Unfortunately, taxpayers sometimes play fast and loose with the legalities surrounding family trusts. Sometimes trustees purport to make allocations of income from a trust to its beneficiaries. The beneficiaries treat the amounts allocated as income for the purposes of the Income Tax Act (Canada) (the “Act”). The allocated amounts, however, somehow end up in the hands of other individuals, often the parents of the beneficiaries in question. The parents are often also the trustees of the trust who made the allocations (fiduciary obligations be damned).
Unfortunately, taxpayers sometimes play fast and loose with the legalities surrounding family trusts. Sometimes trustees will purport to make distributions from a trust to its beneficiaries. The beneficiaries treat the amounts received as income for tax purposes, but then those amounts end up in the hands of other individuals, often the parents of the beneficiaries in question, who are often also the trustees of the trust (fiduciary obligations be damned). The CRA, when it audits a trust, will look closely at its distributions to determine who actually enjoyed the benefit of them.
In Laplante c Canada, 2018 CAF 193 [French only], the taxpayer paid more attention to the legalities but then ran afoul of the civil law equivalent of the “sham” doctrine. The trust, pursuant to written resolutions, distributed gains realized on qualified small business corporation shares to family members of the trustee/taxpayer. The family members received cheques for the distributions from the trust but endorsed the cheques to the taxpayer and signed deeds of gift giving the money to him. The family members claimed the capital gain exemption; the taxpayer paid their resulting minimum tax liabilities. The Court held that the taxpayer was the true beneficiary of the payments in question. [Summary in English from taxinterpretations.com here.]
Greg A. Leslie, “Trusts — Be Mindful of Allocating Deemed Income!”, Tax Hyperion 13:11 (November 2016) summarizes CRA technical interpretation 2015-0604971E5 (October 19, 2016). How does a trust allocate a deemed gain under s 48.1 of the Income Tax Act (Canada)? The CRA believes that a deemed gain is a “nothing” so that it cannot be defined as income or a capital gain for trust purposes. The CRA believes that an amount can be payable under s 104(24) if the trust deed specifically permits an amount equal to the deemed gain to be made payable or the trustees have the discretion to pay out amounts that are defined as income under the Act. The CRA also believes that the trustees must exercise their discretion to make an amount payable via a resolution.
An inter vivos trust is approaching its 21-year anniversary. Before the anniversary, the trust distributes property under 107(2) to Canco, a corporate beneficiary, which is wholly-owned by another inter vivos trust. The other trust was just formed, and so it will not be deemed to dispose of its property for another 21 years. The GAAR committee considered this scenario in the context of a ruling request and decided that GAAR would apply. 2016 CTF Roundtable Q1.
Neal Armstrong alerts us to a nasty trap. Suppose Opco pays a dividend to a trust-shareholder, which immediately distributes an amount to Holdco, a beneficiary of the trust. Suppose that the trust then sells its shares of Opco, before the end of the calendar year. The CRA takes the view that a 104(19) designation in respect of the amount distributed by the trust to Holdco is not effective until the end of the calendar year. As a result, Part IV tax will apply to the amount Holdco received because the amount is a dividend only at the end of the year at a time when Opco and Holdco are no longer connected. See CRA technical interpretation 2016-0647621E5 dated June 3, 2016. File that under “Yikes”.
As a coda to my article on “trusts vs estates”, I offer the following from Chow and Pryor, Taxation of Trusts and Estates (Toronto: Carswell, 2016) at 9.2.2(c)(ii):
The residue is not ascertained until the debts and other liabilities of the deceased are determined and paid out, and the estate assets are called in and, to the extent necessary, converted into cash. This provides a window of opportunity to generate income on the assets destined for the spousal trust and use that income to pay estate liabilities and specific bequests. A personal representative who delays intentionally in a bid to extend that window of opportunity may discover that CRA closes the window on an arbitrary date selected as the date when the personal representative ought, in the judgement of CRA, to have been able to successfully ascertain the residue. This would have the effect of tainting the spousal trust if income happened to be used after that arbitrary date to pay out testamentary debts or non-spousal bequests.
Neal Armstrong notes that the CRA continues to maintain that a US grantor trust is not a bare trust for Canadian tax purposes. See his summary of the CRA response to question 10 at the 2016 STEP conference.
Is it always a good idea to take full advantage of the capital gain exemption (CGE) by crystallizing? Assume Ms X crystallizes her Opco shares, but Opco morphs into an investment holding company by the time of her death. In that case, her heirs might pay more tax. Use of the CGE will preclude taking advantage of a pipeline (per 84.1(2)(a.1)(ii)), which, given dividend tax rates these days, could result in $120,000 of additional taxes on an $800,000 gain ($200,000, on $800,000 of capital gains, vs $320,000 on an $800,000 deemed dividend, assuming a 40% rate on the dividend).
What if Ms X claims only half of her CGE in respect of her Opco shares? The total tax liability could be reduced below even that payable on a capital gain only. After Ms X’s death, the estate would transfer her Opco shares to holdco for a $400,000 note and $400,000 of Special Shares with a high ACB and low PUC. The Special Shares would be redeemed (with $160,000 of tax being paid on the redemption) and the resulting capital loss would be carried back against the gain arising on Ms X’s death. The total tax ($160,000) is less than either of the two possibilities described in the previous paragraph.
David Wilkenfeld, “Crystallization Planning: Less May Be More” <em>Tax for the Owner-Manager</em> 16:2 (April 2016)
The following article appeared in the most recent edition of The Hamilton Law Association Journal.
What is the difference between an estate and a trust? And why does it matter for tax purposes? Continue reading
The CRA, in technical interpretation 2014-0553181E5F (June 25, 2015), says that a spousal trust cannot be a “graduated rate estate” for the purposes of the Act.