Section 132.11

S. 132.1(6) generally permits a mutual fund trust to designate an amount as an addition to its income for a taxation year (provided it has not made a designation under s. 104(13.1) or (13.2)). To the extent that such additional income is allocated to unitholders (or other beneficiaries) in the trust's return for the year in respect of amounts paid or payable to them in the year, it is treated as additional trust income which was paid to them at the end of the year so that the trust may deduct the additional income under s. 104(6) and so that such additional income is included in their hands under s. 104(13).

The lesser of the designated amount and the amounts of additional income allocated to the unitholders is required to be deducted in computing the mutual fund trust's income for the following year. There are three potential limitations on this result. First, s. 132.2(8) provides that there is no such deduction where it is reasonable to consider that the designation for the preceding year "was part of a series of transactions or events that includes a change in the composition of beneficiaries under the trust." By analogy to similar questions which arise under the s. 55(3)(a) exception, this exclusion likely would not be applicable as a result of normal trading in the units of the trust, or for designations which are not publicly disclosed and of which the unitholders would have no inkling. Second, the incurring of losses in the year of the designation would have the effect of reducing or eliminating the amount of the additional income which otherwise could be considered to have been allocated to the unitholders, so that the deduction for the following year would be reduced or eliminated accordingly. Third, if the distributions paid or payable to the unitholders in the year do not exceed the income of the trust before the addition under s. 132.11(6), there would appear to be no ability to push out the additional income arsing under the s. 132.11(6) designaiton to them.

Thus, the general effect of these rules is that a mutual fund trust whose annual distributions exceed its income can gradually build up a reserve (by making successively larger annual designations) to shelter any large taxable capital gain, recapture of depreciation or other extraordinary item which it might realize in a future taxation year. Furthermore, the designation can be used to create a “cushion” to adjust for mistakes in the determination of income without having to amend T3 information slips provided to unitholders.

Example 1 (Cushioning income-computation mistakes)

A REIT in all its relevant years has income of $60 and annual distributions of $100. In Year 1 it makes a s. 132.11(6) designation of $10, thereby increasing the income portion of the distributions for that year to $70. For successive years thereafter, it makes a further designation of $10 in each year, which is offset by a s. 132.11(7) deduction from the previous year’s designation. At the end of Year 5, it discovers that it had understated its Year 4 income by $5. It can amend its Year 4 return by reducing its s. 132.11(6) designation by $5 and adding the identified $5 income amount – without any effect on the income position of its unitholders for that year. If, in filing its return for Year 5, it again makes a $10 s. 132.11(6) designation, then its income will be $65 rather than $60, thereby reflecting that it has a s. 132.11(7) deduction of only $5 for that year.

The designation also can be used to smooth income.

Example 2 (Income-smoothing)

At the beginning of Year 2, a REIT realizes a large capital gain from closing a sale, which might cause its income for that year to exceed its distributions. If it makes a s. 132.11(6) designation in its Year 1 return, it could in effect cause some of this income to be realized in Year 1 rather than Year 2.

The s. 132.11(6) designation also potentially can be used to access a capital gains refund under s. 132(1). The March 1999 Explanatory Notes clearly contemplate that the designation can be used in a year in which the refund is claimed. Although the introduction of s. 104(13.3) prohibited trusts from increasing their income under s. 104(13.1) otherwise than for the purpose of utilizing available losses from other years, this does not appear to preclude using the s. 132.11(6) designation to increase income so as to access the capital gains refund.

Example 3 (Accessing capital gains refund)

A REIT has a net asset value of $1,900 on December 31 of Year 1, and a cost amount for its assets of $1,150 at that time (representing an accrued gain of $750). In the course of Year 1, it had realized a capital gain of $50 (and, thus, a taxable capital gain of $25) and earned ordinary income of $50, redeemed $125 of its units (respecting which it did not make a s. 104(21) designation, as they comprised a class of units with no accrued gain to their unitholders), and distributed $75 to its unitholders.

In the absence of making a s. 132.11(6) designation, the REIT would be able to claim a s. 104(6) deduction of $75, so that its income was reduced to nil. The CDS spreadsheet on which the REIT reported its results for Year 1 would effectively prelude it from making a s. 104(21) designation – and, even if this were not the case, there would be limited benefit to the unitholders from the REIT making the designation, as there were no distributions made in excess of income and, thus, no amounts which could benefit from favourable treatment (i.e., no ACB reduction) under s. 53(2)(h)(i.1)(B)(I).

The REIT makes a $25 designation under s. 132.11(6) in its return for Year 1, thereby increasing its income for Year 1, net of its s. 104(6) deduction, to $25. In its return, it treats its $50 of ordinary income and the s. 132.11(6) amount as having been distributed to its unitholders, i.e., all of its $75 in distributions is treated as distributions of these amounts.

The capital gains redemption of the REIT under the s. 132(4) definition might be ($125/$2,000)*($50+$750), or $50. Assuming a combined federal and provincial tax rate of 25%, its capital gains refund under s. 132(1) and a provincial equivalent might be the lesser of (under (a)(i) of the capital gains refund definition) 25% of its $50 capital gains redemption, and (under (a)(ii) of the capital gains refund definition) its refundable capital gains tax on hand at the end of Year 1, which (based on the same combined rates) might be equal to 50% of the lesser of its taxable capital gain for the year of $25 and its income for the year of $25. As both the (a)(i) and (a)(ii) components would be $12.50, its capital gains refund would be $12.50. This would be equal to and offset its capital gains tax on the $50 capital gain realized by it in Year 1.

In Year 2, it would be entitled under s. 132.11(7) to a deduction of $25 in computing its income for Year 2, assuming there was no change in its unitholders that engaged s. 132.11(8). Accordingly, from the combined perspectives of Years 1 and 2, a better result is achieved.

S. 132.11(8) provides that the deduction under s. 132.11(7) (to effectively reverse an income inclusion for the preceding year under s. 132.11(6)) is not available where it is reasonable to consider that such s. 132.11(6) designation “was part of a series of transactions or events that includes a change in the composition of the beneficiaries under the trust.” The Explanatory Notes of the Department of Finance provide this example of where s. 132.11(8) may apply:

[T]here has been an increase over the two taxation years in the percentage of units held by taxable investors after unusually large amounts of income had been flowed–through to tax-exempt investors as a consequence of the designation under subsection 132.11(6).

The concept (e.g., under Craven v. White) of what would otherwise constitute a series of transactions (namely, a pre-ordained succession of transactions) is expanded by s. 248(10) to include “any related transactions or events completed in contemplation of the series.” The Explanatory Note example references a forward-looking situation, i.e., at the time of the making of the s. 132.11(6) designation, there was knowledge or anticipation that there would be an increase in the ownership of interests in the trust by taxable investors. However, in Copthorne, Rothstein J indicated that the words "in contemplation of" could be retrospective. If this is correct (notwithstanding arguments that such an interpretive approach does not accord with the scheme of the Act), it would indicate that s. 132.11(8) could apply if a s. 132.11(6) designation is made “in contemplation of” a previous change in the composition of the trust’s beneficiaries occurring as part of a series of transactions in the ordinary sense of that phrase.

Copthorne also indicated that a transaction is completed "in contemplation of" a series of transactions whenever it is completed "because of" or "in relation to" the series. Accordingly, the fact that a s. 132.11(6) designation was made following a change in the composition of a trust’s beneficiaries, e.g., a REIT making such a designation following the completion of an issuer bid, should not engage the application of s. 132.11(8) if the reasons for making the s. 132.11(8) designation are independent of that change in composition.

These comments in Copthorne on a required element of causality may also inform a prospective use of the s. 132.11(6) designation. In addition, it may be unclear that s. 248(10), which applies only to related "transactions or events" (see Ho), has the effect of assimilating the making of a mere designation (i.e., a statement in a return) to a common law series as described in Craven v. White - although the wording of s. 132.11(8) itself may imply that the legislative drafter considered that a return designation is included in the universe of transactions and events.

Example (Income-smoothing of sales proceeds)

At the beginning of Year 2, a REIT realizes a large capital gain from closing a sale, which might cause its income for that year to exceed its distributions. If it makes a s. 132.11(6) designation in its Year 1 return, it could in effect cause some of this income to be realized in Year 1 rather than Year 2.

If it contemplated, at the time of making the designation, that it would use some of the proceeds of such sale to fund a normal course issuer bid, it might be considered that such use of the proceeds was part of the same series of transactions that included the sale transaction. Under s. 248(10), the s. 132.11(6) designation would, in turn, be assimilated to that series of transactions if it were made in contemplation thereof, and the making of a designation in a return (which is not the same thing as filing an election with CRA - see Nassau Walnut) were regarded as a "transaction or event."

However, it would be inappropriate to consider that the designation was made "because of" or "in relation to" any change in the composition of the REIT’s beneficiaries if the REIT was indifferent to any such effect of its normal course issuer bid. It instead would be appropriate to consider that the designation is not made as part of a series of transactions entailing a change in the compositin of the REIT if the REIT does not contemplate, and has no specific knowledge of, any such change.