Taxation of Personal Trusts

Introduction

The use of trusts in estate planning gives rise to a variety of tax issues. In some circumstances the use of a trust as part of an estate plan can minimize or defer income tax liabilities, but if drafted incorrectly, or without the proper considerations, the trust could lead to unintended and adverse tax consequences. The purpose of this paper is to highlight not only the tax benefits that personal trusts can provide, but to also highlight some key issues which, if not addressed, could lead to significant problems.

This paper will deal only with “personal trusts”. A “personal trust” is defined in the Income Tax Act (Canada) as either a testamentary trust or an inter vivos trust in which no beneficial interest has been acquired for consideration paid either to the trust or to a contributor to the trust.[1]

Testamentary Trusts vs. Inter Vivos Trusts

A testamentary trust is a trust that arises on and as a consequence of the death of an individual, subject to certain limitations.[2]  An inter vivos trust is a trust that is created during a person’s lifetime.

A testamentary trust may qualify as a graduated rate estate (a “GRE”) if certain requirements are met, and then only for 36 months after the death of the individual. GREs are taxed at graduated tax rates.  When a testamentary trust ceases to be a GRE (either because of the expiration of the 36 month time period or for some other lack of qualification) or when a trust arising as a consequence of the death of any individual loses testamentary trust status generally, such trust becomes subject to tax at the highest marginal rate, notwithstanding that it may have originally qualified as a testamentary trust or a GRE.

GRE’s may provide an opportunity for income splitting where the income of a GRE that would otherwise be paid to a beneficiary subject to tax personally at a high marginal rate is retained in and taxed in the trust. This opportunity is limited to the first three years of the estate that the trust qualifies as a GRE.  An individual is only entitled to one GRE.

Inter vivos trusts are subject to the highest marginal rate of tax on all of the income retained in the trust (with very limited exceptions).[3]

Spousal Trusts

A trust may be created by an individual for the benefit of his or her spouse or common law partner. A spousal trust can either be inter vivos (created during the lifetime of the settlor) or testamentary (created upon death of the settlor).  Testamentary spousal trusts are commonly used where the settlor wishes to ensure that the property held by the trust will pass to the next generation and not be wasted or sold by the surviving spouse.

To qualify as a spousal trust, two conditions must be met:

  • the spouse or common law partner of the settlor must be entitled to receive all of the income of the trust that arises before the death of such spouse or common law partner (this right to income cannot be subject to the trustee’s discretion or limited in anyway); and
  • no person, other than the spouse or common-law partner, may receive or obtain the use of any of the capital of the trust before his or her death.[4] Note that it is not required that the spouse receive the capital of the trust, but no one other than the spouse may receive it during his or her lifetime.

The spouse’s right to income could be an asset that is available to satisfy claims of the spouse’s creditors.

Where a person transfers property to a trust, a disposition under the Act is generally triggered, thereby giving rise to deemed proceeds of disposition equal to fair market value of the property which may result in a taxable capital gain. However, transfers of property to a spousal trust can occur on a tax-deferred basis under subsection 73(1) (for an inter vivos spousal trust) or under subsection 70(6) (for a testamentary spousal trust).  These rollover provisions do not eliminate the tax – they just defer the tax until the spouse disposes of, or is deemed to have disposed of, the property (for example, upon the later death of the spouse), at which time any gain on the property will be subject to tax.

Residence of a Trust

A trust that is resident in Canada will be liable to tax on its worldwide income under subsection 2(1) of the Act. In certain circumstances, it may be desirable to ensure that a trust is not resident in Canada for tax purposes (for example, when certain international tax planning is involved), but in other circumstances, it may be desirable to ensure that a trust is resident in Canada for tax purposes (for example, where some of the trustees are resident in the U.S. and the tax treatment would be more beneficial if the trust were resident in Canada).  Whatever the situation, where there is a potential residency question, it will be important to understand the trust residency test in order to properly advise your client.

The Act does not define how the residency of a trust is determined and therefore the tests for residency have been established by the Courts.

Trustee of Thibodeau Family Trust v. The Queen

Until 2010, the leading Canadian case on the determination of the residency of a trust was Trustee of Thibodeau Family Trust v. The Queen, 78 DTC 6376, a decision of the Federal Court Trial Division.  The trust at issue in Thibodeau had three trustees, two of whom were resident in Bermuda and one of whom was resident in Canada.  The trust deed provided that decisions of the trustees were to be decided by a majority vote.  The evidence showed that on at least five occasions, the two Bermuda trustees overruled the investment proposals made by the Canadian trustee.  On these facts, the Court held that the trust was resident in Bermuda, on the basis that the residence of the majority of the trustees determines the residence of a trust.

Garron Family Trust (Trustee of) v. The Queen and Fundy Settlement v. Canada

The facts in both the Garron and Fundy cases involved discretionary family trusts.  The sole trustee of which was St. Michael Trust Corp, a trust company incorporated and licensed in Barbados.  Capital gains were triggered by the trusts and the trustees took the position that the trusts were resident in Barbados and therefore the capital gains were not subject to tax in Canada pursuant to the terms of the Canada-Barbados Tax Treaty.  The Minister of National Revenue took the position that the trusts were resident in Canada.

At the Tax Court level Justice Woods established the test that the residence of a trust should be based on “where the central management and control of the trust actually abides.” It was determined that central management and control will not necessarily always be in the same place where the trustees reside if the trustees do not actually manage and control the trust property.  In Garron and Fundy, the Court found that Canadian residents made all of the substantive decisions concerning the trust property, even though they were not trustees themselves.  In these cases, the role of the Barbados trustee was limited to executing documents and providing incidental administrative services.  As a result, the Court held that central management and control of the trusts were located in Canada and the trusts were therefore resident in Canada.

Garron was appealed to the Federal Court of Appeal which accepted the management and control test set down by the Tax Court.[5]  A further appeal to the Supreme Court of Canada ended with the same result.[6]  It is important to note, and the Federal Court of Appeal did remark, that the residence of the trust may, in certain circumstances, be a sufficient basis for determining the residence of a trust where the facts show that the trustee actually exercised management and control of the trust property in the jurisdiction where he or she resides.  This is consistent with Thibodeau because there the evidence showed that the Bermuda trustees did in fact exercise management and control.

Allocation of Income to Beneficiaries

A trust is taxable on the income its earns during the year. Where an amount is paid or payable in the year by a trust to a beneficiary such amount is taxed in the beneficiary’s hands[7] and the trust is able to deduct such amount.[8]  Therefore a trust is only taxable on income which is accumulated in the trust.

A trust may designate certain income, which is payable to one or more beneficiaries, to be taxed in the trust.[9]  A similar designation can be made for capital gains realized in a trust that are payable to a beneficiary.[10]  In circumstances where a beneficiary is taxed at the highest marginal rate, and the trust is taxed at a lower rate (e.g. such as a GRE with a smaller amount of income) it may be worthwhile to have the income or capital gains taxed in the trust at a lower marginal tax rate and paid out to the beneficiary on an after-tax basis.

Income earned by a trust will generally lose its character when distributed to a beneficiary and will generally be characterized as income from property.[11]  However, certain designations are available to ensure that certain types of income retain their character:

  • Subsection 104(19) of the Act provides that a Canadian resident trust may deem a taxable dividend received from a taxable Canadian corporation to be received by the beneficiary directly. The effect of this is that for an individual beneficiary who is resident in Canada, he or she will be entitled to the gross-up and dividend tax credit. Similarly a corporate beneficiary will be entitled to a tax-free intercorporate dividend.  Canada Revenue Agency (CRA) has also taken the administrative position that subsection 104(19) of the Act also applies to eligible dividends such that an eligible dividend received by a Canadian resident trust can be treated as eligible dividends in the hands of the recipient beneficiary.[12]
  • Subsection 104(20) of the Act allows a Canadian resident trust to make a designation in respect of capital dividends so that capital dividends received by a trust can be treated as capital dividends when distributed to a beneficiary. This is significantly beneficial to recipient beneficiaries. It also means that capital dividends distributed to a corporate beneficiary and designated by the trust under subsection 104(20) of the Act can also be added to the capital dividend account of the recipient corporation.[13]
  • Subsection 104(21) of the Act allows a trust to make a designation in respect of taxable capital gains realized by the trust such that those capital gains are taxed as such in the hands of the beneficiaries. This designation is particularly useful where the beneficiary has capital losses available to offset the taxable capital gains. Note that a beneficiary may not claim the capital gains exemption based on a104(21) designation alone unless the trust also makes an additional designation under subsection 104(21.2).

21 Year Deemed Disposition Rule

In order to prevent an indefinite deferral of capital gains on property held by a trust, the Tax Act imposes a deemed disposition at fair market value of certain property held by a trust.[14]  Without such a time limit, there could potentially be an indefinite deferral of capital gains on property held in a trust.  For most inter vivos trusts (other than spousal trusts, alter ego trusts and joint partner trusts), a deemed disposition will occur on the twenty-first anniversary of the date of settlement of the trust, and every twenty-one years thereafter.[15]  The first deemed disposition for a spousal trust is on the date of death of the spouse of the settlor followed by further deemed dispositions every 21 years thereafter.

The effect of the 21 year deemed disposition depends on the nature and type of assets held in the trust. If the trust assets have a high cost base (for example, public company shares that are regularly traded), the tax consequences of the deemed disposition will be insignificant if the accrued gains are minimal.  However, if the trust assets have a low cost base and substantial capital gains have accrued (such as may be the case with real estate), the tax triggered by the deemed disposition could be significant.

A common strategy employed to deal with the 21 year deemed disposition is for the trustee to distribute the trust property that has accrued gains to one or more of the capital beneficiaries prior to the 21 year deemed disposition date pursuant to subsection 107(2) of the Act.[16]  Subsection 107(2) will only apply where the following requirements are met:

  • The trust must be a personal trust;
  • The beneficiary receiving the property must dispose of all or part of the beneficiary’s capital interest in the trust; and
  • The beneficiary must be a resident of Canada.

Under this subsection, the trust is deemed to dispose of the property for its cost amount and the beneficiary is deemed to have acquired the property at the same cost amount. The trust therefore recognizes no capital gain or loss.  This provision therefore just provides a deferral of the tax until the beneficiary later disposes of, or is deemed to have disposed of, the property (for example, upon death of the beneficiary), at which time the gain on the property will be taxed in the hands of that beneficiary.  This rollover treatment is severely restricted where the attribution rule in subsection 75(2) applies.  This is discussed in more detail below.

Another strategy to avoid a deemed disposition is to cause all of the interests in the trust to vest indefeasibly.[17]  In other words, the trustee of a trust can avoid the application of the deemed disposition by simply fixing the interests of the beneficiaries without actually making a distribution (subject to a limitation that less than 20% of the interests being vested in non-resident beneficiaries).

In some cases, it may be impractical or imprudent to distribute the trust property to any of the capital beneficiaries. If no steps are taken to deal with the deemed disposition rule, the deemed disposition will occur and tax will be payable if gains are triggered as a result.

Attribution Subsection 75(2)

When applicable, subsection 75(2) of the Act causes any income or losses and capital gains or capital losses earned by an inter vivos trust in respect of the particular property to be attributed to the person who transferred that property to the trust.

Subsection 75(2) of the Act will apply where property is held by a trust on condition that the property:

  1. may revert to the person from whom the property (or property for which it was substituted) was directly or indirectly received;
  2. may pass to persons to be determined by the person who transferred the property at a time subsequent to the creation of the trust; or
  3. cannot be disposed of, during the lifetime of the person who transferred the property, except with that person’s consent or in accordance with that person’s direction.

Pursuant to the first condition, subsection 75(2) will apply if the trust deed allows the settlor (or any other person who contributes property to the trust) to get the property back, even if the ability to reacquire the property is remote. The obvious way in which this condition will be met is where the person that contributed the property to the trust is a potential capital beneficiary of the trust.  But it may also apply in respect of an indirect transfer, such as where an individual makes a gift of property to his spouse, the spouse subsequently transfers the property to a trust and the individual is a capital beneficiary of the trust.[18]  If the individual is named as an income beneficiary, however that does not appear to be caught by subsection 75(2).

Pursuant to the second condition, subsection 75(2) of the Act will apply if a person who transferred property to the trust has the power to exercise control over who will receive the contributed property. This condition will be satisfied where the trust is discretionary and the person from who transferred the property to the trust is a controlling trustee (or if the person has a veto).

Pursuant to the third condition, subsection 75(2) of the Act will apply when a person who transfers property to the trust acts as the sole trustee or has veto power as trustee. Specifically, it will apply in the following circumstances where the person that contributed the property:

  • is the sole trustee;
  • is one of two trustees of the trust if the trust expressly requires the contributor’s consent to any decisions made by the trustees as a whole;[19] or
  • is one of three or more trustees of a trust and the trust deed has a majority rule clause that requires the contributor to be part of the majority.[20]

If subsection 75(2) applies, the income or losses and capital gains or capital losses from the particular property will be attributed to the person from who transferred the property to the trust as long as the person is alive and resident in Canada.

The most significant consequence of subsection 75(2) is that once it applies, it will prevent a tax-free rollout of property from the trust to its capital beneficiaries (other than the person who contributed the property). As mentioned above, subsection 107(2) allows a trust to distribute property to a capital beneficiary on a tax-deferred basis.  However, subsection 107(2) does not apply if subsection 107(4.1) applies.  Subsection 107(4.1) provides that if subsection 75(2) applies “at any time” in the history of the trust, the trust will not be able to distribute any property of the trust on a tax-deferred basis to any beneficiary except where the property is transferred back to the person who contributed the property (or the person’s spouse or common law partner) and that person is a beneficiary of the trust.

It is important to note that subsection107(4.1) applies to all property of the trust, not just the transferred property that gave rise to the application of subsection 75(2).

Subsection 107(4.1) will cease to apply only if the person that contributed the property that triggered the application of subsection 75(2) ceases to exist (for example, on the death of an individual contributor).

If subsection 107(4.1) applies, distributions of property from the trust to a beneficiary (other than the contributor) will be deemed to have occurred for fair market value proceeds of disposition and the trust will realize any accrued gains on the property.

Conclusion

There are several tax issues that estate practitioners should be aware of when dealing with testamentary and inter vivos trusts.  Whether it is questioning the residency of a trust based on central management and control, or considering planning in advance of a 21st anniversary, estate practitioners must be diligent in considering whether tax issues arise in the particular circumstances of the client.

 

[1] Subsection 248(1) of the Income Tax Act (the “Act”)

[2] Definition of “testamentary trust” in subsection 108(1) of the Act

[3] Subsection 122(1) of the Act

[4] Subsection 73(1), (1.01) of the Act

[5] St. Michael Trust Corp. as Trustee of the Fundy Settlement v. The Queen, 2010 FCA 309

[6] St. Michael Trust Corp. as Trustee of the Fundy Settlement v. The Queen, 2012 SCC14

[7] Subsection 104(13) of the Act

[8] Subsection 104(6) of the Act

[9] Subsection 104(13.1) of the Act

[10] Subsection 104(13.2) of the Act

[11] Paragraph 108(5)(a) of the Act

[12] Income Tax Technical News No. 41

[13] Paragraph (g) of the definition of “capital dividend account” under subsection 89(1) of the Act

[14] Subsections 104(4), 104(5) and 104(5.2) of the Act

[15] Subsection 104(4) of the Act

[16] The rollover in subsection 107(2) of the Act does not apply to distributions to non-resident beneficiaries.

[17] Paragraph (g) of the definition of “trust” in subsection 108(1) of the Act

[18] Brenda L. Crockett, “Subsection 75(2): The Spoiler” in “Personal Tax Planning,” (2005), vol 53, no 3 Canadian Tax Journal, 806-830

[19] CRA Views 2008-0292061E5 – Application of subsection 75(2) dated October 27, 2008

[20] CRA Views 2008-0292061E5 – Application of subsection 75(2) dated October 27, 2008