Inter vivos trusts are taxed at the top marginal rate on all income, as determined under the ITA, retained in the trust for a taxation year. They are subject to tax at both the federal and provincial levels.
There can be deductions from income otherwise taxable for amounts paid or payable to beneficiaries. In order for a trust to be able to claim eligible deductions, it is important that they meet the requirements under the ITA. A key requirment is that the amount desired to be deducted must have been paid or payable to the beneficiary in the particular tax year of the trust for which the deduction is desired.The accounting process to determine amounts earned in a trust that are avaiable for distribution can take time and may not line up with the ITA’s requirements. However, there are options for establishing a beneficiary’s right to income from a trust for a specific tax year even if the exact amount has not been set or paid. The result is that the requirements will be deemed to have been met by the deadline. This requires appropriate documentation and coordination between the lawyer and accountant for the trustees of the trust.
Generally when property is transferred to a trust, other than as a sale at fair market value, there is a deemed disposition of the property to the transferor at fair market value which may trigger tax liability for the transferor. This does not apply in all cases such as transfers to spousal trusts, alter ego and joint partner trusts and bare or self-benefit trusts. In these cases, the transfers can be done at cost base. There is still a deemed disposition but it just does not trigger the liability that would otherwise result.
In order to qualify for the rollover treatment, these trusts must meet certain requirements under the ITA. Bare trusts in particular should be used with caution as they are not as simple as they sound and may trigger estate administration tax consequences if other estate planning documentation is not in place in addition to the trust deed.
Many, but not all, inter vivos trusts are subject to a 21 year deemed disposition rule. What this rule does is cause the trust to be deemed to have disposed of all of its property at fair market value on each applicable 21 year deemed disposition date. This of course can trigger substantial income tax liability. Exceptions exist for trusts such as alter ego and joint partner trusts as well as bare or self-benefit trusts and spousal trusts. Also, the rule only applies to discretionary trusts and not fixed interest trusts. It may be possible to have a discretionary trust be convertible to a fixed interest trust to address the rule.
An attractive aspect of using trusts can be the ability to transfer trust property out to beneficiaries of the trust, in satisfaction of their interest in the trust or a portion of their interest, at cost base. This avoids tax being triggerd in the trust and essentially delays realization of gains until the beneficiary sells or otherwise disposes of the property in a way that triggers a tax liability. The ability to roll assets out may not apply to all trusts but where it is an intended purpose of a trust and otherwise an available option, it is critical not to trigger application of a particularly unpleasant atribution and anti-avoidance section of the ITA – subsection 75(2).
Subsection 75(2) of the ITA is triggered in the following circumstances:
- property is held on condition that it or property subsubstituted for it may
- revert to the person from whom the property (or property for which it was substituted) was directly or indirectly received, or
- pass to a person to be determined by the person at a time subsequent to the creation of the trust, or
- that, during the existence of the person, the property shall not be disposed of except with the person’s consent or in accordance with the person’s direction
Some examples will make the rule a little clearer. Say Bob transfers property to a trust where he is also a beneficiary. That offends the first part of the rule. Alternatively, Bob transfers property to a trust and is not a beneficiary but he is the sole trustee, one of two trustees or must form part of a majority of the trustees for decisions regarding the distribution of trust property. That would offend the next part of the rule although there is still some debate about the situation where there are just two trustees. The safe option is to ensure a trustee who transfers property to a trust is never in a control position (not even negative control).
Finally, if Mary transfers property to a trust and is not a beneficiary and is not a trustee, or at least not a trustee with control (even negative control), but has a power to approve dispositions from the trust such as being a protector of the trust with certain powers like approving dispositions or just a power reserved to her as the settlor of that property to approve dispositions then the last part of the rule would be violated.
The result of triggering 75(2) is that all income (including capital gains) and losses of the trust are attributed back to the person who transferred the property to the trust in contravention of the rule to be taxed in their hands instead of the trust. The other result is the prevention of trust property from being rolled out to beneficiaries at cost base as discussed above.
There are few remedies for 75(2) violations and, in the rare instances where it might be possible to correct the situation, the steps necessary will be expensive but likely less than the tax. To avoid unexpected results, all transfers to a trust should be carefully reviewed before completion and consideration should be given to including protective wording in the trust deed to prevent unwanted transfers.
The attribution in 75(2) ceases when the person who transferred the property in violation of the rule ceases to exist or ceases to be resident in Canada. However, this does not revive the ability to transfer propeprty out of the trust to the beneficiaries on a rollout basis. That privilege is permanently lost if 75(2) applied to the trust at any time.
In the last few years, the CRA started an audit program directed at inter vivos trusts. They are examining various issues including the circumstances surrounding the establishment of the trust, the retention of the initial settlement property and whether the “paid or payable” requirements have been met to allow income amounts to be deducted from the trust’s income. The CRA is also monitoring trusts for avoidance transactions. Therefore, it is even more important than ever to follow all legal steps properly to establish and maintain trusts as well as thoroughly documenting key aspects of the trust’s administration.
The filing deadline, as with all trusts, is within 90 days from the end of the tax year of the trust. Inter vivos trusts have a calendar year end.