Trust Dividend Designations and the Vefghi Case

A common tax structure involves a holding company (“Holdco”) with an operating subsidiary (“Opco”). Where Opco pays a taxable dividend to Holdco, except to the extent Opco receives a dividend refund, Holdco is not subject to Part IV tax of 38 1/3% (referred herein as a ‘tax-free intercorporate dividend”). The exemption arises due to the companies being “connected” for Part IV tax purposes since Holdco controls Opco.

Interposing a discretionary family trust between Holdco and Opco is a common variant of the standard structure. It combines the flexibility of a trust with Holdco’s ability to receive tax-free intercorporate dividends from Opco. In summary:

• When the trust allocates an Opco dividend to Holdco, it can make a designation in its tax return, using s.104(19) of the Income Tax Act (Canada) (the “ITA”), which deems Holdco to receive the amount as a taxable dividend paid by Opco. Without the designation, Holdco would receive the amount as property income;
• The ITA treats the trust and Holdco, as corporate beneficiary, as non-arm’s length (“NAL”) persons; and
• For connected corporation purposes an extended meaning of “control” applies – Holdco controls Opco since more than 50% of Opco’s voting shares belong to Holdco, along with any NAL person.

On August 11, 2025, the Federal Court of Appeal (the “FAC”) released a decision in the Canada v Vefghi Holding Corp case that has significant implications for corporate connectivity and s.104(19) designations in the context of corporate reorganizations, sales and mergers.

Summary of the Case Facts

• Vefghi Holding Corp. (“Vefghi Holdco”) was a corporate beneficiary of the Vefghi Family Trust (the “Vefghi Trust”), which owned all of Vefghi Environmental Consultant Inc.’s (“Vefghi Opco”) common shares.

• Vefghi Holdco and the Vefghi Trust had December 31 taxation year-ends.

• On June 30, 2015, Vefghi Opco paid a dividend to the Vefghi Trust.

• On July 1, 2015, the Vefghi Trust sold its Vefghi Opco common shares to a 3^rd party.

• As a result of the sale, Vefghi Holdco and Vefghi Opco ceased being connected on that day.

• In their respective December 31, 2015 tax returns, the Vefghi Trust distributed the dividend to Vefghi Holdco with a s.104(19) designation and Vefghi Holdco reported it as a tax-free intercorporate dividend.

• The CRA assessed Vefghi Holdco with Part IV tax on the basis that:
  • s.104(19) deemed the dividend to be received by Vefghi Holdco on December 31, 2015; and
  • Since Vefghi Holdco and Vefghi Opco were not connected on that date, the dividend was subject to Part IV tax.

• Vefghi Holdco appealed to the Tax Court of Canada (the “TCC”) and succeeded, with the judge ruling that the s.104(19) deeming provision resulted in Vefghi Holdco receiving the same dividend as Vefghi Trust and, therefore, receiving it at the same time, being June 30, 2025 when Vefghi Holdco and Vefghi Opco were still connected.

Decision of the FCA

The Minister of National Revenue (the “MNR”) appealed to the FCA, which reversed the TCC’s decision and found the CRA was correct in assessing Part IV tax. The FCA’s ruling hinged on two key factors:

• Based on the provision’s wording, a s.104(19) designation deems the beneficiary to receive a dividend on the same shares as the actual dividend received by the trust but not, as the TCC ruled, the same dividend.

• A s.104(19) designation is only valid if all the provision’s conditions are met, one of them being that the trust is resident in Canada throughout its taxation year. Since Vefghi Trust could only satisfy this criterion at the end of its December 31, 2025 taxation year, Vefghi Holdco could not be deemed to receive the dividend before that time.

The FCA’s decision affirms that where a trust makes a s.104(19) designation, the beneficiary is deemed to received the allocated dividend at the end of the trust’s taxation year.

Takeaways

The FCA’s decision brings a new, mostly concerning, dimension to the holding company-trust-operating company structure. While the decision provides certainty with respect to when a trust’s beneficiary is deemed to receive an allocated dividend, it raises serious real-life, practical issues for taxpayers.

For example, in the context of a business sale, paying a pre-closing dividend – as occurred in the Vefghi case – is common. Where the sale results in a corporate beneficiary and the operating company no longer being connected, the transaction’s closing date may have to be postponed until after the trust’s year-end to avoid application of Part IV tax. This may not always be feasible commercially.

The FCA’s decision also impacts routine corporate reorganizations such as where an operating company is being liquidated and dissolved. To avoid Part IV tax on a liquidating dividend, the dissolution must occur after the trust’s year-end. Consider a situation where the trust and operating company have December 31 year-ends. The operating company’s dissolution would have to be January 1, or later, of the subsequent taxation year. As a result, the operating company would file a return for the December 31 year-end and a second return covering January 1 to the date of dissolution, which could be just one day.

As a final point, it should be reiterated these issues would not arise with a standard holding company-operating company structure. One hopes parliament will introduce legislation to correct this imbalance, but until such time, caution and careful planning are necessary when contemplating trust allocations of dividends to a corporate beneficiary.