A Business Sale, a Family Trust, and an Unexpected Tax Bill

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On July 1, 2015, an operating company paid a dividend of $1,363,283 to the family trust that owned its common shares. That same day, the trust sold those shares to an arm’s-length buyer. Months later, the trust designated the dividend to its corporate beneficiary, and the CRA assessed Part IV tax on it.

In Canada v. Vefghi Holding Corporation, 2025 FCA 143, the Federal Court of Appeal had to decide one question: when do you test whether the paying company and the corporate beneficiary are connected? The Court held that the test is applied at the end of the trust’s taxation year. As a result, a sale that closes after the dividend but before the trust’s year-end can turn a tax-free intercorporate dividend into one subject to Part IV tax.

This article walks through how Part IV tax works for family trust structures, what each court decided, and what the ruling means if you are planning a sale. If you would rather watch, the full video is here: Watch the video on YouTube.

How Part IV Tax Works on Intercorporate Dividends

When one Canadian corporation pays a taxable dividend to another, the receiving corporation includes it in income. It then deducts the same amount under subsection 112(1). In most cases, the result is no Part I tax on that dividend.

However, section 186 adds a separate tax. Part IV tax applies when a private corporation receives a dividend from a corporation it is not connected with. The rate is 38 1/3% under paragraph 186(1)(a). The tax is refundable, and the corporation gets it back under subsection 129(1) as it pays taxable dividends to its own shareholders.

The Tax Court described the purpose of Part IV tax as reducing or eliminating the corporate tax deferral on passive investment income. In other words, it stops owners from parking portfolio dividends in a holding company at a lower rate than they would pay personally.

What “connected” means

Under subsection 186(4), two corporations are generally connected if either of these tests is met:

  • Control test: the recipient controls the payer. Under subsection 186(2), this includes holding more than 50% of the voting shares together with persons it does not deal with at arm’s length.
  • Ownership test: the recipient owns more than 10% of the payer’s voting shares and shares worth more than 10% of the fair market value of all its issued shares.

If the corporations are connected, Part IV tax generally does not apply to the dividend. Subsection 186(4) tests connection at a particular time, and that is where the Vefghi case begins.

How a Family Trust Passes a Dividend to a Corporate Beneficiary

Many owner-managed businesses use a structure practitioners call a trust sandwich. A family trust owns shares of the operating company, and a holding company is one of the trust’s beneficiaries. The operating company pays a dividend to the trust, and the trust passes it on to the holding company.

For tax purposes, subsection 104(2) deems a trust to be an individual. Therefore, a dividend paid to the trust is received by an individual, and Part IV tax does not apply at that stage.

Subsection 104(19) is the rule that lets the dividend keep its character as it moves to the beneficiary. For it to apply, the following conditions must be met:

  • The trust receives a taxable dividend from a taxable Canadian corporation during its taxation year.
  • The trust is resident in Canada throughout that year.
  • The amount is payable to the beneficiary and included in the beneficiary’s income under the trust income rules.
  • The trust designates the amount in its tax return for the year in which it received the dividend.

When these conditions are met, the designated amount is deemed to be a taxable dividend on the same share, received by the beneficiary in the beneficiary’s taxation year in which the trust’s taxation year ends. Without the designation, the beneficiary would have income from property instead of a dividend.

The Court noted one gap in the wording. Subsection 104(19) identifies the beneficiary’s taxation year of receipt, but it does not name the day. For a corporate beneficiary, that day determines whether the two corporations are connected.

The Facts: Two Family Trusts, Two Share Sales

The appeal covered two separate structures, each with its own agreed statement of facts. In both, a family trust received a dividend from an operating company, and the trust’s shares in that company were sold to an arm’s-length buyer shortly afterward. As a result, the operating company and the corporate beneficiary were connected when the dividend was paid, and they stopped being connected before the trust’s December 31 year-end.

Vefghi Holding structure S.O.N.S. structure
Dividend paid to the trust July 1, 2015 June 30, 2015 (paid by promissory notes)
Share sale to arm’s-length buyer July 1, 2015 July 1, 2015
Amount designated to the corporate beneficiary $1,363,283 $1,967,731
Trust year-end December 31, 2015 December 31, 2015
Corporate beneficiary’s year-end December 31 August 31
Year the CRA assessed Part IV tax Year ending December 31, 2015 Year ending August 31, 2016

In each case, the trust designated the amount under subsection 104(19) in its 2015 tax return. The CRA then assessed Part IV tax on the basis that the corporations were no longer connected when the beneficiary was deemed to receive the dividend.

The parties asked the Tax Court to answer a single question of law under Rule 58 of the Tax Court of Canada Rules (General Procedure). In plain terms: when a trust designates a dividend under subsection 104(19), at what point do you test whether the paying corporation is connected with the corporate beneficiary?

What the Tax Court Decided (2023 TCC 135)

The Tax Court sided with the taxpayers. The judge found that Part IV tax is levied on dividends a corporation receives, so connection is tested when the corporate taxpayer receives the dividend.

The judge then reasoned that subsection 104(19) creates a legal fiction: the beneficiary is deemed to receive the same dividend the trust received. Since the trust received that dividend on a specific date, the judge held that the corporate beneficiary is treated as receiving it on that same date, unless the deeming rule clearly points to a different time.

On that view, connection was tested before the sale, and no Part IV tax applied in the Vefghi Holding structure. The S.O.N.S. structure needed a different answer. Its August 31 year-end meant the trust’s receipt date fell in an earlier taxation year than the one subsection 104(19) points to, so the judge treated the dividend as received sometime in the year ending August 31, 2016.

The Crown appealed, and the taxpayers cross-appealed, arguing that connection should be tested when the dividend was declared or paid.

What the Federal Court of Appeal Decided

On August 11, 2025, the Federal Court of Appeal allowed the Crown’s appeal and dismissed the cross-appeal. The Court held that connection is tested at the end of the trust’s taxation year in which the trust received the dividend. The three-judge panel was unanimous.

The Court agreed with the Tax Court on the starting point: connection is tested when the private corporation receives the dividend. The two courts differed on when a corporate beneficiary receives a dividend that reaches it through a trust.

The structure has to be respected

The Tax Court had noted that no Part IV tax would have applied if the dividends had been paid directly to the holding companies. The Court of Appeal pointed out that they were paid to trusts instead. Relying on Shell Canada, the Court said the legal relationships a taxpayer chooses must be respected unless a specific provision says otherwise or the arrangement is a sham.

A deeming rule goes only as far as its words

The Court relied on two authorities for how to read deeming rules. In R. v. Verrette, the Supreme Court of Canada described a deeming provision as a statutory fiction. In La Survivance, the Federal Court of Appeal said that because a deeming rule alters reality, its meaning is limited to what it clearly expresses.

Applying that approach, the Court found that subsection 104(19) deems the designated amount to be a taxable dividend on the same share. It does not deem it to be the same dividend the trust received, and it does not deem receipt on the trust’s date of receipt. The provision fixes only the beneficiary’s taxation year.

Why the last day of the trust’s year

The Court then worked out which day in that year applies:

  • The trust’s receipt date is ruled out. In the S.O.N.S. structure, the trust received the dividend on June 30, 2015, which fell in the beneficiary’s taxation year ending August 31, 2015. The trust’s year-end of December 31, 2015 fell in the beneficiary’s next taxation year, ending August 31, 2016. Since subsection 104(19) places the deemed dividend in that later year, the trust’s receipt date could not be the date of deemed receipt.
  • The filing date is ruled out. A trust usually files its return after year-end. If a beneficiary also had a December 31 year-end, the filing date would fall outside the taxation year the provision requires.
  • The last day of the trust’s year fits. The designation cannot be made before year-end, and the trust must be resident in Canada throughout the year. The earliest point at which every condition can be satisfied is the end of the trust’s taxation year.

The Court concluded that the last day of the trust’s taxation year is the only date that avoids a conflict with the wording of subsection 104(19).

Purpose cannot override clear wording

The taxpayers argued that these dividends were never the passive investment income Part IV is meant to target. The Court accepted that the dividends arguably would have escaped Part IV tax if the holding companies had owned the shares directly. Even so, citing Placer Dome, it held that the purpose of a provision cannot create an unexpressed exception to clear statutory language.

A separate point on section 112

The taxpayers also raised a concern about the subsection 112(1) deduction. The Court said that question was not before it. However, it explained that the deemed dividend keeps its status as a dividend on a share of a taxable Canadian corporation for section 112 purposes. The timing of receipt matters for Part IV, while the character of the dividend is a separate question.

The taxpayers applied to the Supreme Court of Canada for leave to appeal in October 2025 (SCC file 42041).

What This Means If You Are Planning a Sale

If a family trust sits between your operating company and your holding company, the trust’s year-end now matters as much as the closing date. Here is what to review with your advisor before a transaction.

Map the calendar before you declare a pre-sale dividend. Put three dates side by side: the dividend payment date, the closing date, and the trust’s year-end. If the closing will end the connection between the operating company and the corporate beneficiary before the trust’s year-end, the Court’s approach points to Part IV tax on any amount designated under subsection 104(19).

Consider where the dividend lands. The Tax Court noted that a dividend paid directly to the holding company would not have attracted Part IV tax in these facts. Whether a direct payment is available depends on who owns which shares in your structure.

Look at the timing of the closing. Where it is commercially possible, closing after the trust’s year-end keeps the corporations connected on the date that counts. In practice, buyers set their own timelines, so this option will not always be available.

Remember that Part IV tax is refundable. The holding company recovers Part IV tax under subsection 129(1) as it pays taxable dividends to its shareholders. However, getting it back means paying dividends out, which may not suit an owner who wanted to keep the funds in the holding company.

Watch for other events that end a connection. The Court gave an example of a paying corporation that is wound up before the trust’s year-end. On the Court’s reasoning, the corporations would not be connected at year-end, and Part IV tax would apply. Amalgamations, redemptions and changes in control deserve the same review.

Every structure is different. A dividend-then-sale sequence that looks routine can produce a different result once a trust is in the chain, so it is worth having the timing checked before the dividend is declared.

Watch the Video

We walk through the structure, the timeline and the Court’s reasoning step by step in the video: Part IV Tax and Family Trust Dividends on YouTube

Planning a Sale or Reorganization?

If a family trust holds shares in your operating company and a sale or reorganization is on the horizon, we can review your timeline before the dividend is declared.

Book a free 30-minute discovery call: https://www.cloudiverse.ca/book-a-free-30-minute-discovery-call/

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Disclaimer

This article is for general educational purposes only and does not constitute tax, legal or accounting advice. It is based on the Federal Court of Appeal’s reasons and the Income Tax Act as of the date of publication, and the law may change. Every situation depends on its own facts. Before acting on any information in this article, speak with a qualified professional about your specific circumstances. Cloudiverse CPAs Inc. accepts no liability for decisions made based on this content.