Trusts - Just the Basics Introduction The use of a trust can be important for both tax and non-tax reasons. A trust may be implemented for complex planning or to simply ensure that funds are directed in a certain manner to a beneficiary of the trust. This Tax Topic will deal with personal trusts. A personal trust is defined in s. 248(1) of the Income Tax Act, (the Act ). It is defined to be either a testamentary or inter vivos trust, where interests in the trust were not acquired for consideration paid either to the trust or to a person who contributes property to the trust. This Tax Topic will be part of a two part series on Trusts. In this Tax Topic, basic issues including the taxation of trusts will be looked at in some detail including the application of trust law in the common law provinces. Unless otherwise specified, it will not address Quebec law. The second Tax Topic in this series will examine the different types of trusts that exist in the context of planning with life insurance. The use of trusts date back over six hundred years. The original purposes stemmed more for legal uses rather than tax reasons. However, trusts have evolved into being considered an important tax-planning vehicle. In our current context, trusts have married both tax and legal benefits together. Trusts are a conduit for income tax purposes and for legal purposes they are useful for control and ownership. The changes proposed in the 2014 Federal Budget regarding the tax treatment of testamentary trusts were adopted on December 16, 2014, and have applied since January 1, 2016 to existing trusts and to those yet to be created. The most significant change includes the elimination of the graduated rates that currently apply to testamentary trusts and grandfathered inter vivos trusts created before June 18, 1971. The tax consequences of the proposed changes will be extensive given the resulting amendments to the Act. These changes will be indicated below, where applicable. Structure and Parties A trust is a relationship between the trustee, who holds legal title to the subject property of the trust and the beneficiaries, who hold beneficial title to that subject property. Beneficial ownership means that the beneficiary does not have title to the property but has rights in the property, which is a normal incident of ownership. The trustee has a fiduciary duty to the beneficiaries of the trust to ensure that at the end of the day, the capital and income of the trust have been appropriately held for their benefit.
The three parties to a trust are the settlor, trustee and beneficiary. 1) Settlor The settlor is the individual who settles the trust. Legal title to the subject property of the trust is transferred to the trustee of the trust for the benefit of the beneficiaries. When a trust is revocable, the settlor continues to enjoy control over the property and can revoke the trust as specified in the trust document. The settlor in this instance can be a beneficiary under the trust. When a trust is irrevocable the settlor gives up his or her right to enjoy property transferred to the trust and will generally not be a beneficiary under the trust. Making a distinction between the two types of trusts is relevant from a tax perspective when considering the attribution rules. This topic will be covered in another section of this text. The Act defines the settlor of the trust in the context of the trust. Where a testamentary trust exists, the settlor is the individual whose death caused the trust to come into existence. In the event of an inter vivos trust, the settlor is the individual who transfers property to the trust during his or her lifetime. A more detailed discussion of these trusts will follow. The fair market value of the property transferred to the trust by the settlor cannot be exceeded by the fair market value of other property subsequently transferred to the trust by other parties. If this occurs, there may be a question as to who is the actual settlor of the trust. This becomes relevant for tax reasons when considering the attribution rules. 2) Trustee Trustees are guided in their powers and obligations by the trust document itself. Where the document is silent on powers and obligations or in the instance where no trust document exists, provincial trustee legislation is applied. The common law provinces have now adopted a prudent investor approach. The selection of a trustee may be difficult. There are some preliminary considerations that should be undertaken before appointing a trustee. The settlor of the trust should not be a trustee of the trust due to the attribution rules. A beneficiary of the trust may be a trustee. To establish the trust however, there should be a separation between common law legal ownership and beneficial ownership. There is also the potential for a conflict of interest given that the beneficiary is also a trustee. Actions taken by the trustee, who is a beneficiary, may be viewed as self-serving and not in the best interests of all of the beneficiaries. As a result, it is preferable to name other parties to be trustees. It is extremely important to assess the person who will take on the role of trustee. In many instances, the settlor may seek an individual who knows them well and understands the way in which he or she would like the property distributed. The complexity of the trust should be considered. The potential for a conflict of interest is also a matter that should be reviewed. For instance, children who will ultimately be beneficiaries under the trust may not be suitable to also be a trustee of the trust. Where there is no suitable trustee, a corporate trustee may be considered. The fees associated with this service however should be considered in light of the size of the trust and its complexity. Residency Until recently a trust has been considered to be resident where a majority of its controlling trustees reside. However, residency of a trust has recently been considered by the court and the case law is discussed in greater detail below. In the Garron Family Trust case, the court considered that the management and control of assets occurred in Canada although the corporate trustee of each trust was in the Barbados. The Federal Court of Appeal (FCA) later dismissed the appeal of the case (St. Michael Trust Corp. et. Al v. Canada 2010 FCA 309, 2010 DTC 5189 (referred to as the Garron case). The case was appealed to the Supreme Court of Canada where the Court confirmed that the appropriate test to apply when determining the residence of a trust is the central management and control test. The question is: where is the trust s real business carried on? The answer to that question provides insight as to residency. In Antle, a serious of transactions where property was sold to a Barbados Spousal Trust were considered by the court. The taxpayer argued that there was no taxable capital in Canada because the trust was not resident in Canada. The court indicated that the facts fell outside of the court s very clear enunciation of a Canadian resident for trust purposes. The court determined that the series of transactions did not create a trust. The trust was found to be a sham. The case was appealed to the Federal Court of Appeal and dismissed. (see Antle v. Canada, 2010 FCA 280, 2010 DTC 5172). 2
If the trustees emigrate to a new jurisdiction, the trust will become a non-resident of Canada. It is therefore important that the drafter of a trust document be fully aware of any potential residency issues of the trustees. If the trust becomes a non-resident, all the tax consequences associated with the emigration of the trust will apply, resulting in a deemed year end immediately before that time as well as a deemed disposition and reacquisition of each property of the trust at fair market value. (See s. 128.1(4)(b) and proposed s. 94(5)) of the Act). The use of non-resident and off shore trusts in planning is beyond the scope of this paper, but caution should be used when considering these types of trusts, as there are many issues to review before implementing them. Determining the trustee who has control or management of the trust may be difficult to assess. Canada Revenue Agency (CRA) has indicated that where a trustee exercises more than 50% of management and control of the trust in a jurisdiction, that will be a determinative factor. Attention should also be given to provincial conflict law, where in some jurisdictions the trustee must not only reside in a jurisdiction but also must administer a trust in that place. Income Tax Folio S6-F1-C1, Residence of a Trust or Estate, enumerates several factors to be considered in determining the trustee who possesses management and control including: changes in the trust investment, control over assets, management of assets, banking, power to contract with professional advisors and responsibility for the preparation of the trust accounts. However, in the case where the facts demonstrate that a major part of the central management and control of a trust is assumed by a person other than the trustee (i.e., the settlor or the beneficiary under the trust), CRA will take into account the actions taken by these persons in respect of the trust, to determine the residence of the trust (i.e., the territorial jurisdiction where the central management and control of the trust takes place). For example, to determine the territorial jurisdiction, CRA will take into account any relevant factor such as the factual role of the trustee and other persons with respect to the trust property, including any decisionmaking limitations imposed thereon, either directly or indirectly, by any beneficiary, settlor or other relevant person; and the ability of a trustee and other persons to select and instruct trust advisors with respect to the overall management of the trust. On June 18, 2015, in Discovery Trust v. Canada (National Revenue), 2015 NLTD(6) 86, the Supreme Court of Newfoundland and Labrador Trial Division (general) rendered a first-of-its-kind decision in Canada on the specific matter of the provincial residence of a trust for tax purposes. In this matter, by extension, the Court applied the criteria of where the central management and control of the trust actually takes place to identify the province of residence of the trust. The Discovery Trust ( Trust ) had been created in 2002 by Craig L. Dobbin in St. John s, Newfoundland and Labrador, and the initial trustees and beneficiaries under the Trust were Mr. Dobbin s children and most of them lived in that same province. In April 2006, the trust indenture was amended; the trustees resigned and Royal Trust Corporation of Canada ( Royal Trust ) was designated as the new trustee of Trust. Trust s assets including shares held in a holding company ( Holdco ) were then moved to Alberta. The statutes of Newfoundland and Labrador governing Trust were replaced by the statutes governing trusts in Alberta In October 2006, Mr. Dobbin died. Between the time of his death and the year 2008, a series of transactions had been made, including certain transactions concerning the shares held in Holdco. In 2008, the assets of Holdco were sold. The proceeds of disposition were attributed to Holdco, then, ultimately to Trust, which was taxed according to Alberta s tax rates, being a resident in that province. The Minister was of the opinion that Trust was resident in Newfoundland and Labrador at the time of the transactions, since its beneficiaries themselves were residents of that same province. The beneficiaries approved, directly or indirectly, all transactions involving Trust; they more or less replaced the official trustee, Royal Trust, when it came to making decisions regarding Trust s activities. Furthermore, in his analysis, the Minister took it for granted that the transfer of Trust s assets from Newfoundland and Labrador to Alberta was for tax reasons. After studying the facts at issue, the Court ruled that the beneficiaries were not acting as substitutes for the trustee, that the province where the central management and control of Trust actually took place was Alberta, and, as a result, Trust was resident in Alberta. The appeal was upheld. 3
In this matter, the following observations can be made: - The principle arising from the decision of the Supreme Court of Canada in Fundy Settlement and the test of where the central management and control of the trust actually takes place apply to determine the provincial residence of the trust; - The central management and control applies in the context of property held by a trust; - The consultation of beneficiaries concerning transactions made by the trust is a common business practice and is acceptable and prudent. This does not automatically imply the abnegation of the trustee s powers; - The tax motives argued by the Minister as regards the transfer of Trust s assets does not allow for the determination of a trust s deemed residence. 3) Beneficiary(ies) The beneficiary will be entitled to the use and enjoyment of the subject property of the trust. Beneficiaries can either receive income or capital or both from the trust depending upon the trust terms on distribution. The trustee has a fiduciary duty to take an even hand approach to distribution from the trust unless the trust document dictates another scheme. In the case of a minor beneficiary (under the age of majority which varies from province to province) payment cannot be made directly to the minor beneficiary. An application however may be made to the court to provide for the payment of income towards the beneficiary s maintenance, education or benefit. Most provincial trustee legislation will permit the court to approve payment for food, shelter, clothing, special care and education. A court may also allow for capital payments for the benefit of a minor to be made where warranted. i) Beneficiaries and corporations The relationship of the beneficiaries of a trust to a corporation must also be considered as it may have adverse tax consequences. Corporations could be associated depending upon the control attributed to the beneficiaries of a trust pursuant to s. 256 (1.2)(f) of the Act. This provision provides that each beneficiary of a discretionary trust (see discussion below on discretionary trusts) is deemed to own each of the shares of the corporation, which are owned by the trust. In the case of a non-discretionary trust, beneficiaries are deemed to own the proportion of shares that relate to their beneficial interest in the trust. When an individual owns shares in a corporation and also is a beneficiary of a trust that owns shares in a corporation, the two corporations could be considered associated. Corporations will wish to avoid this situation because it would cause a sharing of the small business limit for purposes of the small business deduction. Requirements to create a trust In common law, in order for a trust to be legally constituted, three certainties must co-exist. The three certainties are: 1. Certainty of intention meaning a clear intention to create a trust by the settlor; 2. Certainty of property means the property must be clearly ascertainable; 3. Certainty of beneficiaries meaning the beneficiary must be clearly identifiable either by name or class. If these three elements do not exist the trust will fail. Trusts can be created either informally or formally by way of written documentation. A formal written trust is preferred because it can confirm the intention of the testator and the existence of the three certainties. When insurance is part of the subject property of the trust, the insurance policy should be clearly identified in order that the requirement set out under point 2 above be met. The provisions respecting trusts set out in the Civil Code of Québec (CCQ) are generally inspired by common law, however, they have certain differences. One of these differences is found in article 1260 CCQ, which provides that a trust can result only from an act in writing. However, under Quebec civil law, the trust cannot result from the simple intention of the settlor. Moreover, in certain cases, under article 1261 CCQ, a trust can be established by law, or by a judgment where authorized by law. Distributions from a trust How distributions are made from the trust depends upon how the beneficiaries are defined and what they are entitled to under the terms of the trust document. Beneficiaries under a trust are either income 4
beneficiaries, where they are entitled to only the income of the trust or capital beneficiaries (also referred to as residuary beneficiaries ) where they would be eligible to receive the capital from the trust. What may be considered income for tax purposes may not be considered income for trust law purposes. See also CRA document no. 2004-0060161E5 for a discussion on this issue. Payments from a trust depend also upon the type of assets held in the trust. Payments can be in the form of cash, a transfer of assets in specie (a transfer of the very thing), or by way of a promise to pay as in the form of a promissory note. Where a non-discretionary trust exists, a beneficiary may enforce payment regardless of the provisions or conditions found in the trust document. In this instance, the rule in Saunders v. Vautier (1841) 49 ER 282 should be considered. In that case, a vested gift made on a contingency did not stand. It was determined that the beneficiary could claim the assets if there was no other individual who would have a claim to the assets if the contingency were not met. See also Guest v. Lott et al. 2013 ONSC 7781 where the rule in Saunders v. Vautier was applied. Proceeds of a life insurance policy paid to a trust will be distributed tax- free to the beneficiaries of the trust. The tax treatment of life insurance proceeds received by a trust is substantially the same as if the proceeds are received by the individual. Death benefit proceeds of a life insurance policy paid to a trust are received tax-free (receipt of proceeds in consequence of death is not a disposition of a life insurance policy under s. 148(9) of the Act and therefore is not subject to tax). A payment from a trust may be made tax-free to a capital or income beneficiary in satisfaction of a capital or income interest of a trust (pursuant to subsection 107(2) or 106(2) and (3) of the Act). The trust document should identify capital and income beneficiaries notwithstanding that the beneficiary may receive death benefit proceeds from a life insurance policy via the trust, insurance proceeds do not retain their character when flowed through the trust (subsection 108(5) of the Act). As a result, if death benefits from a life insurance policy are distributed by a trust to a private corporation, the company will not receive a credit to the capital dividend account. It should be noted that although a life insurance policy is not capital property as defined under the Act, it nevertheless can constitute trust capital property and is eligible to be rolled out to the capital beneficiaries of the trust on a tax-deferred basis where subsection 107(2) of the Act applies. i) Discretionary trust v. non-discretionary Distributions from a trust arise from the trust document itself. A trust can be discretionary or nondiscretionary in nature. Determining whether the trust should be discretionary or not is very much driven on the basis of what situation the beneficiaries are in at the time distributions from the trust are contemplated. When a trust is discretionary, the trustee exercises discretionary powers in favour of the beneficiary as to when, if at all, payment will occur. This may be advantageous in a number of situations. In the case of a beneficiary facing creditors, payment can be deferred or paid to a third party on the discretion of the trustee. This avoids the payment being exposed to the creditors of the beneficiary. Where a beneficiary is disabled and receiving government assistant payments, a discretionary trust (Henson Trust) may be used to avoid jeopardizing these payments. A full discussion on this topic will be analyzed in detail in the Tax Topic entitled Trusts as a Planning Tool. Where marital breakdown may be at issue, entitlement to payments under a discretionary trust may not form part of the division or equalization calculation, because it is the trustee who controls when, and if, payment is to occur. The law in this area however is not entirely clear. In the Ontario case of Sagl v. Sagl (1997) 31 R.F.L. (4 th ) 405 (Ont. Gen. Div.) Mr. Sagl had a 1/7 th interest in a discretionary family trust. Mr. Sagl and his wife had separated and were involved in very contentious matrimonial proceedings. The court determined that the 1/7th interest should be included in Mr. Sagl s net family property calculation. However, a decision from the Alberta Queen s Bench in Kachur v. Kachur [2001] 4 W.W.R. 294 (Alta. Q.B.) appears to contradict the reasoning in Sagl. There the husband s interest in the discretionary trust was found to be nil because the true intent of the trust was to benefit the children and grandchildren. The trustee therefore would inevitably exclude the husband from distribution. Another interesting case to note in the family law context is the Ontario case pf Spencer v. Riesberry, 2012 ONCA 418 (CanLII). In Spencer, title to a home occupied as a family residence was owned by a family trust. On separation, the question became was this a matrimonial home and therefore subject to s. 18(1) of the 5
Ontario Family Law Act? The residence was found to be excluded from a matrimonial home perspective but the interest in the trust had to be determined for equalization purposes. Taxation of a trust For the purposes of s. 104(2) of the Act, trusts are separate taxable entities. However, this is the only context in which this is the case. Trusts are not considered legal entities and cannot be sued. Trusts are taxed separate from the settlor and the beneficiaries. A trust may be required to pay income taxes. For the purposes of taxation, trusts fall into two categories: inter vivos and testamentary. Inter vivos trusts are taxed at an individual s highest marginal tax rates on every dollar of income (provincial or federal). Since January 1, 2016, testamentary trusts have also been taxed at an individual s highest marginal tax rate (provincial and federal). However, two exceptions are provided, namely, graduated rate estates (GREs) and qualified disability trusts (QDTs). Under section 117 of the Act, these two categories of trusts continue to be taxed at an individual s graduated tax rates. An estate is deemed to be a GRE if it meets the following criteria: - The estate came into existence at and following the death of the taxpayer; - The point in time follows the death by no more than 36 months; - The estate is a testamentary trust at that point in time; - The Social Insurance Number (SIN) (or in the case of an individual who was not assigned a SIN prior to his death, any other information that the Minister approves) appears on the return of income filed by the estate for its taxation year, which includes this point in time, and for each of its taxation years ending after 2015; - The estate is designated as a GRE belonging to the individual on the return of income that it files for its first taxation year ending after 2015; - No other estate is designated as a GRE belonging to the individual on the return of income filed for a taxation year ending after 2015; This definition has been in effect since December 31, 2015. A QDT is a trust: - that at the end of the trust s year, is a testamentary trust that began to exist upon the death of a given individual or following his death; - that is resident in Canada for the year of the trust; - that includes in its return of income an election, made jointly with one or more beneficiaries (the electing beneficiary ) under the trust in prescribed form, to be a QDT for the year, includes the SIN of each of its beneficiaries (there is no relief for a late election and an incompetent beneficiary may require a guardian to make the election); - under which each of these beneficiaries is an individual who is named by the given individual in the indenture under which the trust was established, as a beneficiary and in respect of which beneficiary paragraphs 1 18.3(a) to (b) apply for said beneficiary s taxation year and said beneficiary has not elected to be a QDT, jointly with another trust for a taxation year of that trust ending in the same year. These rules apply both to existing trusts and to trusts yet to be created.. The new rules will therefore constrain the favourable tax treatment of income retained by testamentary trusts other than those that qualify as the graduated rate estate (GRE) or a qualified disability trust (QDT). They will result in higher taxes for testamentary trusts and estates, and for certain inter vivos trusts established before June 18, 1971. 6
a) Inter vivos trusts An inter vivos trust is created during the lifetime of the settlor. It is defined under s. 108(1) of the Act as a trust other than a testamentary trust. Inter vivos trusts have a calendar year end and file income tax returns on that basis. An inter vivos trust is entitled to a deduction for amounts paid or payable to its beneficiaries in calculating its income for tax purposes. Certain tax advantages could result by flowing income through the trust to low tax rate beneficiaries. Planning opportunities in this regard however have been curtailed by the kiddie tax or rules about income splitting. i) Kiddie tax income splitting Prior to January 1, 2000, trusts were a very attractive way of splitting income between family members. Income could be transferred from a high-rate taxpayer to a low-rate taxpayer. The low-rate taxpayer usually included children. In 1999 the Federal Budget addressed this issue by adding s. 120.4 of the Act concerning the kiddie tax. Prior to the kiddie tax rules coming into effect, income splitting was achieved by an inter vivos trust becoming a shareholder in a small business corporation. The beneficiaries of the trust would normally be the shareholders spouse, or dependent children. The trust would subscribe for common shares of the corporation either on incorporation or by the implementation of an estate freeze of the pre-existing common shares. The corporation would then subsequently pay dividends on the common shares to the trust. The trust would then distribute or allocate this income to the low-income beneficiaries. This resulted in a significant reduction in the amount of tax paid both at the corporate level and personal levels. The kiddie tax provisions under the Act effectively cause split income to be taxed at the highest marginal tax rate for specified individuals. Specified individuals are those who are not 17 years of age prior to the taxation year, at no time in the year became a non-resident, and had a parent resident in Canada at any time in the taxation year. Split income includes income from a trust derived from taxable dividends, or property or services in support of a business carried on by a person related to the individual. In the 2011 Federal Budget, the kiddie tax rules were extended to capture capital gains realized after March 22, 2011 by a minor or allocated to a minor from a disposition of shares to a person who does not deal at arm s length with the minor, where taxable dividends from the shares would have been subject to the kiddie tax. Capital gains subject to this measure are treated as non-eligible and therefore do not benefit from a lower capital gains tax rate or the lifetime capital gains exemption. The definition of split income to include business and rental income from third parties paid to a minor child. The rules apply if a minor s relative regularly performs income-generating activities, or in the case of a partnership, where the relative has an interest. ii) Deemed disposition at fair market value of property transferred to a trust Under paragraph 248(1)(c) disposition, any property transferred to a trust (the property of the trust) is deemed to have been subject to a disposition at the property s fair market value at the time of transfer, save for two exceptional situations set out in the Act. The first exception is found in paragraph 248(1)(f), which provides that there is no disposition of property if as a consequence of the transfer there is no change in the beneficial ownership of the property, and: - the transferor and the transferee are trusts that are, at the time of the transfer, resident in Canada; - the transferee does not receive the property in satisfaction of the transferee s right as a beneficiary under the transferor trust; - the transferee held no property immediately before the transfer (other than property the cost of which is not included, for the purposes of this Act, in computing a balance of undeducted outlays, expenses or other amounts in respect of the transferee); - the transferee does not file a written election with the Minister on or before the filing-due date for its taxation year in which the transfer is made (or on such later date as is acceptable to the Minister) that this paragraph not apply; - if the transferor is an amateur athlete trust, a cemetery care trust, an employee trust, a trust deemed by subsection 143(1) to exist in respect of a congregation that is a constituent part of a religious organization, a related segregated fund trust (in this paragraph having the meaning assigned by section 138.1), a trust described in paragraph 149(1)(o.4) or a trust governed by an eligible funeral arrangement, an employees profit sharing plan, a registered disability savings plan, a registered education savings plan, 7
a registered supplementary unemployment benefit plan or a TFSA, the transferee is the same type of trust; and - the transfer results, or is part of a series of transactions or events that results, in the transferor ceasing to exist and, immediately before the time of the transfer or the beginning of that series, as the case may be, the transferee never held any property or held only property having a nominal value. In this exception, if all of the listed conditions are met, no disposition of property will be deemed to have occurred at the time of transfer of this property to the trust. The second exception is found in paragraph 248(1)(k) ITA, which provides that there is no deemed disposition of property during the transfer of the property to a trust as a consequence of which there is no change in the beneficial ownership of the property, where the main purpose of the transfer is: i) to effect payment under a debt or loan, ii) to provide assurance that an absolute or contingent obligation of the transferor will be satisfied, or iii) to facilitate either the provision of compensation or the enforcement of a penalty, in the event that an absolute or contingent obligation of the transferor is not satisfied, In this situation, if these conditions are met, no disposition of property will be deemed to have occurred at the time of transfer of the property to the trust. Furthermore, section 69 ITA makes provisions for a transaction (disposition or acquisition, as the case may be) deemed to be at the fair market value of the property in cases where the consideration paid for this property is deemed inadequate. The situations referred to are the following and are adapted to the transfer of property to a trust: - where a trust has acquired anything from a person with whom the trust was not dealing at arm s length (for example and according to the facts of the case, the settlor or a beneficiary) at an amount in excess of the fair market value thereof at the time the trust so acquired it, the trust shall be deemed to have acquired it at that fair market value; - where a trust has disposed of anything o from a trust with whom it was not dealing at arm s length for no proceeds or for proceeds less than the fair market value thereof at the time the trust so disposed of it, o o from any trust by way of gift, or from a trust because of a disposition of a property that does not result in a change in the beneficial ownership of the property; the trust shall be deemed to have received proceeds of disposition therefor equal to that fair market value. - where a trust acquires a property by way of gift, bequest or inheritance or because of a disposition that does not result in a change in the beneficial ownership of the property, the trust is deemed to acquire the property at its fair market value. iii) Tax-Free Rollover As mentioned in the section Deemed disposition at fair market value of property transferred to a trust in this document, property transferred to a trust is deemed to be disposed of at the time of transfer into the trust at fair market value, failing an exception set out in the Act. This may create a tax liability at the time of transfer to the settlor of the trust. This is why tax-free rollover planning opportunities are sought when creating an inter vivos trust. Alter ego and joint spousal trusts are examples of trusts that allow for assets to be rolled into the trust tax-free. These trusts also avoid probate fees 1. Planning opportunities in these areas will be examined in the next Tax Topic in this series entitled Trusts as a Planning Tool. b) Testamentary trusts (i) Taxation New rules in effect since January 1, 2016 Testamentary trusts are created through provisions in a Will, by some other instrument or by consequence of death. Under s. 108(1) of the Act a testamentary trust means a trust or estate that arose on and as a consequence of the death of an individual. As indicated previously, since January 1, 2016, testamentary trusts are taxed at an individual s highest marginal tax rate (provincial and federal). As well, since January 1, 2016, testamentary trusts are required to move to a calendar year for tax filing and must remit quarterly 1 Probate fees do not apply in Quebec. 8
instalments. A testamentary trust can no longer claim the basic exemption for alternative minimum tax and will no longer enjoy certain other tax benefits under the Act. The changes do not apply to an estate that qualifies as a GRE, nor to a testamentary trust that qualifies as a QDT that are defined in the section entitled Taxation of a trust. QDTs benefit from graduated rates on all undistributed income but none of the other tax benefits granted to GREs. c) Other taxation points Only individuals can create a testamentary trust. A trust cannot be created by another trust or by a corporation. This is relevant for planning considerations where probate is in issue. (See the second Tax Topic in this series, Trusts as a Planning Tool ). This brings into question whether an individual appointed under a power of attorney document would be able to create a trust for the purposes of tax and estate planning. (For a further discussion of considerations on this issue reference should be made to Part 2 of this Tax Topic and the Tax Topic entitled Powers of Attorney: How Far Can You Go with Estate Planning? ) Testamentary trusts may be funded by assets of the estate or by other sources that do not form part of the estate. For instance, insurance proceeds can be used to settle an insurance trust, which is classified as a testamentary trust. An insurance trust can be created through the provisions in a will, by another instrument or by reference to the will in the contract 2. For a further discussion on insurance trusts see the Tax Topic Insurance Trusts and the Insurance Trust Guide. Testamentary trusts cannot be settled with property prior to the consequence of death. If this were the case, they would be tainted and classified as inter vivos trusts. As well, contributions made by another individual to the trust once the settlor has died will also cause the trust to be tainted. Since January 1, 2016, the benefits connected with testamentary trust status are no longer crucial. However, to qualify as a GRE, which will afford significant tax benefits not just graduated rate taxation, the estate has to be a testamentary trust, so the comments found in this document remain relevant. Assets from one testamentary trust can however flow into another testamentary trust without tainting the trust. (See Technical Interpretation #9801035 dated September 22, 1998.) Furthermore, a testamentary trust can also lose its status when the trustee fails to distribute assets from it. If a trust is continued after the moment that it is to be collapsed (usually after existing for 21 years), CRA takes the position that the trust then becomes an inter vivos trust. When this occurs, the trust income is taxed at the highest marginal tax rate. A GRE can have a tax year other than the calendar year. The income that remains in the GRE at the end of the year is taxed at the graduated tax rates making the GRE a very attractive tax-planning vehicle. Income that is paid out to a beneficiary or for their benefit is taxed in the hands of the beneficiary. The rules regarding the kiddie tax are not applicable to a testamentary trust. Therefore income splitting amongst beneficiaries with the lowest tax brackets can occur. Where multiple trusts have been created by the same settlor, they may be deemed to be one trust if substantially all property has been settled by one person and the same beneficiaries or class of beneficiaries are recipients under the trust agreement. (See s. 104(2) of the Act). This subsection was designed to prevent the creation of multiple testamentary trusts with the same beneficiaries in order to take advantage of the low rates of tax on low amounts of income. Since January 1, 2016, only one trust can be considered the GRE of a deceased individual and effectively eliminates this planning. This observation does not apply to inter vivos trusts or to testamentary trusts that do not qualify as the GRE or QDT, since the top rate of tax applies to them. (i) Tax-Free Rollover into a Testamentary Spouse Trust A testamentary spousal trust is subject to conditions under s. 70(6) of the Act. Like an inter vivos spousal trust, the spouse must be entitled to receive all of the income of the trust that arises before the spouse s death and no person except the spouse may, before the spouse s death, receive or otherwise obtain the use of any of the income or capital of the trust. With a testamentary spousal trust, the property must vest in the trust within 36 months after the death of the taxpayer. This time period can be extended where a written application is made to the Minister. 2 It is possible to create an insurance trust in Quebec. However, due to the complexity of the structure, it is recommended to rely on a professional with the necessary expertise on the matter. 9
If all of the requirements for a spousal trust are met, the property is transferred to the trust for proceeds equal to its tax cost. The trust is deemed to acquire the property at a cost equal to the tax cost of the property to the transferor. (Part 2 of this series will look at inter vivos and testamentary spousal trusts in the planning context). On the death of the spouse a deemed disposition will arise in the spousal trust. Since January 1, 2016, taxable capital gains that arise in the spousal trust (whether testamentary or inter vivos) will be deemed payable to the deceased spouse in the year of his or her death,. However, since January 1, 2016, there is uncertainty as to whether or not capital losses of trusts carried back to the year of the spouse s death can be absorbed if the income is deemed payable to the spouse and if the possibility of returning this income to the trust is not allowed. On November 16, 2015, the Minister of Finance (Finance Canada) sent a letter to STEP, the CALU and the CBA/CICA Joint Committee on Taxation, which had submitted several memoranda on the changes made to the taxation of certain trusts, in particular, the carrying forward of losses of trusts. The aim of this letter was to consult the organizations regarding a proposed solution. The proposed solution was to amend subsection 104(13.4) ITA in such a manner as to suspend its application following the death of a spouse unless the trust was a testamentary trust that was a trust created for the spouse s spouse or common law partner after 1971 and the testator died prior to 2017. Furthermore, the spouse was required to be a resident of Canada at the time of his or her death, and the estate subject to graduated rate taxation in respect of the spouse needed to elect jointly to accept the application of this subsection. In this way, subsection 104(13.4) would only apply if these types of trusts so elected. Except in the case of those already authorized to make the election referred to in the preceding paragraph, the application of the proposed solution would return living trusts to the situation they were in prior to the addition of subsection 104(13.4). Finance Canada indicated that it looked at this solution from the perspective of equity, neutrality and preventing the erosion of the tax base. Following this consultation letter of November 16, 2015, on January 15, 2016, Finance Canada submitted new legislative proposals for public consultation. The proposals that were submitted aim at amending the tax treatment of the income of certain trusts and their beneficiaries; they include, among others, ensuring that income arising in certain trusts on the death of the trust s primary beneficiary is taxed in the trust and not in the hands of that beneficiary, subject to a joint election for certain testamentary trusts to report the income in that beneficiary s final tax return. The comments on all of the legislative proposals submitted need to be filed no later than February 15, 2016. d) 21-year deemed disposition rule To prevent a trust from being used as an indefinite tax deferral vehicle s. 104(4) of the Act was designed to force trusts to recognize and pay tax on their accrued capital gains every 21 years. The trust is deemed to dispose of each capital property for proceeds equal to its fair market value and to have reacquired the property immediately after for an amount equal to that fair market value. In certain scenarios, the Act provides for a rollover of assets from a trust to beneficiaries on a tax-free basis. The 21-year deemed disposition rule does not apply to spousal, alter ego or joint partner trusts. In these cases, the deemed disposition is deferred to the death of the contributor of the trust or the spouse, even where the death occurs after the 21st year following the commencement date of the trust. Further planning opportunities in this regard will be discussed generally in the next Tax Topic entitled Trusts as a Planning Tool, which has already been referred to in the preceding pages. As the 21-year deemed disposition rule applies to capital property only, and since life insurance is not considered to be capital property, this rule does not apply to life insurance held in an inter vivos trust. e) Tax Treatment of Distributions from a Trust Amounts which became payable to a beneficiary of an inter vivos or testamentary trust are included in the beneficiary s income under s. 104(13) of the Act. Since January 1, 2016, based on subsections 104(13.1) and 104(13.2) of the Act, a trust could elect that a portion of the income and capital gains attributed to the beneficiary in the course of a year be taxed in the hands of the trust rather than in the hands of the beneficiary. To do so, the trust would need to make a designation to the effect that the attributed income is not to be considered as having been paid to or payable to the beneficiary. 10
However, since January 1, 2016, subsection 104(13.3) of the Act provides that a designation made under subsection 104(13.1) or 104(13.2) is no longer valid if the income taxable to the trust, in respect of this designation, is greater than zero. Therefore, the designation can only be used if the trust has losses that totally offset the income. Moreover, since subsection 104(13.3) ITA applies in particular to GREs, the income must actually remain in the trust in order for the trust to be able to benefit from graduated tax rates. In other words, since January 1, 2016, it is no longer possible to pay income to the beneficiary, then elect that it be taxed in the hands of the trust in order to benefit from graduated rates. f) Preferred Beneficiary Election Preferred beneficiary elections can be filed for both testamentary and inter vivos trusts. Pursuant to s. 104(14) of the Act, a joint election is filed that permits the income to be retained by the trust but to be taxed on the beneficiary s tax return. The elected amount is deducted in computing the trust s taxable income. (See s. 104(12) of the Act). S. 108(1) of the Act defines a preferred beneficiary to include an individual who has attained the age of 18 years old and is dependant as a result of being mentally or physically handicapped. The beneficiary can be a spouse (including same-sex partners), common-law partner, child, grandchild or great grandchild of the settlor. This planning allows the income that would otherwise be distributed to the beneficiary to accumulate in the trust. It also allows the preferred beneficiary to effectively utilize his or her personal exemption limit and to enjoy income up to that amount tax-free. This can also be beneficial in preventing the disabled individual from losing government disability benefits. g) Attribution and Revisionary Trust Rules The attribution rules can have a significant impact on trust planning. The rules state that income can be attributed back to the settlor upon certain transfers of property. This is the case when it appears that the transfer occurred primarily for the purposes of income splitting. The trust attribution rules found in s.74.3 will not apply unless s. 74.1 or 74.2 apply under the Act. The trust attribution rules will only be applicable if a beneficiary of the trust is a designated person in respect of a person who has directly or indirectly lent or transferred property to the trust. A designated person as defined under 74.5(5) means a spouse, non-arm s length minor or minor niece or nephew of the individual transferor or lender. Section 74.5 of the ITA provides, that a transfer for fair market value consideration will not cause s. 74.1(1) and (2) of the Act to apply. As well, section 74.4 (2) of the Act also must be considered. It relates to transfers and loans of property to a corporation where the intent is to reduce income of the transferor and benefit a named party. When a transfer is to occur involving family members and corporations, special note must be taken of these sections to ensure that the proposed plan does not invoke the attribution rules. Subsection 75(2) of the Act pertains to the revisionary trust rules. If a person contributes property to a trust and the property is held in the trust subject to certain conditions, any income or capital gain from the contributed property is treated as income or capital gain of the contributor. Careful consideration of the revisionary trust rules must be considered and the impact these rules have on trust roll-outs under s. 107 (2) and (4.1). A full discussion of these issues is beyond the scope of this paper but should be considered and reviewed. Subsection 75(2) effectively attributes income or capital gains from the trust to the settlor when the trust grants the settlor a right of reverter or control over the disposition of the trust assets. Variations of trusts Generally, a court will be reluctant to vary the terms of a trust. Only in instances where it can be demonstrated that the variation will benefit the beneficiaries, will a court provide approval. Unless the trust agreement allows for a variation, provincial trustee legislation in most instances will require that a trustee seek approval from the court. Where the beneficiaries may agree as to the variation but a minor child is also a beneficiary, a court application to vary must be sought to ensure that the minor child s interests are also considered. (See the Alberta case of Sadlemyer v. Royal Trust Co. of Canada, 2012 ABQB 241). A court will vary a trust where it is in keeping with the settlor s intention - see Eaton v. Eaton-Kent 2013 ONSC 7985. 11
A variation of a trust may also effectively terminate the original trust and create a new one. If this occurs, there will be a deemed disposition of all the trust property, which could result in a realization of taxable capital gains. Note should be taken that a variation of a trust may also cause the attribution rules to apply. Caution in that regard should be taken when seeking a variation of trust terms. Winding Up Generally a trust will be wound up pursuant to the wind up provisions in the trust document. Most trust documents contemplate a wind up of the trust within 21 years in order to avoid the deemed disposition rules referred to previously. Where the trust document does not address this issue, provincial trustee legislation requires the trustee to seek court approval for a winding up of the trust. Where the beneficiaries and guardians of minor beneficiaries approve of the wind up, the court must be satisfied that it will be in the best interests of all of the beneficiaries to approve the winding up of the trust. Pursuant to subsection 107(2) of the Act, the capital from a trust can be distributed to any Canadian resident beneficiary at the cost indicated for the trust. This defers any capital gain until death of the beneficiary (unless disposed of prior to that by the beneficiary) unless the trust is revocable as set out in s. 75(2) of the Act. Conclusion Trusts can provide a vehicle that allows for tax planning and control of assets. There are several aspects that must be considered when creating a trust. Being aware of these issues can serve to better understand when a trust might be appropriate and when another planning tool might be considered. The new rules pertaining to the taxation of testamentary makes it challenging to plan using this instrument. However, knowledge of the changes will assist in discussions with clients. The Tax Topic entitled Trusts as a Planning Tool discusses the various types of trusts when planning with life insurance. Last updated: January 2016 Tax, Retirement & Estate Planning Services at Manulife writes various publications on an ongoing basis. This team of accountants, lawyers and insurance professionals provides specialized information about legal issues, accounting and life insurance and their link to complex tax and estate planning solutions. These publications are distributed on the understanding that Manulife is not engaged in rendering legal, accounting or other professional advice. If legal or other expert assistance is required, the service of a competent professional should be sought. This information is for Advisor use only. It is not intended for clients. This document is protected by copyright. Reproduction is prohibited without Manulife s written permission. Manulife, the Block Design, the Four Cubes Design, and strong reliable trustworthy forward-thinking are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license. 12