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Trusts: Is Capital Dividend from Mutual Funds Income or Capital?

by Michael A. Mann

This article was written by Michael A. Mann in response to a letter from a reader of the Canadian MoneySaver magazine.

“If a trust deed specifies that a beneficiary can receive only income for life from the trust (no capital), how would a capital dividend from a mutual fund be considered – income or capital” C.W. St. John’s, NF

The reader raises a very interesting point. It is important to understand that income can mean different things for different purposes. In other words it is possible for something to be determined to be taxable as income and yet for trust purposes not to be considered income.

Normally, unless a trust agreement otherwise defines income, income for trust purposes is not to be considered from any capital appreciation. If a stock were purchased and subsequently rose in value and then were sold, the increase in capital would not be considered to be income for trust purposes. Accordingly a beneficiary (whose only entitlement is to income) would have no interest in the increased value of the stock. Instead, this increase would form part of the capital to which the parties who are ultimately entitled to the residue would share.

Revenue Canada, however would take a different view of this. The gain would be defined to be a capital gain which is a type of income and is therefore taxable.

Normal dividends are considered to be income for both income tax purposes and trust purposes. The normal dividend is taxable in accordance with the dividend rules. It is also considered to be income to which an income beneficiary is entitled to.

A dividend from the capital dividend account is a more difficult matter to categorize. Under the Income Tax Act the portion of the capital gain which was not subject to tax in a corporation is placed in the capital dividend account. The corporation is permitted to declare a capital dividend out of this account which can be received by the recipient without any income tax consequences. Therefore, for income tax purposes, the capital dividend is not to be considered income. The dividend is in fact a distribution of capital as it represents a partial distribution of an appreciation to a capital asset in the corporation. Accordingly, for trust purposes the dividend out of the capital dividend account is not considered to be income but rather should form part of the corpus of the trust.

The reader questions whether a capital dividend from a Mutual Fund is to be considered income or capital. If the distribution is in fact a return of capital rather than a taxable dividend, there would be no income tax consequences as capital can be returned to the trust without tax consequences. As it is strictly a return of capital it would be considered to be capital and the income beneficiary would have no entitlement to it.

As you can see from a trust law point of view, the general rule is that capital appreciation or return of capital to a trust forms part of the corpus of the trust to which the income beneficiary has no entitlement. Whether that is considered to be income for income tax purposes depends upon the very technical way in which the distribution is made and does not in and of itself change the nature of the distribution for trust law purposes. This entire area is a very difficult one and one in which trustees must be very careful when allocating between income and capital. A number of large trust companies take the position that if there is any doubt, the distribution is considered to be capital unless a judge rules otherwise.

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