Michael Goldberg, Tax Partner, Minden Gross LLP, MERITAS law firms worldwide and Number 627 founder of "Tax Talk with Michael Goldberg", a quarterly conference call about current, relevant and real life tax situations for professional advisors who serve high net worth clients.
Thanks to Ryan Chua of Minden Gross LLP for his comments on earlier drafts of this series of articles. All errors and omissions are the author's.
Based on a host of recently enacted legislation attacking the use of offshore trusts by Canadians,1 eliminating immigration trusts, severely restricting testamentary trust tax benefits, generally attempting to eliminate inter-provincial testamentary tax planning opportunities,2 and so on, it seems safe to say that the federal government views the use of trusts in Canada dimly these days. And yet, even following all of this legislative upheaval, and even if one assumes that more changes may still be coming, it is likely that trusts will continue to be highly used estate planning and succession planning vehicles in Canada.
The main reasons for the endurance of trusts for these purposes are that they are incredibly useful tools that permit individuals to maintain varying amounts of control over assets that they dispose of as part of their estate and succession planning, whether such dispositions occur while they are alive or after they are dead, and due to the flexibility that can be built into trusts to accommodate all manners of changes in family situations. Another significant reason that trusts will continue to be used is that, even with all of the legislative changes and the general chilly tax climate impacting trusts, they continue to provide a host of opportunities for shifting income from high rate taxpayers to low rate taxpayers, which is generally referred to as income splitting.
In the first instalment of this series of articles, some of the basic tax requirements for using trusts to split income will be reviewed. The second instalment of the series will delve into a number of common income splitting opportunities that are accessible through the use of trusts, namely:
- planning to allow additional family members to access their capital gains exemption (sometimes called capital gains exemption (or CGE) multiplication);
- preferred beneficiary and age 40 trust planning;
- prescribed rate loan planning; and
- Ontario surtax planning.
The third instalment of the series will provide a historical overview of income splitting using testamentary trusts, and will touch on the upheaval to trusts, wills, and estates practices caused by the enactment of Bill C-43. Finally, in the last instalment of the series we'll review some of the benefits and risks of planning with Alberta trusts and with trusts deemed to be resident under subsection 94(1) of the Income Tax Act (the "Act").3
Income Splitting Basics
Income and Capital Encroachment
The ability to use a trust to income-split with family members is dependent on the actual terms of the instrument under which any particular trust is formed.4 For example, discretionary family trust deeds will generally contain broadly drafted powers to permit trustees to make discretionary allocations of income and capital among the beneficiaries of a trust. In addition, a properly drafted trust deed should define "income" as including income for all purposes of the Act.
Unfortunately, many older trust deeds will not include a definition of income that dovetails with the Act. For example, I've seen some trusts where income has been defined as income for GAAP purposes. In other situations, I've seen trust deeds where there is no definition of income at all, in which case the income of those trusts is left to be determined under the law of trusts.
In both of these cases, the terms of the trust deed will likely not permit the allocation of capital gains or "phantom income"5 to beneficiaries. However, so long as the trust deed contains a broad capital encroachment power, it may still be possible to structure capital distributions that permit the trust to allocate its actual realized taxable capital gains income to capital beneficiaries and, under certain circumstances, it may even be possible to allocate taxable income from deemed capital gains to capital beneficiaries.6
Taxable Allocation of Income and Losses
Assuming that it is possible to allocate income from a trust for trust and tax law purposes, then it should be possible to use a trust for income splitting because, pursuant to subsection 104(13), amounts allocated and made "payable" to a beneficiary in a particular year will be taxable in the beneficiary's hands instead of in the trust.7 For purposes of this and a number of other provisions in section 104, subsection 104(24) deems amounts not to have become payable unless the amounts have either been actually paid to a particular beneficiary in the taxation year or unless that beneficiary has a legally enforceable right against the trust for payment of such amounts in that taxation year.
Although it is possible to allocate income to beneficiaries, losses realized in a trust cannot be allocated from a trust to its beneficiaries.8
Character of Income
Generally, income earned by a trust loses its character once it is distributed to beneficiaries,9 so maintaining the character of allocated taxable income in the hands of beneficiaries is very important. Fortunately, section 104 contains specific rules to ensure that certain types of income retain their character.10
For example, subsection 104(19) ensures allocated taxable dividends will be treated as taxable dividends in the hands of trust beneficiaries, and subsection 104(20) ensures that the tax status of capital dividends is maintained. In addition, provided that a trust has been drafted appropriately, it should be possible for the trust to allocate realized capital gains to its beneficiaries under subsection 104(21) and, provided that the trust contains a broad definition of income that captures deemed capital gains, it should be possible for these types of capital gains to be allocated as well. In both cases, if the capital gains would otherwise be eligible for CGE treatment, then through the joint operation of subsections 104(21) and (21.2), the trust's beneficiaries will be able to claim their personal CGEs, assuming the beneficiaries are otherwise eligible to do so.
As was mentioned previously, even without broad income definitions in the trust deed, so long as the trust deed contains broad capital encroachment powers, and provided that capital distributions are made in the year that those gains are realized, it may still be possible to allocate the trust's capital gains and exempt capital gains (CGEs) to capital beneficiaries.11
Complying with the Terms of the Trust
In order to enjoy the benefits of income splitting and CGE multiplication, allocations of trust income and distributions of trust property must be made in accordance with the terms of each particular trust deed to beneficiaries of a particular trust or, if the terms of the trust permit, for the benefit of those beneficiaries.
If the trustees of a trust purport to make allocations or distributions to non-beneficiaries of the trust, such trustee actions will be made in breach of the terms of the trust deed and, in addition to any trust law consequences of such breaches, the income that was intended to be allocated will, for purposes of the Act, remain taxable in the trust. In addition, a tax-deferred rollout of appreciated property of the trust pursuant to subsection 107(2) to persons who are not beneficiaries of the trust will not be possible. As a result, if distributions of trust property are made to non-beneficiaries, the trust will be fully taxable on any unrealized gains in respect of such distributions.12 This latter issue can be particularly problematic for trusts reaching their 21st anniversary. If these results aren't bad enough on their own, the recipient of such allocations and distributions will likely be considered to have received a benefit from the trust which would subject that person to tax on the value of the benefit under subsection 105(1).
This article first appeared in the Wolters Kluwer newsletter The Estate Planner No. 242, dated March 2015.
1 See Bill C-48, Technical Tax Amendments Act, 2012, which received royal assent on June 26, 2013.
2 All of these items were dealt with in Bill C-43, Economic Action Plan 2014 Act, No. 2 ("Bill C-43"), which was enacted on December 16, 2014.
3 Unless otherwise noted, all statutory references are to the Act.
4 Among other terms for this instrument, it is sometimes called a trust deed or a trust settlement.
5 For example, deemed dividends on redemptions or deemed capital gains, such as those that occur on the 21st anniversary of a trust.
6 For examples of how this might be accomplished, see CRA document number 9531165 dated March 13, 1997, and CRA document number 9428005 dated February 24, 1995.
7 To avoid double taxation, the Act will generally permit a trust to claim a deduction for amounts that become payable in the hands of its beneficiaries pursuant to the terms of subsections 104(6) or 104(12).
8 However, pursuant to subsection 75(2), where this provision applies to a transferor of property to the trust, all income and capital losses from such property (or substituted property) will attribute back to the transferor. Losses of a trust from an active business will not attribute back to the transferor (see CRA document number 2013-0476871E5 dated October 3, 2014).
9 Pursuant to subsection 108(5)(a) income received by a beneficiary from a trust is generally characterized as income from property.
10 One example of where taxable income allocations will lose their character is if they are made to non-residents. In such cases the rules in subsection 212(1) will need to be consulted, as modified by tax treaty, if any. 10
11 Supra, footnote 5.
12 See, for instance, CRA document number 9637535 dated January 9, 1997.
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.