Discretionary family trusts are used extensively for tax, family and succession planning, as they afford enormous flexibility. In most cases, when such trusts are created, beneficiaries do not pay for their interest, and this assumption is made herein. Once a trust is settled, it will exist until all the assets are distributed to the beneficiaries and the trust is wound up.
Upon death, Canadian resident individuals are deemed to dispose of their assets at fair market value ("FMV"). Many trusts do not have a finite lifespan. To prevent income tax from being deferred across multiple generations, a trust is deemed to dispose of most of its capital assets every 21 years on the anniversary of its creation. Immediately thereafter, those assets are deemed to be reacquired at the then-FMV and the 21-year clock begins again. As an example, if a trust holds common shares of privately held companies, any inherent gains would be triggered every 21 years.
Subject to some exceptions, there is planning to defer payment of tax that would otherwise be payable on the 21-year anniversary date. The Income Tax Act ("Act") generally allows the trustee(s) to distribute trust capital property on a roll-out basis to Canadian-resident beneficiaries in satisfaction of all or a part of their capital interest in a trust. In these circumstances, the trust is deemed to have received proceeds of disposition equal to its cost and not FMV. The recipient-beneficiaries assume the same cost amount. The result is a deferral of income tax on capital gains on trust assets until the recipient-beneficiary's death (or the death of his/her spouse or common-law partner, depending upon the recipient-beneficiary's Will, whichever is later).
When a 21-year anniversary date approaches, most trustees assess the merits of using the roll-out provisions to distribute capital properties to beneficiaries. It should always be recognized that there are many commercial and family issues in addition to the tax issues which need to be considered.
When planning to distribute capital assets using the tax-deferred rollout, the trustee(s) should carefully review the trust settlement documents, previous trust transactions and the status of potential recipient-beneficiaries.
First, the trust trustee(s) must determine if the settlement documents grant the trustee(s) the authority to distribute capital assets before the trust is wound up and if so:
- Which beneficiaries are entitled to capital assets of the trust; and
- What discretion do trustee(s) have as to the percentage of the capital assets each beneficiary can, or must, receive.
The trustee(s) must also determine if a tax-deferred rollout is available, as the rules do not apply in every circumstance. In particular, a tax-deferred rollout is not available in circumstances where:
- The settlor of the trust has retained sufficient influence as
to if, how and when trust assets are distributed to the trust
beneficiaries. Where this circumstance exists, the tax-deferred
rollout is not available for property distributed to any person
other than the settlor or his/her spouse or common law
The tax-deferred rollout can be denied to the unwary if the trust settlement documents are drafted too broadly and the settlor has influence which he/she could use, even where there is no intention to do so.
- A Canadian-resident trust distributes property to any
person who is not resident in Canada.
- Where a trust is settled in favour of an individual
over 64 years of age for the benefit of the individual and/or the
individual's spouse or common law partner, or in the case of
certain trusts settled on behalf of an individual because of the
death of their spouse of common law partner, and property is
distributed to a beneficiary other than that individual and/or
his/her spouse or common law partner.
- The rollout is a qualifying transfer, which broadly means the rollout does not result in a change in the beneficial ownership of the distributed assets.
In the above four circumstances, the tax-deferred rollout denial is automatic. In addition, an election can be made so that the tax-deferred rollout does not apply in the following additional circumstances:
- The trustee(s) of a trust makes the election on the
roll-out of certain properties which, in very general terms,
- In the case of a Canadian-resident trust, any property.
- In the case of a non-resident trust:
- Real estate (or an interest therein) situated in Canada.
- Certain insurance properties.
- An income interest in a Canadian-resident trust, certain resource properties, retirement income allocations from a partnership, or a life insurance policy in Canada, or
- Inventory, depreciable or intangible assets used in a business carried on in Canada by the trust through permanent establishment (broadly, this means a fixed place business located in Canada).
An election might be appropriate where the trust is not expected to otherwise generate income to utilize losses incurred in current or previous taxation years. By electing out of the tax-deferred rollout, the trust would still not incur income tax to the extent the resultant gains are offset against the trust losses. The reverse can also be true, in that the trust may have accrued losses in the distributed property, which could be used against capital gains the trust realized from other sources. In the case of a graduated rate estate, the marginal tax rate of the trust may be substantially less than the marginal tax rate of the recipient-beneficiary, so a prepayment of income tax may make sense in the long run.
In either case, any recipient-beneficiary receives the property at its then-FMV and not the trust's cost amount.
The election must be made in the trust's information and tax return for the year in which the property is distributed.
- A Canadian-resident beneficiary who receives property not described in point v (above) from a trust not resident in Canada can make the election not to have the tax-deferred rollout apply.
A beneficiary might make an election in a circumstance to obtain a FMV cost base to avoid paying income tax on gains accrued while the Canadian property was owned by the trust. To be clear, the election cannot be made in respect of property described in point v. The election establishes the Canadian-resident beneficiary's cost base at the then-FMV. Therefore, when the property is eventually sold, the beneficiary would only be subject to income tax in Canada on capital gains accrued after the time of distribution from the trust.
This election may be of limited use in many circumstances, as the beneficiary may realize a capital gain on the disposition of his/her capital interest in the non-resident trust.
The election must be made in the beneficiary's tax return for the year in which the distributed property is received.
The elections in points v and vi (above) are made on each property. Accordingly, the election can be made in respect of one property and not on another.
Recent changes to the taxation of trusts
In the last few years, the Department of Finance has introduced significant amendments to curtail what it perceived to be abusive tax-minimization strategies, including planning involving trusts. Such strategies had been in use for decades. Initially, the changes focused on the taxation of trusts established upon the death of individuals. Subsequent changes enacted into law in June 2018 targeted income-splitting techniques used by Canadian private corporations and their shareholders. Many of the planning opportunities restricted in the 2018 changes involved trusts.
The 2018 changes have left many asking themselves if planning with trusts is now extinct. Nothing could be farther from the truth. Trusts remain an important tool for planning in situations involving family members with challenges, second and subsequent marriages and, yes, tax planning.
In recent Tax Alerts, Collins Barrow has described many of the new income-splitting rules. Generally, dividends or other amounts (excluding salaries), derived from a business entity where a person related to the recipient is involved are subject to the new income-splitting rules. In this case, the amount is taxed in the hands of the recipient at top marginal tax rates. However, there are numerous exceptions. One is where the individual owns shares of a corporation representing 10% or more of the outstanding voting shares of the corporation and 10% or more of the FMV of all shares of the corporation. Where shares are currently held through a trust, one solution may be to use the tax-deferred rollout provisions discussed above to distribute sufficient shares to an individual so he/she can satisfy the minimum 10% votes and FMV tests. This does not necessarily mean the trust is wound up. Another exception is where an adult individual has sufficient involvement in the underlying business. In this case, the individual can still receive dividends from the corporation indirectly through the trust and pay tax at the individual's marginal tax rates as opposed to the top marginal rate.
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.