Vefghi Holding Corp. v. Canada: How To Avoid The "Tax Trap" On Timing Of Flow-Through For Dividend Income And Timing Of Receipts For Trusts

Overview—Using trusts as flow-through vehicles

For Canadian tax planners and business owners, utilizing inter vivos trusts to flow income through from corporations to beneficiaries is a common strategy for tax deferral and to multiply access to the lifetime capital gains exemption. A discretionary trust allows the trustees to decide which beneficiaries receive income, how much, and from which source. This flexibility enables the trust to allocate different types of income (e.g., dividends from different corporations) to different beneficiaries based on their individual tax situations or other tax planning objectives.

However, a 2025 landmark decision by the Federal Court of Appeal (FCA) in Vefghi Holding Corp. v. Canada, 2025 FCA 143, has highlighted a significant "tax trap" regarding the timing of these distributions.

The Mechanism of Subsection 104(19)

Subsection 104(19) of the Income Tax Act (ITA) allows the trust to designate taxable dividends received in the trust's taxation year from a taxable Canadian corporation to one or more beneficiaries. The designated beneficiary is deemed to have received dividends directly from the corporation, not from the trust, for most income tax purposes. This mechanism enables the trust to "flow through" the dividend income, allowing the beneficiaries to access tax attributes such as the dividend tax credit for individuals or the inter-corporate dividend deduction for corporations. This structure is also known as a "trust sandwich".

With respect to inter-corporate dividend deduction, subsection 186(1) of the ITA requires the recipient corporation to be connected with the payer corporation. Connectedness is satisfied if the recipient controls the payer or the recipient owns more than 10% of the voting shares and the value of the payer.

The Timing of Connectedness and Ruling

Subsection 104(19) applies to dividends received by, or flowed through, the trust during the trust's taxation year. But it is unclear exactly when during the trust's taxation year the issue of connectedness should be examined.

In Vefghi, the inter-corporate dividends flowed from the payer corporation, the operating corporation in the corporate ecosystem, through a discretionary trust to the recipient corporation, the holding corporation in the ecosystem. Shortly after the dividends were distributed, the holding corporation sold the operating corporation.

The CRA denied the holding corporation's claim of the inter-corporation dividend deduction because the two corporations were not connected at the year-end of the trust's taxation year. The holding corporation disagreed, arguing that the connectedness must be examined when the dividends were distributed to itself by way of designation by the trust.

The Tax Court of Canada (TCC) sided with the knowledgeable Canadian tax lawyer acting for the taxpayer, holding that it is at the time the dividends were paid to the recipient that the test of connectedness should be considered.

The Federal Court of Appeal (FCA) reversed that decision, siding with the CRA and ruling that connectedness must be tested at the trust's year-end (typically December 31).

The taxpayer has applied to the Supreme Court of Canada (SCC) for leave to appeal. It has not been decided whether the Supreme Court will hear the case.

But for now, the effect of the ruling by the Federal Court is significant. If the dividend issuer is sold after a dividend is paid but before December 31, the dividend will be subject to tax.

Pro Tax Tip—Strategic Planning and Compliance

To navigate the risks associated with flow-through dividend issuance, corporations and trusts must strategically manage the timing of the distribution and the corporate sale. The corporate beneficiary must maintain control or the 10% threshold of the payer corporation until the end of the trust's taxation year. If a sale of the operating company is planned, consider delaying the closing until after the trust's year-end when a dividend has already been distributed during that year. Corporations and trusts should consult with an experienced Canadian tax lawyer to ensure the integrity of the corporate and trust structure in order to avoid the pitfall set up by Vefghi.

FAQ

What is the primary tax risk for a "trust sandwich" structure if the underlying operating corporation is sold mid-year?

If an operating corporation is sold after it pays a dividend to a trust, but before the trust's taxation year-end, the "connected" status between the operation corporation, being the dividend payer, and the corporate beneficiary is severed. This results in the Canada Revenue Agency (CRA) assessing Part IV tax on the designated dividend, which would have otherwise been avoided if the shares were held directly or if the connection had been maintained until December 31.

What happens when the taxpayer in Vefghi appeals this decision?

The taxpayers in Vefghi have applied for leave to appeal to the Supreme Court of Canada as of October 2025. Until the Supreme Court decides to hear the case or issues a different ruling, the decision by the Federal Court remains the governing law.