Insert index tab here: 4. TAXATION OF PERSONAL TRUSTS. (Then recycle this sheet.)

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1 Insert index tab here: 4. TAXATION OF PERSONAL TRUSTS (Then recycle this sheet.)

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3 TAX FUNDAMENTALS FOR THE ESTATE PRACTITIONER PAPER 4.1 Taxation of Personal Trusts These materials were prepared by Nicholas P. Smith of Legacy Tax + Trust Lawyers, Vancouver, BC, for the Continuing Legal Education Society of British Columbia, February Nicholas P. Smith

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5 4.1.1 TAXATION OF PERSONAL TRUSTS I. Introduction... 1 II. Types of Trusts... 1 A. Testamentary Trust v. Inter Vivos Trust... 1 B. Spousal Trust... 2 III. Allocation of Income to Beneficiaries... 3 IV. Residence of a Trust...4 A. Trustee of Thibodeau Family Trust v. The Queen... 4 B. Interpretation Bulletin IT C. Garron Family Trust (Trustee of) v. The Queen... 4 V. 21 Year Deemed Disposition Rule... 5 VI. The Taint of Section 75(2)... 6 VII. Conclusion... 8 I. Introduction Trusts are used in personal tax and estate planning for a variety of reasons. Some of these reasons include minimizing and deferring income tax liabilities, avoiding probate fees, facilitating the administration of particular properties or entire estates, avoiding the Wills Variation Act and protecting assets from third party claims (subject to restrictions on fraudulent conveyances). The purpose of this paper is to highlight some of the tax issues that a non-tax estate practitioner should be alert to when dealing with personal trusts. II. Types of Trusts A. Testamentary Trust v. Inter Vivos Trust A personal trust is either a testamentary trust or an inter vivos trust in which no beneficial interest has been acquired for consideration paid either to the trust or to a contributor to the trust. 1 A testamentary trust is a trust that is settled upon a person s death and an inter vivos trust is a trust that is settled during a person s lifetime. For tax purposes, the key distinction between the two types of trusts lies in their tax treatment. Testamentary trusts are taxed at progressive rates just like individuals whereas inter vivos trusts are subject to the highest personal marginal rate of federal tax of 29% on all of the income retained in the trust (with very limited exceptions). 2 Note that if a person contributes property to a testamentary trust after the death of the settlor, the trust will lose its testamentary status and will become an inter vivos trust. 3 1 Section 248(1) of the Income Tax Act (the Act ). 2 Section 122(1) of the Act. 3 Definition of testamentary trust in s. 108(1) of the Act.

6 4.1.2 Testamentary trusts provide an opportunity for income splitting where income of a testamentary trust that would otherwise be paid to a beneficiary subject to tax at a high marginal rate is taxed in the trust. If a settlor tries to create multiple testamentary trusts to take advantage of multiple sets of lower marginal tax rates, s. 104(2) of the Income Tax Act (the Act ) is an anti-avoidance provision that allows the Minister of National Revenue to treat the multiple trusts as a single trust where they have been substantially funded by the same person and are for the benefit of the same beneficiary or class of beneficiaries. B. Spousal Trust One type of special purpose trust that deserves mention is a spousal trust. This is a trust created by one spouse or common law partner for the benefit of the other. A spousal trust can either be inter vivos (created during the lifetime of the settlor) or testamentary (created upon death of the settlor). Testamentary spousal trusts are more commonly employed so that the settlor can determine the use, management and disposition of property over more than one generation. Where, for example, a settlor owns a commercial rental property that he wants to leave to his wife but he wants the property to be professionally managed, and after her death, he wants the property to be left to their children, a spousal trust can make this happen. 4 If the settlor instead gifts the property directly to his wife, he has no control over how she will manage the property and whether she ultimately leaves the property to their children after her death. A spousal trust has two requirements: (a) the settlor s spouse or common law partner is entitled to receive all of the income of the trust that arises before the death of the spouse or common law partner; and (b) no person, other than the spouse or common-law partner, may receive or obtain the use of any of the income or capital of the trust before the death of the spouse or common-law partner. 5 The entitlement of the spouse to income cannot be restricted in any way and it cannot be subject to the discretion of the trustee. If the spouse has creditors, the spouse s entitlement to income could be an asset that is available to satisfy creditors claims. Although the spouse has the unfettered right to income from the spousal trust, there is no requirement that the spouse have any entitlement to capital during the lifetime of the spouse. It is possible to restrict the spouse to being an income beneficiary with other persons being entitled to the capital upon the death of the spouse. Following the death of the spouse, any person including the settlor or the children can be entitled to the income or capital of a spousal trust. The transfer of property to a trust is generally regarded as a disposition under the Act thereby giving rise to deemed proceeds of disposition equal to fair market value of the property. However, rollover treatment is available for transfers of property to a spousal trust on a tax-deferred basis. A rollover is available for transfers of capital property to an inter vivos spousal trust under s. 73(1) or to a testamentary spousal trust under s. 70(6) of the Act. In either case, the trust will be deemed to have acquired the capital property for an amount equal to the adjusted cost base (in the case of nondepreciable property) or the undepreciated capital cost (in the case of depreciable property). These rollover provisions do not eliminate the tax they just defer the tax until the spouse disposes of, or is deemed to have disposed of, the property (for example, upon death of the spouse), at which time the gain on the property will be taxed. 4 Michael N. Kandev and Fred Purkey, Practical Applications of Trusts, Report of Proceedings of Fifty-Sixth Tax Conference, 2004 Tax Conference (Toronto: Canadian Tax Foundation, 2005), 40: Section 73(1), (1.01) of the Act.

7 4.1.3 III. Allocation of Income to Beneficiaries A trust, unlike a corporation, is not a separate legal entity but for income tax purposes, a trust is deemed to be an individual under s. 104(2) of the Act. Accordingly, a trust is taxable on its income earned during the year. Any amount paid or payable in the year to a beneficiary from a trust is included in the beneficiary s income and therefore taxed in the beneficiary s hands. 6 The trust receives a deduction for the income paid or payable to a beneficiary. 7 Therefore, a trust is only taxed on income which accumulates in the trust. A trust can make a designation under s. 104(13.1) to have income payable to beneficiaries taxed in the trust. Section 104(13.2) applies with the same effect with respect to capital gains that are payable to a beneficiary. These designations represent a tax-planning opportunity where the beneficiary is taxed at a higher marginal rate than the trust (such as a testamentary trust which is taxed at progressive rates of tax). In these circumstances, it is worthwhile to have the income or capital gains taxed in the trust at the lower marginal tax rates and paid out to the beneficiary on an after-tax basis. Income earned by a trust will generally lose its character when it is distributed to beneficiaries. Income received by a beneficiary from a trust is characterized as income from property. 8 However, there are designations available to cause certain types of income to retain their character: Section 104(19) provides that a trust resident in Canada may designate that a taxable dividend received from a taxable Canadian corporation be deemed to be received by the beneficiary directly. The effect is that a resident individual beneficiary will be entitled to the gross-up and dividend tax credit. A beneficiary that is a corporation will be entitled to a tax-free intercorporate dividend. The Canada Revenue Agency ( CRA ) confirmed at the 2008 Canadian Tax Foundation conference that s. 104(19) also applies to eligible dividends so that an eligible dividend received by a trust resident in Canada can retain this characterization when distributed to a beneficiary. 9 Section 104(20) allows a trust resident in Canada to make a designation in respect of capital dividends so that capital dividends received by the trust retain this characterization when distributed to a beneficiary. The effect is that the capital dividends will remain tax-free in the hands of a Canadian resident beneficiary. Capital dividends designated in respect of a corporate beneficiary can also be added to the capital dividend account of the recipient corporation. 10 Section 104(21) allows a trust to designate taxable capital gains to be taxable capital gains of its beneficiaries. The designation is useful if the beneficiary has capital losses available to offset the taxable capital gains. This designation does not allow a beneficiary to claim the $750,000 capital gains exemption unless the trust makes an additional designation under s. 104(21.2). 6 Section 104(13) of the Act. 7 Section 104(6) of the Act. 8 Section 108(5)(a) of the Act. 9 Income Tax Technical News No Paragraph (g) of the definition of capital dividend account under s. 89(1) of the Act.

8 4.1.4 IV. Residence of a Trust Given that a trust is deemed to be an individual, if a trust is resident in Canada, it is liable to tax on its worldwide income under s. 2(1). The Act is silent with respect to determining the residence of a trust and accordingly the guidelines have been established by jurisprudence. A. Trustee of Thibodeau Family Trust v. The Queen A recent Tax Court decision, Garron Family Trust (Trustee of) v. The Queen, 2009 TCC 450, affirmed by the Federal Court of Appeal in 2010, changes the long-standing understanding on determining the residence of a trust. Prior to Garron, the most frequently cited decision was Trustee of Thibodeau Family Trust v. The Queen, 78 DTC 6376, a decision of the Federal Court Trial Division. The facts in Thibodeau involved a family trust that had three trustees, two of whom were individuals resident in Bermuda and Mr. Thibodeau himself who was resident in Canada. The trust deed provided that decisions of the three trustees were decided by a majority vote. It was demonstrated that on at least five occasions, the Bermuda trustees overruled the investment proposals made by Mr. Thibodeau. On these facts, the Court held that the family trust was resident in Bermuda. Based on Thibodeau, it was generally accepted that the residence of the majority of the trustees determines the residence of a trust. B. Interpretation Bulletin IT-447 In its administrative policy expressed in Interpretation Bulletin IT-447 Residence of a Trust or Estate, the CRA accepts that residence of a trust is normally dependent upon residence of the trustees who exercise management and control of the trust. However, the CRA recognizes that in some situations, the facts may indicate that a substantial portion of the management and control rests with some other person such as the settlor or the beneficiaries. In these circumstances, the CRA notes the residence of this other person that has management and control may be considered to be the determining factor for the trust regardless of any contrary provisions in the trust agreement. Accordingly, the CRA s administrative view has always recognized that the residence of a trust is not strictly determined by the residence of its trustees but the Federal Court of Appeal in Garron has taken this a step further by establishing that the residence of a trust is determined by the location where management and control is exercised which is not necessarily the same as the residence of the person that exercises management and control. C. Garron Family Trust (Trustee of) v. The Queen The facts involved Mr. Garron and another individual, Mr. Dunin, who were residents of Canada. They were shareholders in an operating company that successfully operated a business in Canada specializing in producing automotive interior systems. As part of a reorganization in 1998, Mr. Garron and Mr. Dunin froze their interests with the goal that no Canadian tax would be payable on any future capital gains that could result from any future increase in the value of the operating company. Mr. Garron and Mr. Dunin each incorporated holding companies to subscribe for new common shares in the operating company. Each holding company was wholly owned by a discretionary family trust. The sole trustee of each trust was St. Michael Trust Corp, a trust company incorporated and licensed in Barbados. In 2000, the business was sold in an arm s length transaction where the purchaser purchased the shares of the holding companies owned by the two family trusts. The resulting capital gain was $450 million. The trusts took the position that the trusts were residents of Barbados and therefore the capital gains were exempt from Canadian income tax under the Canada-Barbados Tax Treaty. The Minister of National Revenue argued that the two family trusts were residents of Canada. Justice Woods of the Tax Court laid down the test that the residence of a trust should be based on where the central management and control of the trust actually abides. As the facts of this case

9 4.1.5 illustrate, central management and control is not necessarily where the trustees reside if the trustees do not actually have management and control of the trust assets. The Court found that Mr. Garron and Mr. Dunin, residents of Canada, made all of the substantive decisions concerning the trust assets and that the role of the Barbados trustee was really just to execute documents and to provide incidental administrative services. Accordingly, Justice Woods concluded that central management and control of the two family trusts were located in Canada and the trusts were therefore resident in Canada. Garron was appealed to the Federal Court of Appeal which accepted the management and control test set down by the Tax Court. 11 The Court rejected the widely held rigid legal test that ties the residence of the trustee, regardless of the facts, to the residence of the trust, noting it is not sound in principle because the determination of residence for tax purposes should be a question of fact. The Court pointed out it may well be that the residence of the trustee is a sufficient basis for determining the residence of a trust where the trustee actually exercises the powers and discretions over the management and control of the trust property and does so where he or she resides. On this view, the Court s reasons are not inconsistent with the findings in Thibodeau because there, the evidence showed that the Bermuda trustees exercised management and control. The Federal Court of Appeal observed that there is a line to be drawn in determining whether management and control lies with the trustees or with the beneficiaries. On one side of the line, beneficiaries can make recommendations to the trustees but the trustees are ultimately free to decide how to exercise their powers and discretions under the trust. The facts in Thibodeau fall on this side of the line because the evidence there showed that the majority of the trustees exercised management and control. In these circumstances, the location from which the trustees exercise management and control determines the residence of the trust. On the other side of the line, the beneficiaries are really exercising the powers and discretions under the trust, managing and controlling the trusts and displacing the appointed trustee. In these other circumstances, the location from which the beneficiaries exercise management and control will determine the residence of the trust. The Federal Court of Appeal upheld the Tax Court s finding that the facts in Garron fell on the side of the line where management and control were exercised by Mr. Garron and Mr. Dunin, and not by the Barbados resident trustee. The Garron decision makes it clear that trusts cannot rely on puppet foreign trustees to support the non-residence of a trust. The determination of the residence of a trust is a question of fact based on all of the evidence in its totality. This is not the last chapter in Garron as it is our understanding that the taxpayers will seek leave to appeal to the Supreme Court of Canada. V. 21 Year Deemed Disposition Rule The Act imposes a deadline by which trusts are deemed to dispose of capital property and to dispose of any interest in land included in the inventory of a business carried on by the trust. 12 Without such a time limit, there could potentially be an indefinite deferral of capital gains on property held in a trust. For most inter vivos trusts, the first such deemed disposition will take place on the twenty-first anniversary of the settlement of the trust, and every twenty-one years thereafter. 13 Spousal trusts have a different initial deemed disposition date being the date of death of the spouse followed by deemed dispositions every 21 years thereafter. On the date of the deemed disposition, the trust will be deemed to have disposed of and reacquired the property at fair market value, thereby forcing the trust to realize all accrued gains and losses. 11 St. Michael Trust Corp. as Trustee of the Fundy Settlement v. The Queen, 2010 FCA Sections 104(4), 104(5) and 104(5.2) of the Act. 13 Section 104(4) of the Act.

10 4.1.6 The impact of the 21 year deemed disposition depends on the nature of assets held in the trust. If the trust assets have a high cost base (for example, public company shares that are regularly traded), the tax consequences of the deemed disposition will be insignificant if the accrued gains are minimal. However, if the assets have a low cost base as they have been held for a long period of time and substantial gains have accrued (such as residential real estate purchased in Vancouver 21 years ago), the tax triggered by the deemed disposition could be significant. In determining when the 21 year clock starts ticking, keep in mind the date on the trust deed is not necessarily the date a trust is created. The date that a trust is created is the day on which three certainties are satisfied: certainty of intention, certainty of subject matter and certainty of objects. A trust deed may identify the settlor, the trustees, the terms of the trust and the property to be held in trust. However, if the property is transferred to the trust at a later date, the trust is not created until the date of transfer of the trust property to the trustees. There are strategies to defer capital gains for more than 21 years. A common strategy is to distribute the trust property to a capital beneficiary prior to the 21 year deemed disposition pursuant to s. 107(2) of the Act. 14 Section 107(2) is a rollover provision that applies where the following requirements are met: the trust must be a personal trust; the beneficiary receiving the property must dispose of all or part of the beneficiary s capital interest in the trust; and the beneficiary must be a resident of Canada. Under this subsection, the trust is deemed to dispose of the distributed property for its cost amount and the beneficiary is deemed to have acquired the property at the same cost amount. The trust therefore recognizes no capital gain or loss. This rollover provision does not eliminate the tax - it just defers the tax until the beneficiary disposes of, or is deemed to have disposed of, the property (for example, upon death of the beneficiary), at which time the gain on the property will be taxed in the hands of the beneficiary. This rollover treatment is severely restricted should the attribution rule in s. 75(2) apply, which is discussed below. Christine McCaffrey of KPMG will be providing more detail on distributions to resident and non-resident beneficiaries in her presentation at this conference. In some cases, the trustees may not want to distribute the property to the capital beneficiaries because if the property is taken out of the trust, this may defeat the initial estate planning objectives (such as providing for disabled beneficiaries). If no steps are taken to get around the 21 year deemed disposition rule, the deemed disposition results in the trust having reacquired the property at fair market value. The trust could decide to sell the trust assets at the resulting high cost base to raise the funds required to pay the tax from the deemed disposition. The 21 year deemed disposition does not apply to trusts in which all the interests have vested indefeasibly. 15 Thus, the trustee of a trust can avoid the application of the deemed disposition by simply fixing the interests of the beneficiaries without actually making a distribution (subject to less than 20% being vested in non-resident beneficiaries). VI. The Taint of Section 75(2) Whenever a trust receives property, the attribution rule in s. 75(2) must be considered as the application of the subsection could be inadvertently triggered, the consequence of which is that any income or losses and capital gains or capital losses earned by the trust in respect of the particular 14 The rollover in s. 107(2) of the Act does not apply to distributions to non-resident beneficiaries. 15 Paragraph (g) of the definition of trust in s. 108(1) of the Act.

11 4.1.7 property are attributed to the person who transferred the particular property to the trust. There are other attribution rules in the Act that can potentially apply to trusts but given the breadth of s. 75(2), estate practitioners should be particularly mindful of this attribution rule when dealing with inter vivos trusts. Section 75(2) has no application for testamentary trusts. Section 75(2) is most commonly thought of in relation to property transferred to a trust by the settlor but it could apply to any person that transfers property to a trust. Warning bells should go off when a trust deed is drafted such that the settlor retains a degree of flexibility and control over a trust. The conditions under s. 75(2) will be present where property is held by a trust on condition that the property: may revert to the person from whom the property or property for which it was substituted was directly or indirectly received; may pass to persons to be determined by the contributing person at a time subsequent to the creation of the trust; or cannot be disposed of, during the lifetime of the contributing person, except with the contributing person s consent or in accordance with the person s direction There are three conditions under which the attribution rule in s. 75(2) could apply. Under the reversionary condition, the subsection applies if the trust deed allows the settlor or other person who contributed property to a trust to reacquire the property, even if the ability to reacquire the property was remote. This condition will occur where the person that contributed the property is a potential capital beneficiary. This condition applies to direct and indirect transfers of property. An example of an indirect transfer is where a taxpayer gifts property to his spouse and the spouse subsequently transfers the property to a trust. 16 In this example, the taxpayer could be regarded as having made an indirect transfer to the trust and will be caught by s. 75(2) if the taxpayer is named a capital beneficiary of the trust. If the person that contributes property is made an income beneficiary, that does not appear to be caught by s. 75(2). Under the second condition, the attribution rule in s. 75(2) applies if the person that contributed property to the trust has the ability to exercise control over who will receive the contributed property. This condition will be satisfied where the trust is discretionary and the person from whom the property was received is a controlling trustee (or if the person has a veto). The third condition will be satisfied if the person that contributes property to the trust acts as a trustee who has sole or veto power as trustee. Specifically, s. 75(2) applies in the following circumstances where the person that contributed the property: (a) is the sole trustee; (b) is one of two trustees of the trust if the trust expressly requires the contributor s consent to any decisions made by the trustees as a whole 17 ; or (c) is one of three or more trustees of a trust and the trust deed has a majority rule clause that requires the contributor to be part of the majority. 18 Where s. 75(2) applies, the income or losses and capital gains or capital losses from the particular property will be attributed to the person from whom the property was received during the existence of the person while the person is resident in Canada. There are two observations here. First, s. 75(2) 16 Brenda L. Crockett, Subsection 75(2): The Spoiler in Personal Tax Planning, (2005), vol 53, no 3 Canadian Tax Journal, CRA Views E5 Application of s. 75(2) dated October 27, CRA Views E5 Application of s. 75(2) dated October 27, 2008.

12 4.1.8 ceases to apply to the particular property once the contributor is deceased or is no longer resident in Canada. Second, the attribution only applies to the particular property that meets the conditions of s. 75(2) and not to other property held by the trust. The potentially more damaging consequence of s. 75(2) is that it can virtually wipe out the rollover treatment of distributions of any property from the trust to its capital beneficiaries. This is because of s. 107(4.1) of the Act. As discussed above, s. 107(2) allows a trust to distribute property to a capital beneficiary on a tax-deferred basis. However, subsection 107(2) does not apply if subsection 107(4.1) applies. Section 107(4.1) provides that if s. 75(2) applies at any time in the history of the trust, the trust will not be able to distribute any property of the trust on a tax-deferred basis to any beneficiary except where the property is transferred back to the person who contributed the property (or the person s spouse or common law partner) and that person is a beneficiary of the trust. Section107(4.1) is particularly harsh because the denial of the rollover under s. 107(2) applies to all property of the trust, not just the transferred property that gave rise to s. 75(2). Further, even if s. 75(2) no longer applies at the time of distribution of property from the trust to the capital beneficiary, if s. 75(2) had applied at any time during the history of the trust, that is enough to invalidate the rollover under s. 107(2). There is no way to undo s. 107(4.1) if s. 75(2) has applied at any time in the history of the trust. The only way that s. 107(4.1) ceases to apply is if the person that contributed the property that triggered the application of s. 75(2) ceases to exist (for example, on the death of an individual contributor). Where s. 107(4.1) applies, any distributions of property from the trust to a beneficiary (other than the contributor) will be deemed to have been disposed of for proceeds equal to fair market value. The result, therefore, is that the trust will be forced to realize any accrued gains on the property. A simple example illustrates the far-reaching consequences of s. 107(4.1). For example, a $100 contribution to a trust by a settlor that is a capital beneficiary will result in the application of s. 75(2) in respect of any income earned from the $ The attribution of the minimal income (for example $5) earned on the $100 is not worrisome. However, if the trust holds other assets with significant accrued gains (for example, real estate), then there can be a permanent denial of rollover treatment to the distribution of the real estate all because of the $100 contribution. Therefore, it is important when a trust is considering a distribution of property to its capital beneficiaries (for example, to avoid the 21 year deemed disposition rule) to review the terms surrounding any property received by the trust to confirm whether the trust has been tainted by s. 75(2). VII. Conclusion It is hoped that this paper can give the basic tools to an estate practitioner to identify circumstances where potential tax liability could arise on setting up personal trusts due to the attribution rule under s. 75(2) and the 21 year deemed disposition rule. In light of the recent Federal Court of Appeal decision in Garron, estate practitioners should review trusts that they have established and treated as being non-resident to ensure that the residence of the trust is not subject to redetermination based on the central management and control test. 19 Supra, n. 16.