In Trusts We Trust: Not Just For the Rich

Photo Credit: SQI CPA Professional Corporation

All references to a spouse in this article also include common-law partners. All references to the ‘Act’ mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised.

Good morning Toronto. For many of us, the word 'trust' often reminds us of wealthy families and Hollywood dramas over inheritances. In reality, trusts are powerful tools which Canadians can use in their tax and estate planning. In today’s article, we will explore the basic definition of a trust and some of the situations it can make sense for. This article is part of a multi-part series. Next time, we will explore income splitting, income attribution, deemed disposition events, and the General Anti-Avoidance Rules (GAAR) for trusts.

The definition of a trust is set out in ITA §104(1). Most trusts follow this set formula: ‘A’ (the settlor) places property (real estate, funds, shares, etc) in the care of ‘B’ (the trustee), for the eventual benefit of ‘C’ (the beneficiary). By doing this, ‘A’ imposes specific conditions over the property that is managed by the trustee in a ‘trust document’. ‘B’ can be an individual, a group of individuals, or an institution (such as a bank). This arrangement must also satisfy the ‘three certainties’ to BE a trust. That is: there is certainty that ‘A’ intended to create the trust, and the property and beneficiaries of the trust are clearly defined.

Generally, the ITA treats a trust as if it were a natural individual: that is, a separate entity from ‘A’, ‘B’, and ‘C’. Even though ‘B’ has control and/or ownership over the property, the trust’s assets are separate from ‘B’s personal assets. Like a person, the trust generally is taxed in its own right, subject to income attribution rules. Due to new regulations, all trusts are typically required to file a T3 Trust Income Tax Return each year, regardless of the value of the assets in the trust or the income generated by the trust.

With this in mind, trusts can be classified in three main ways.

First, all trusts fall into two broad categories: testamentary or living trusts, as per ITA §108(1). The former is created due to the death of an individual, as a consequence of a court order or, (more commonly) their will. Contrastingly, living (or inter vivos) trusts are created during a person’s lifetime.

Second, all trusts are either revocable or irrevocable. As the name suggests, a revocable trust allows the settlor (the person who creates the trust) to alter or even dissolve the trust, while irrevocable trusts generally requires the consent of the beneficiary to alter/dissolve the trust. As a short introduction to next time, any income, capital gain, or capital loss from a revocable trust is attributed and payable solely by the settlor under ITA §75(2).

Third, trusts can be further identified by their specific type, such as a Graduated Rate Estate (GRE) Trust, Alter Ego Trust, Spousal Trust, etc. Each trust type carries unique tax and legal implications. The conditions of each trust type are scattered throughout the ITA due to many of the trust types being made ad hoc to address specific circumstances. While there are many types of trusts, we will discuss the few most commonly encountered.

Graduated Rate Estate (GRE) trusts are testamentary trusts which are unique in that they are one of the very few trust types allowed to use graduated tax rates (GTRs). For the first 36 months following the death of an individual, a GRE uses the same GTRs and brackets as an individual taxpayer, which can lead to significant tax saving as opposed to the flat top-rate taxation scheme that is typical for most other trusts. This window is crucial for giving the estate time to complete administration without incurring excessive tax. To qualify, the trust must be designated on the first T3 return, and there must be only one GRE per decedent – these conditions also apply to the undermentioned trust types that will be discussed.

Qualified Disability Trusts (QDTs) are another type of testamentary trusts that can use GTRs, provided that the beneficiary is named on the document establishing the trust, and that the beneficiary qualifies and further requalifies (if needed) for the Disability Tax Credit. The trust must also be designated as a QDT by the beneficiary and be resident in Canada. As the name implies, these trusts are used to provide long-term financial security for persons with disabilities. As long as the criteria are met, the QDT can continue using GTRs on an indefinite basis.

Testamentary spousal trusts are also commonly used in tax/estate planning, particularly for tax deferral purposes. These trusts must meet strict requirements to qualify for this favoured tax treatment – a key condition being that the spouse, while alive, is the only person who can receive and benefit from any income or capital generated in the trust, pursuant to §70(6)(b) of the Act. When conditions are met, any capital gains tax on transferred property is deferred until the death of the surviving spouse, at which point the trust incurs a deemed disposition ‘event’.*

*Note: A deemed disposition means the government considers you to have sold and repurchased the asset on the same day as the ‘event’ at Fair Market Value, even if no sale took place. This means that capital gains tax is triggered and payable. Depending on how long the property was held for, this tax may be significant.

Another common type of trust is the alter ego trust, which is a type of inter vivos trust for settlors 65 years or older. Like a spousal trust, the settlor must be the only person who can receive trust income/capital while alive. When the settlor transfers assets to the trust, any capital gains which are payable are similarly deferred to the death of the settlor, at which point the trust triggers a deemed disposition event.

Unlike the above examples, bare trusts have a fundamentally different structure and function. In the previous types of trust, the trustee has specific instructions from the settlor on how to manage the funds. In bare trusts, this arrangement does not exist. The trustee holds the title to the property, but takes all instructions from the beneficiary, who holds all the rights to the control and benefit of the property. This arrangement is much simpler compared to other trusts – many bare trusts may not even have formal trust documents. However, bare trusts generally trigger income attribution rules. Bare trusts tend to be often used to gift minors with property. Minors cannot hold property and securities, so in these cases, the parent or a family member tends to fufill the trustee role.

In all, trusts serve many valuable purposes – especially in estate planning. In Canada, when a person dies, all of the assets that they own individually form their estate. Depending on the initial setup, joint assets (i.e. a house owned with a spouse) may transfer to the other listed owner and bypass probate*– the process for validating the individual’s last will and appointing an executor of the estate. The probate process can take months to years, depending on the complexity of the estate, especially if the will is contested. Use of a trust also offers greater privacy for the trust’s assets, as probate records are publicly accessible.

*There are many types of joint ownership. For assets to automatically transfer to the surviving owner on the death of the other owner, the asset must be held as Joint Tenancy with Rights of Survivorship (JTWROS). In this arrangement, the parties will almost always have equal legal and beneficial ownership.

Whether it be passing on a home or the succession of a family business, trusts allow assets to be passed on in a carefully controlled manner. Trusts can be especially beneficial when the surviving spouse or dependent lacks the financial expertise to properly manage the assets or is otherwise disabled/mentally incapacitated. In these cases, a trust helps ensure that funds are managed in a responsible manner and that the intended beneficiaries can receive the care and support as in line with the settlor’s wishes.

When executed correctly, a trust ensures continuity and greater respect for the settlor’s intentions. Contrastingly, Canadian courts have significantly broader power to ‘deviate’ or outright invalidate wills over trusts.

A recent landmark case, Lam v. Law Estate, drew significant attention from the legal community for this reason. In British Columbia, wills are governed by the Wills, Estates, and Succession Act (WESA). Specifically, §60 of this Act states that all support in a will should be ‘adequate, just and equitable’. The BC Supreme Court found that in the mother’s will, the distribution of assets between Ms. Law (the plaintiff) and her brother did not meet the contemporary standard of fairness, heavily favouring the son. On this basis, the court varied the will to provide Ms. Law a more equitable share.

While we do not (and will not) comment on whether this decision is ‘right’ or ‘wrong’, this case indeed stands as a modern precedent that demonstrates the powers of courts in overriding a testator’s wishes under specific legal standards. Nonetheless, each province has their own laws which deal with wills and succession. Specifically in Ontario (where I suspect the vast majority of my readers are), challenges fall under Part V of the Succession Law Reform Act (SLRA), which allows the courts to enter deviations in the event the claimant is financially dependent on the decedent. As a generality, challenging a will is not like what Hollywood portrays – one cannot contest a will because they were ‘forgotten’. Most challenges in Canada usually rely on a lack of capacity, undue influence, outright forgery, or improper execution.

On the other hand, once a trust is established, there is a much stricter set of circumstances which allow courts to vary trusts. In Ontario, these circumstances are contained in the Variation of Trusts Act (VOTA), which provides that courts can only vary trusts if the beneficiary cannot consent for themselves, provided the variation is in the best interest of those individuals.

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