In Trusts We Trust: Limits of the Law

Photo Credit: CPA British Columbia

All references to a spouse 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! In our last article, we discussed the basic principles of a trust and the situations where trusts can be a sensible option for Canadians. Today, we will consider the Act’s treatment of the more technical side of trust taxation – namely, income splitting, income attribution, deemed disposition, and the General Anti-Avoidance Rules (GAAR). If you have not already, I highly recommend reading our last article ‘In Trusts We Trust: Not Just For the Rich’ for a backgrounder before starting this article!

Generally speaking, if the trust generates income or receives income, it must distribute this income to the beneficiaries to avoid tax. Not doing so would mean that the trust is taxed using the flat-top rate scheme on all of its income, 53%. When the income is distributed ('flowed-down') to the beneficiary, it is taxed in the beneficiary’s hands and maintains its ‘character’. This means that beneficiary is treated as if they earned the income themselves. Dividends are taxed as dividends, investment income is treated as investment income, etc.

This same treatment applies to capital gains and losses. If the trust were to realize a capital gain or loss, and then flow-down to the beneficiary in the same taxation year it was incurred, it would be taxed in the beneficiary’s hands as if the beneficiary personally incurred the gain/loss. Currently, 50% of capital gains are included in the beneficiary’s income for tax purposes, which makes capital gains a significantly lower tax liability compared to other forms of income. In other words, $200k of capital gains income would have roughly the same tax as $100k of employment income.

This method of tax minimization, called ‘income splitting’, is a method used by many family trusts to lower overall taxes by ‘flowing-down’ income to beneficiaries – usually related family. In the above example, the income of the trusts was solely derived from passive income – the rental income and the Holdco dividend. Specifically, it was historically common for trusts to have shares of a family-owned corporation, which would declare dividends, payable to the trust. The trust would later flow the income down to the beneficiaries, who generally were taxed at lower rates.

To address this, the government introduced legislation to target income derived from these private corporations. We call this the Tax on Split Income (TOSI) rules, the provisions for which are in §120.4(1) of the Act. If income is subject to these rules, when it is flowed-down to the beneficiary, it will still be taxed at the highest bracket. While TOSI can also apply in other situations, the biggest application is usually on dividends from private corporation shares.

To be clear, while TOSI does not prevent these dividends from being paid, these rules are a major impediment to income splitting that involves private corporations. If the trust is trying to pay dividends from private corporations, there should be consideration for whether the following exemptions apply. Namely:

• If the beneficiary is over 18 and worked for the business for at least 20 hours a week in the current year, OR worked an average of 20 hours a week over the past 5 years (the ‘Excluded Business’ exemption)
• If the beneficiary is over 25 and personally owns shares that have more than 10% of the voting power and value of the company, provided the corporation is not a professional corporation (sorry, doctors, lawyers, and accountants), AND less than 10% of the corporation’s income was from providing professional services, AND less than 10% of the corporation’s income was not a related business (the ‘Excluded Shares’ exemption)
• If the beneficiary is over 25, and the amount they received is reasonable compensation for their labour contributions, or for the capital/risk they’ve contributed to the business (in the form of loans, personal investment, etc), although this rule is very subjective (the ‘Reasonable Return’ exemption)

While there are quite a few exemptions for adults, minors generally receive very little relief from TOSI, with the exception of the inheritance exemption. In this sense, the old ‘kiddie tax’ rules pre-reform still live on, under a broader scope. In almost every situation, it can be expected that minors will be taxed at the highest graduated tax rate if income is derived from corporations.

Separate from TOSI rules, the Act also contains income attribution rules. If these rules apply, when the income is flowed down to the beneficiary, it will be ‘attributed’ back to the settlor, who pays tax on the income.

We have already briefly covered one of these rules. Under §75(2) of the Act, all income and capital gains earned from trust assets in a revocable trust are attributed back to the settlor. Furthermore, revocable trusts are prohibited from using the Lifetime Capital Gains Exemptions (LCGE) on the sale of Qualified Small Business Corporation (QSBC) or Qualified Farm/Fishing Property (QFFP) shares, even if the trust can otherwise qualify. These exemptions are extremely valuable tax benefits which can significantly reduce capital gains tax on the sale of qualifying shares.

Furthermore, the Act sets out specific provisions that apply when property or money used to purchase property is transferred to a beneficiary through a trust as a gift. When the recipient is the spouse of the settlor, both income and capital gains are attributable to the settlor under §74.1(1). In the case of minors, while §74.1(2) states that the income is attributable, capital gains/losses are NOT. Further, §74.1(2) does not apply if the minor turns 18 during the taxation rule OR if the minor is unrelated to the settlor. For children over 18, there is no attribution of income or capital gains, although TOSI rules can apply.

§74.1(1) and §74.1(2) can be overcome if the property or money is loaned to the minor/spouse at a rate greater than or equal to the Prescribed Rate in the Regulations AND the minor/spouse pays the interest back by 30 January of the following year. If these rules are respected, no such attribution to the settlor shall occur. As of the writing of this article, the Prescribed Rate is 4%.

Finally, all trusts are subject to deemed disposition rules. Under §104(4), a trust would be deemed to have disposed of all of its capital property (except for depreciable property) and have immediately reacquired it on the 21st anniversary of its creation, for its FMV. For the purposes of §104(4), depreciable property is property that wears out or becomes obsolete over time. Examples include business equipment, vehicles, licences, etc. Generally, these types of property are eligible for Capital Cost Allowance, which allows businesses to deduct depreciation over several tax years. These types of property, are subject to different tax rules, which will be discussed in future articles. Notably, the 21-year rule does not apply to spousal and alter ego trusts. In these cases, the deemed disposition occurs when the second spouse or settlor dies, respectively. Likewise, bare trusts do not meet the requirement of a trust under the Act, hence they also do not follow the 21-year rule.

The deemed disposition rule is meant to act as an anti-deferral mechanism, preventing the trust from indefinitely holding appreciating assets without ever realizing the accrued gains. The rule forces a notional sale, thus ensuring that the gains are eventually taxed. However, this can pose a significant challenge in planning, especially if the gain is significant and the trust lacks liquidity.

Generally, if the trust is subject to the 21-year rule, the trustees will elect to either sell the assets to satisfy the imminent capital gains tax or (if the trust documents allow it) transfer the assets on a tax-deferred basis to the beneficiary. In the latter case, the beneficiary would assume the trust’s Adjusted Cost Base and defer tax until they either sell the asset, trigger a deemed disposition event (such as becoming a non-resident), or die.

Sometimes, trusts attempt to transfer property to a new trust through a series of transfers. Doing so can trigger GAAR under §245 of the Act. According to the CRA, GAAR is considered ‘whenever a taxpayer makes a transaction mainly to avoid, defer or reduce tax, and that transaction results in an outcome that is inconsistent with the object, spirit and purpose of the relevant tax rules.’

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