This is the second part of a two-part article that discusses the inclusion and use of powers to add and remove beneficiaries ("PARBs") in drafting, planning, and establishing family trusts. Part I was published in Tax Topics No. 2174 on November 7, 2013.
PARBs are powerful tools; while some tax and trust practitioners are quite comfortable with using PARBs in Canadian discretionary family trusts ("Family Trusts"), these provisions have always made me uncomfortable.
In this two-part series I have been exploring the non-tax and tax issues associated with PARBs and although my research has eased some of my concerns, it has also led me to the conclusion that PARBs are not riskless "chicken soup" provisions. In particular, Part I of the series reviewed the more conventional non-tax and tax issues associated with PARBs, and Part II reviews some other potential tax issues that PARBs may pose for unsuspecting tax practitioners.
Tax Matters — Are There Other Issues?
As I thought more about PARBs, I began to wonder if the mere inclusion of such powers could give rise to other tax issues. This led me to look at the definition of "beneficially interested" in subsection 248(25) of the Income Tax Act (the "Act"),1 some of the more relevant portions of which are reproduced below.
(ii) because of the terms or conditions of the particular trust
or any arrangement in respect of the particular trust at the
particular time, the particular person or partnership might,
because of the exercise of any discretion by any person or
partnership, become beneficially interested in the particular trust
at the particular time or at a later time, and
(iii) at or before the particular time, either
(II) another person with whom the particular person or partnership, or a member of the particular partnership, does not deal at arm's length,
(III) a person or partnership with whom the other person referred to in subclause (II) does not deal at arm's length, . . .
Does the inclusion of a PARB mean that pursuant to paragraph (a) of this definition everyone in the world would become beneficially interested in the trust? I would hope not as I'm not sure that, say, the Prime Minister of Malaysia2 could be seen to have any "right . . . as a beneficiary under a trust" just because of the inclusion of such a clause. However, bad facts often lead to bad decisions,3 so I worry that the case that tests an issue will end up being the wrong one. Still, I would like to think a reasonable panel of judges and CRA officials would place sensible limits on paragraph (a) of the "beneficially interested" definition.
However, I think that the same reasonable panel of judges would find that where a trust includes a PARB, subclauses 248(25)(b)(iii)(A)(I)–(III) would likely result in anyone not at arm's length with the settlor/freezor being found to be beneficially interested in a trust with this type of power. Assuming that this is the case, then one needs to consider what provisions in the Act are impacted by a person's being beneficially interested in a trust (at least under paragraph (b)).
In that regard, because the term "beneficiary" is specifically defined in subsection 251.1(3) of the affiliated person rules to include persons beneficially interested in a trust, a PARB could result in a broader group of affiliated persons with a trust than one might otherwise have anticipated. Although it is hoped that in practice the application of the affiliated person rules between a trust and its "beneficiaries" would be rare, it is a risk that should be kept in mind.4
Fortunately, unless paragraph 248(25)(a) is applicable, a PARB should generally not overly expand the classes of persons who would be considered to be non-arm's length with a trust under paragraph 251(1)(b). This is because the determination of whether a taxpayer and a person beneficially interested in a trust are non-arm's length is to be made without taking into account subclauses 248(25)(b)(iii)(A)(II)–(IV).5 Consequently, it is hoped that it would be rare for other provisions in the Act that rely on non-arm's length relationships to be impacted by a trust that includes a PARB.
However, if the beneficially interested concept is applicable for purposes of subsection 55(2), then it appears that PARBs in trusts could cause those trusts to be unable to avail themselves of the exception to that provision, which might otherwise be available under paragraph 55(3)(a). The reason for this is that only trusts that meet the restricted related persons provisions in paragraph 55(5)(e)6 qualify for this exception. In this regard, although the CRA has indicated that "the concept of 'person beneficially interested' is irrelevant for the purposes of subparagraph 55(5)(e)(ii)", it also indicated that it "feel[s] that the right described in subparagraph 55(5)(e)(ii) I.T.A. and paragraph 248(25)(a) I.T.A. are fairly similar".7
It is unclear whether the CRA's views regarding subparagraph 55(5)(e)(ii) would also be applicable to situations caught by paragraph 248(25)(b). Nevertheless, given the CRA's conclusion, it would appear that the inclusion of a PARB might well be problematic for the purposes of subsection 55(2).
Until recently, I think that one could have stopped his or her review of the Act by merely reviewing the beneficially interested related provisions in the Act. For example, the CRA has previously provided rulings confirming that a person who was merely beneficially interested in a trust would not be subject to the association rules in section 256 if he or she was not a beneficiary of the trust.8 Unfortunately, due to the Propep decision, to be cautious, the analysis should also consider the provisions in the Act that rely on a person being a "beneficiary" under a trust.9
For those of you who don't recall this odd decision of the FCA,10 the facts involved a trust deed that was designed so that a specific individual would only be a beneficiary under the trust if the trustees exercised their discretion to make him a beneficiary, but the trustees had not exercised this discretion. Nonetheless, the Court found that the individual, a minor, was not just beneficially interested in the trust but was also a beneficiary of the trust. The result of the Court's decision was that the association rules in section 256 resulted in the corporation controlled by the trust and a corporation owned by the individual's father both being found to be associated corporations. Although one would hope that the application of Propep would be limited, the existence of the decision may make reliance on the comments made by the CRA prior to Propep risky.
Conclusion — Chicken Soup?
There is no question that in appropriate circumstances the inclusion of PARBs in Family Trusts may be beneficial and that for certain well-informed clients these benefits may outweigh any risks in doing so.
However, I don't think that these clauses are like "chicken soup". My concern is that, over time, PARBs will find their way into standard terms in Family Trust precedents (similar to what has transpired in the off-shore trust world), and that for the non-tax and the tax reasons described in this article they could result in real "hurt". Moreover, because modern Family Trusts can often be drafted with corporate, trust, and bail-out11 beneficiaries, it appears that they can usually be drafted to provide all of the flexibility one would hopefully ever need.12
The author wishes to thank Elie Roth of Davies Ward Phillips & Vineberg as well as a number of other tax and trust specialists who provided comments on earlier versions of this article. Any errors or omissions are the author's sole responsibility.
1 All statutory references are to the Act.
2 Zoolander, Dir. Ben Stiller, 2001.
3 See Propep Inc. v. R., 2009 DTC 5170 (discussed below).
4 Some other provisions that employ the "beneficially interested" phrase include: paragraph (c.1) of the definition of "principal residence" in section 54, which requires that everyone beneficially interested in a trust be listed where the principal residence is claimed by a trust; and subsections 191(2) and (3), which deal with the "substantial interest" exception in the context of Part VI.1 taxes.
5 Subclause 248(25)(b)(iii)(A)(IV) deals with controlled foreign affiliates.
6 Generally, trusts where the only beneficiaries are the lineal descendants of an individual and/or registered charities, which is quite typical in many traditional Family Trust situations.
7 See CRA Document No. 2004-0086961C6, October 8, 2004.
8 See CRA Document No. 2008-0285041C6, October 10, 2008.
9 Although the "beneficiary" definition is used regularly throughout the Act, in this article comments will be limited to the application of this definition in connection with the association rules.
10 Propep Inc. v. R., 2009 DTC 5170. See Jack Bernstein, "Association through a Trust: When Is A Person a Beneficiary?", Tax Profile No. 3 (March 2010).
11 Usually the freezor in a Family Trust used for an estate freeze.
12 Different considerations might apply to older trusts that don't have some or all of these types of provisions—but such trusts likely wouldn't have had powers to add or delete beneficiaries either.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.