse, child/grandchild, in-laws, majority interest in a corporation, partnership or trust, et cetra considering the expanded definition of affiliated person for purpose of section 251.2), that the new affiliate becomes a majority-interest beneficiary and potentially subject the trust to a loss restriction event. The Department of Finance recognized the practical nightmare this causes and has issued a comfort letter stating that it is prepared to recommend to the Minister of Finance an amendment to the legislation that limits a majority-interest beneficiary to a person who is actually a beneficiary of the trust.15 However, this may be cold comfort to planners and trustees dealing with the currently enacted legislation.
Another noteworthy provision within section 251.2 that could cause the trust to inadvertently trigger a loss restriction event is the “notional person” deeming rule.16 This subsection describes certain transactions and events in respect of which a trust is deemed to be subject to a loss restriction event (i.e., by deeming a notional person to have become a majority-interest beneficiary). One of these events is where a corporation, partnership or trust (the subject entity) who is a majority-interest beneficiary becomes a “subsidiary” of another person (the acquirer), and the acquirer and the trust were not affiliated immediately before that time. For this purpose, a “subsidiary” means a subject entity in which a person holds directly or indirectly, together with each affiliated person, an aggregate of more than 50 percent of the equity value.
As an example, if a discretionary trust has a corporate beneficiary and shares of that corporation are sold to another person who was not affiliated with the trust immediately before the transaction, the trust would be deemed to have undergone a loss restriction event even though no new beneficiaries were added. This may also apply on internal reorganization as, depending on the organizational and trust structure, the internal purchaser entity may not necessarily be affiliated with the trust.17 Note that because of how subsidiary is defined for this purpose, the notional person deeming rule applies where more than 50 percent of the FMV of the shares are acquired, even if the shares were non-voting.
New section 251.2 is a complex provision and practitioners must turn their attention to it when dealing with trust matters so that they can plan accordingly. For instance, it may be advantageous to roll out underwater trust property to capital beneficiaries under subsection 107(2) before a loss restriction event in order to avoid the mandatory write-down and preserve the tax basis.
1 See, for example, CRA Document No. 2009-0332571R3.
2 See subsection 251.1(2) of the Act.
3 See subsection 251.1(3) of the Act.
4 See paragraph 111(4)(a) of the Act.
5 See paragraph 111(4)(c) and (d) of the Act.
6 See subsections 111(5), 66(11.6), 37(6.1) and 127(9.2) of the Act.
7 See subsection 249(4) and subsection 251.2(7) of the Act.
8 Property losses expires immediately because the non-capital loss streaming rule in subsection 111(5) provides only for losses from carrying on a business; capital losses expire automatically due to paragraph 111(4)(a).
9 See subsection 251.2(3) of the Act.
10 See paragraph 251.1(1)(a) of the Act.
11 Subparagraph 251.2(5)(a)(ii) expands the concept of affiliated persons, and connection by blood relationship, marriage or common-law partnership and adoption are defined in subsection 251(6).
12 See subparagraph 251.1(4)(d)(i) of the Act.
13 This is by virtue of the definitions in subsection 251(6).
14 See CRA document 2014-0534841C6.
15 December 23, 2014 Finance Letter.
16 See subsection 251.2(4) of the Act.
17 See affiliated person rules for trust in paragraphs 251.1(1)(g) and (h), as well as the interpretation provisions contained in subsection 251.1(4).