Michael Goldberg, Tax Partner, Minden Gross LLP, MERITAS law firms worldwide and 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.
Special 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.
Part I of this series of articles reviewed some of the basic tax requirements for using trusts to split income. In the second instalment of the series we will review some common income splitting opportunities that are accessible through the use of trusts. In particular, capital gains exemption ("CGE") multiplication planning, preferred beneficiary and age 40 trust planning, prescribed rate loan planning, and Ontario surtax planning will each be reviewed in turn.
CGE Multiplication Using Trusts
Although it is possible to multiply the CGE among family members by issuing shares directly to the family members, doing so can result in the current shareholder suffering a loss of both control over the shares and flexibility in arranging his or her future planning. For example, unborn persons at the time the planning is put in place would not be eligible to share in the CGE multiplication. Also, for various personal, creditor or other reasons, the benefit of hindsight might have lead the current shareholder to determine that it would have been better not to give shares to a particular person. Unfortunately, once property, such as shares, has been given away it is often very difficult to get it back.
Provided that one is dealing with a typical discretionary family trust deed, multiplication of the exemption should be possible by relying on the rules in subsections 104(21) and (21.2) of the Income Tax Act (Canada) (the "Act").1 In addition, it should generally be possible to avoid many of the drawbacks associated with direct share ownership since, subject to the trustees complying with their fiduciary duties, they will generally be free to choose to allocate the exempt capital gains (i.e., CGEs) among some or all of the trust beneficiaries, including beneficiaries who were born following the creation of the trust.
Preferred Beneficiary Election and Age 40 Trusts
In addition to the general rules that permit income splitting, there are some special rules that permit income splitting and CGE multiplication without making amounts payable to beneficiaries.
For example, when a "preferred beneficiary election" can be in compliance with the tests set out in subsection 104(14) it will be possible to cause income of a trust to be taxable in a qualifying beneficiary's hands even though no amount is made payable to the beneficiary. However, since 1995 the ability to use the preferred beneficiary election has generally been limited to situations involving disabled beneficiaries. Prior to that time, the preferred beneficiary election was much more widely used.
Another special situation that can enable income splitting without making amounts payable is where the so-called "age 40 trust" rules in subsection 104(18) are complied with.2
In order to qualify as an age 40 trust, amounts that would otherwise been income of a trust in a particular taxation year must meet a number of conditions. In particular, the amounts cannot have become payable in the year and they must be held in trust for an individual who has not turned 21 in the year. In addition, the individual beneficiary's rights must have vested and they must not be subject to the exercise or failure to exercise any discretionary power. Finally, the individual beneficiary's rights must not be subject to any conditions to receive the income other than that the individual survive to an age not exceeding 40 years. It is for this reason that these trusts are often referred to as age 40 trusts.
Prescribed Rate Loan Planning
The Loan for Value Exception
In general, low interest rate loans that are made directly or indirectly through a trust to spouses (including commonlaw partners), non-arm's length minors, and other non-arm's length persons that allow such persons to earn income from property will be caught by the personal attribution rules in the Act,3 which will result in all of the income and losses (and for spouses all of the capital gains and capital losses) being attributable back to the lender. Fortunately these rules will not apply in any situation involving "loans for value".4
Planning that uses the loans for value exemption to the attribution rules is commonly referred to as prescribed rate loan planning. In order to qualify for the loan for value exception to the personal attribution rules, a loan will need to meet a number of conditions.5
First, the loan must bear interest at the lesser of the prescribed rate of interest in place at the time the loan is made and an arm's length interest rate at that time. In general, the prescribed rate will be the lower of these rates, and currently that rate is 1%. In addition to bearing interest at the appropriate rate, interest on the loan must actually be paid to the lender no later than 30 days after the end of the particular year. This latter condition is extremely important since a failure to pay interest by the time limit in any particular year will cause the prescribed rate exception to cease to apply to that loan forever.
Benefits of Prescribed Rate Loan Planning
Although loans for value could be and often are directly made to individuals, the flexibility and control provided by making these loans to trusts often makes trusts the ideal vehicle of choice for making such loans. Almost continuously since the middle of 2009, it has been possible to lock in a prescribed rate loan at a 1% interest rate. The result of the rate being so low is that a borrower who has received such a loan does not need to generate very much net income from the loan in order to cover the debt payments and, assuming that the borrower is taxed at a lower rate than the lender, income splitting will have been achieved. Of course, if actual returns earned by the of the planning are factored in.6 Also, since interest must actually be paid each year it will be desirable that the investments generate annual cash returns to facilitate payment.
Although equity markets have been generally performing extremely well as of late, interest sensitive markets have continued to lag, which might make prescribed rate loan planning less beneficial for some fixed income investors. However, over time it is anticipated that even the returns in these markets will return to historical norms and since, subject to future legislative changes, the current 1% prescribed rate can be locked in forever, putting this planning in place while rates are low may yield long-term family benefits.
Modifications to Higher Rate Pre-Existing Prescribed Rate Loans
Because prescribed rate loans are forever, some clients may still have older prescribed rate loans in place at rates in excess of the current 1% prescribed rate. If you run into one of these older loans and want to impress your client by helping them to refinance the loan to take advantage of the current 1% prescribed rate, you will want to make sure you do it correctly.
Simply amending the rate on the loan does not work. Neither does refinancing the loan with proceeds of a new loan. In fact, it appears that the only way to refinance an existing prescribed rate loan with a lower prescribed rate loan is for the borrower to actually dispose of its income earning properties and to use the proceeds to repay the original loan.7 In some cases this may result in the realization of taxable income on the disposition and, as a result, it may turn out that leaving the high rate loan in place will continue to be preferable to refinancing the loan.
Ontario Provincial Surtax Planning
In general, if the Kiddie Tax rules in section120.4 are applicable to income earned by a child, the child will pay tax on that income at the child's top marginal tax rate. While this is generally true, in Ontario there may still be some advantage to income splitting with minor children provided that the child has little, if any, other income. borrower are also low, the benefits of the income splitting may be quite limited, especially when costs and aggravation
The reason for this benefit is that Ontario provincial surtaxes will not become payable until the child's income exceeds the Ontario provincial surtax thresholds. Savings from this type of planning are generally quite modest. For example, for each minor receiving $42,000 of ordinary investment income, split income savings in 2014 will be a bit less than $2,900. Actual savings will differ depending on the type of income earned and may be more or less than this amount. There will also be some additional compliance costs to this planning so actual savings will be somewhat lower than this amount, but for some, even with these costs and depending on the number of minor children a person has, this planning will still be worth pursuing.
[Please note: At the time of publication, the 2015 Ontario Budget had not yet been presented.]
This article first appeared in the Wolters Kluwer newsletter The Estate Planner No. 243, dated April 2015.
1 Unless otherwise noted all statutory references are to the Act. These rules were discussed in Part I of this series of articles under the heading "Character of Income".
2 Rules in subsections 104(13.1) and (13.2) might also be used to designate amounts paid by a trust to a beneficiary as being taxable only in the trust, which can give rise to a number of income splitting benefits. For example, for testamentary trusts these rules would allow designated amounts paid out to beneficiaries to still enjoy the testamentary trust's graduated tax rates. Even where non-testamentary trusts are used, these rules may provide certain inter-provincial tax planning benefits. However, due to the December 16, 2014, enactment of Bill C-43, Economic Action Plan 2014 Act, No. 2 (discussed further in Part III of this series of articles), effective for the 2016 and subsequent taxation years, the ability to utilize the designations provided under these provisions will be significantly restricted.
3 See, in particular, subsection 56(4.1) (low interest loans made for the benefit of non-arm's length persons where certain reasonability tests are met), sections 74.1 (income or losses from the transfer or loan of property made for the benefit of spouses or minors), section 74.2 (capital gains or capital losses from the transfer or loan of property made for the benefit of spouses), and section 74.3 (extends the rules in sections 74.1 and 74.2 to loans made to certain trusts).
4 The rules in section 120.4 (Kiddie Tax rules), while not attribution rules, must also be kept in mind when prescribed rate planning involves minors.
5 The loan for values in respect of subsection 56(4.1) are found in subsection 56(4.2) and nearly identical rules in respect of sections 74.1, 74.2, and 74.3 are found in subsection 74.5(2) (there are also exclusions for transfers made for fair market value consideration in subsection 74.5(1) but these are not relevant to this discussion).
6 Consequently, unless the amount of a prescribed rate loan is substantial, it will generally not be worth implementing this strategy.
7 See CRA Document No. 2002-0143985, dated October 18, 2002 and CRA Document No. 9336625, dated April 29, 1994.
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.