The Federal Court of Appeal (“FCA”) decision in Canada v. Vefghi Holding Corporation, 2025 FCA 143 provides the answer to a longstanding technical question, namely, the point in time governing the determination of “connected status” in respect of dividends received by a corporate beneficiary and payor corporation in a “trust sandwich” structure.
By way of background, it is a common planning technique for owner-managed corporations to employ a structure where common shares of an operating company (“Opco”) are owned by a discretionary inter vivos family trust (the “Trust”) with another corporation (“Benco”) included in the beneficiaries of that very same trust. These structures are often referred to (somewhat unimaginatively) as “trust sandwich” structures. The aim of these structures is to provide a mechanism to “purify” Opco in a tax deferred manner.
If Opco accumulates too much “non-active” cash or other passive investment assets it shares may not qualify as qualified small business corporation shares and accordingly may not be eligible for the lifetime capital gains exemption. To ensure this status a mechanism is required to remove the redundant cash from Opco. Having an individual shareholder of Opco receive dividends from the corporation would achieve this purpose however this would result in the loss of the deferral opportunity presented by the lower corporate tax rates.
The “trust sandwich” structure is designed to preserve this deferral opportunity while allowing for the movement of redundant assets out of Opco. To do so a dividend can be declared on the common shares of Opco held by the Trust which can then allocate and pay the dividend to Benco. Assuming, among other things, Opco makes the appropriate designation under 104(19) of the ITA, the dividend is deemed to be received by Benco on the share in fact owned by the trust in Benco’s taxation year in which includes the trust’s year end.
To not attract tax under Part IV of the ITA as a result of such a “trust sandwich” structure dividend Benco and Opco must be “connected” within the meaning assigned by subsection 186(4) of the ITA. Part IV of the ITA is, in general terms, a mechanism designed to prevent tax deferral on passive investment income in the context of inter-corporate dividends.
As the FCA in Vefghi noted “Generally two corporations will be connected … if one corporation controls the other corporation or owns more than 10% of the shares with full voting rights and shares having a fair market value of more than 10% of the fair market value of all of the issued shares of the other corporation” and “Subsection 186(2) of the [ITA] provides that a corporation will control another corporation if more than 50% of its voting shares are held by the other corporation and / or persons with whom the other corporation does not deal at arm’s length.”
Typically, in “trust sandwich” structures Opco and Benco achieve connected status via subsection 186(2) and what is known as “common control”. However, where there is a sale of Opco after the payment of the dividend to the Trust but before the Trust’s year end, after that sale “common control” of Opco and Benco would typically no longer be present. Accordingly, Opco and Benco would no longer be “connected” at the trust’s year end.
It has been the longstanding position of the Canada Revenue Agency (the “CRA”) (see for example CRA Doc. No. 2020-0845821C6) that taxable dividends designated by a trust are deemed to be received by the beneficiary at the end of the trust’s taxation year (i.e. December 31). Accordingly, under this position, in the context of a trust sandwich structure, dividends received by Benco where there has been a midyear sale of an Opco would attract Part IV tax because at this point in time Benco and Opco would no longer be “connected”.
Vefghi originated as a rule 58 question in the context of assessments by the Minister of National Revenue (the “Minister”) of tax under Part IV of the ITA on certain dividends received by “Bencos” in “trust sandwich” structures (the “Bencos” being Vefghi Holding Corporation (“Vefghi”) and S.O.N.S. Environmental Ltd. (“SONS”)). The salient difference between the two scenarios was, that in the case of Vefghi, Vefghi had a calendar year end aligning with the relevant trust’s year end, while the SONS year end did not so align (being August 31).
Specifically, the Tax Court was asked:
Where a trust designates a portion of a taxable dividend (the "Amount") received on a share of the capital stock of a taxable Canadian corporation (the "Issuer"), pursuant to subsection 104(19) of the federal Income Tax Act (the "Act"), such that the Amount is deemed to have been received by a beneficiary (the "Beneficiary"), when is it determined whether the Issuer is connected with the Beneficiary for purposes of paragraph 186(1)(a) of the Act?
The TCC answered the rule 58 question essentially in this way: the time that the dividend was as a question of fact actually received (i.e. the date of declaration and payment) will govern the determination of “connectedness” provided that this date would be during the corporate beneficiary’s taxation year that included the year end of the trust. In other words, the date of receipt of the dividend governed unless the effect of the deeming rule in 104(19) was to deem the dividend to be received in a taxation year of the corporate beneficiary that did not include the actual date of receipt.
The TCC reached its conclusion in part because it held that “104(19) deems the dividend to have been received by the corporate beneficiary in the corporate beneficiary’s taxation year in which the taxation year of the trust ends. However, the subsection does not state at what specific point in that taxation year the dividend is received.” The TCC also held that that subsection 104(19) creates certain “legal fictions” and that “unless the legal fiction created by the deeming rule specifically results in the dividend being received at a different point in time, then the dividend is received by a corporate beneficiary on the same date as the date that it was received by the trust”.
Applying the TCC’s answer to the rule 58 Question to Vefghi’s scenario resulted in no Part IV tax being exigible. While, applying the same answer to SONS resulted in the opposite finding. This difference in result was attributable to the difference in taxation years of the two corporations. In the case of SONS, it had an August 31 year end, and the effect of the deeming rule in subsection 104(19) was to deem the dividend received to be included in income in its August 31, 2016 year end which did not include the date that the dividend was in fact received (July 1, 2015). Because by the time SONS was deemed to have received the dividend under the TCC’s interpretation it was no longer connected with the Payor corporation, Part IV tax applied.
The FCA took issue with certain aspects of the Tax Court’s reasoning.
The FCA held that while, “104(19) of the Act deems … a dividend received by a trust that is designated by the trust to be a taxable dividend on the same share as the share on which the dividend was paid to the trust” it does not deem the dividend to be the same dividend. In other words, it is a partial deeming rule preserving only certain aspects of “reality”.
The FCA also held that all the conditions required to make a designation under subsection 104(19) must be satisfied before the corporate beneficiary is deemed to receive a dividend. Accordingly, the FCA then held that this designation cannot be made before the trust’s year end. Therefore, the FCA concluded that since it is only once the designation is made that the corporate beneficiary is deemed to receive the dividend, that the determination of “connectedness” can only be made at the time of the trust’s year end.
The FCA then held that the date of the designation is not the date the designation is made in the tax return (finding that result would conflict with the wording of subsection 104(19)) but rather the last day of the trust’s taxation year.
Many tax advisors will find themselves disappointed by this decision.
As noted earlier, the reason why “trust sandwich” structures are put in place is two achieve two tax objectives: retain deferral on corporate retained earnings and while retaining access to the capital gains exemption.
It is unclear to me that this is an undesired policy result.
While the answer of the TCC to the rule 58 question was challenging to understand, it tried to accommodate the ITA to commercial realities. In my view the decision of the FCA, while not clearly “wrong” and in some sense simpler than the decision of the TCC, creates an unwarranted “tax trap”. Certain planning techniques can be employed to “work around” this “trap” but these techniques create complexity and expense for taxpayers. In my view, Parliament should amend subsection 104(19) to address this issue.
Any article or other information or content expressed or made available in this Section is that of the respective author(s) and not of the OBA.