15 June 2021 STEP Roundtable Q. 3, 2021-0883151C6 - Reasonable Return on Note

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether the beneficiary of a trust would be able to rely on the “reasonable return” exception in either subparagraph (f)(ii) or (g)(ii) of the definition of “excluded amount” in subsection 120.4(1) if the interest rate on an outstanding promissory note is equivalent to an interest rate that would have been charged between parties dealing at arm’s length with each other.

Position: Question of fact and law that can only be determined after a review of all the facts and circumstances applicable to a particular situation.

Reasons: The CRA does not intend to generally substitute its judgement of what would be considered a reasonable amount where taxpayers have made a good faith attempt to do so based on the reasonableness factors.

2021 STEP CRA Roundtable – June 15, 2021
QUESTION 3. Reasonable Return on Promissory Note Issued by Family Trust

A family trust can distribute its income to a beneficiary by making an amount payable in the year to the beneficiary, provided the beneficiary is entitled in the year to enforce payment of it (as per the requirements of subsection 104(24) of the Income Tax Act). If the amount payable to the beneficiary is in the form of an interest bearing promissory note owing to the beneficiary, the beneficiary will report interest income for each year the promissory note remains outstanding. Assuming the beneficiary is not a minor and has not performed any work, has not contributed any property or assumed any risk with respect to any related business owned directly or indirectly by the trust, would the beneficiary be able to rely on the “reasonable return” exception in either subparagraph (f)(ii) or (g)(ii) of the definition of “excluded amount” in subsection 120.4(1) if the interest rate is equivalent to an interest rate that would have been charged between parties dealing at arm’s length with each other?

CRA Response

As noted in our response to Q13 and 14 of the 2019 STEP Roundtable, in respect of a specified individual who is a beneficiary of a trust, where such an individual receives an amount of income from the trust that is included in the beneficiary’s income pursuant to subsection 104(13), paragraph (c), or in the case of taxable dividends designated by the trust under subsection 104(19), subparagraph (a)(i) of the definition of “split income” must be considered. While the issuance of a promissory note by a trust to a beneficiary may be an acceptable method of providing evidence of an amount made payable to a beneficiary for the purposes of subsection 104(13), such evidence does not have any impact on the determination of whether such income would otherwise be considered split income of that individual.

Based on the above, the amount of income received by the beneficiary from the trust and evidenced by the promissory note will be “split income” to the beneficiary and subject to tax on split income (“TOSI”) unless it is an “excluded amount” as each of these terms are defined in subsection 120.4(1).

Paragraph (d) of the definition of split income provides, inter alia, that split income is an amount included in computing the individual’s income for the year to the extent that the amount is in respect of a debt obligation that is of a trust and is not described in paragraph (a) of the definition of “fully exempt interest” in subsection 212(3), listed or traded on a public market, or a deposit standing to the credit of the individual. It is assumed that such interest receipts, in respect of the promissory note issued to the beneficiary, would be funded by the operations of a “related business” in respect of the beneficiary, as defined in subsection 120.4(1).

Based on the above, the interest income paid to the particular beneficiary by the trust will be “split income” to the beneficiary and subject to TOSI unless it is an “excluded amount” as each of these terms are defined in subsection 120.4(1). In that regard, it does not appear to qualify as an “excluded amount” pursuant to subparagraph (f)(ii) (assuming the beneficiary is between the age of 17 and 24) since the note does not appear to be “arm’s length capital” as defined in subsection 120.4(1). If the beneficiary has attained the age of 24 years before the particular year, the “reasonable return” exception provided in subparagraph (g)(ii) must be considered for such interest income.

Whether the arm’s length rate of interest charged is a reasonable return in the case where the individual has not assumed any risk, is a mixed question of fact and law that can only be determined after a review of all the facts and circumstances applicable to a particular situation. Notwithstanding the above, in determining whether something constitutes a reasonable return, the CRA does not intend to generally substitute its judgement of what would be considered a reasonable amount where taxpayers have made a good faith attempt to do so based on the reasonableness factors set out in the definition of “reasonable return” as provided in subsection 120.4(1).

Additional guidance on the TOSI rules can be found on the Canada Revenue Agency (CRA) website at: https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/income-sprinkling/guidance-split-income-rules-adults.html.

Allison Thomas
2021-088315