Saturday, May 6, 2006

"Trust" Me: Contributions Can Return To Haunt You

The Income Tax Act contains a variety of rules designed to prevent tax avoidance through income splitting. A good example of how these rules usually work is found in subsection 75(2), which limits income splitting through trusts.

Benefits of a family trust are well known, they include: creditor-proofing; splitting the lifetime capital gains exemption among the beneficiaries; and providing for minors, disabled adults and children who are financially irresponsible. However, there are traps for the unwary trust contributor.

Subsection 75(2) applies in any case where: (a) the trust allows the contributor to get the property he or she contributed back; (b) the contributor can control which beneficiaries receive the property; or (c) the property cannot be disposed of without the contributor's consent.

The consequences of subsection 75(2) can be quite severe. The typical consequence is that any income (or loss) or capital gain (or capital loss) earned by the trust from the contributed property is deemed to be that of the contributor. Most advisors are aware of the typical attribution consequence. There are also far-reaching effects in the application of other provisions of the Income Tax Act. Usually a trust can distribute capital property to a beneficiary on a tax-deferred basis. This means that a transfer of property out of a trust does not create a capital gain. The property is transferred at its cost to the trust. However, if the criteria for section 75(2) are met at any time (even if there is no actual income or gain to attribute to the contributor), then at the time of distributing the property to a beneficiary the trust would have to pay tax on the increase in value of the property over the time the trust owned it. This is true regardless of whether the capital property received is same as the contributed property.

Here’s an example of subsection 75(2): let's say the Jones' have a family trust where the children are the beneficiaries, and their father, Allan, is the sole trustee of the trust. Allan contributes $100 to the trust on January 1, 2006. Since Allan as trustee decides which of the children can benefit under the trust, subsection 75(2) applies. Allan is deemed to receive any income or gains that the trust earns on the $100 he contributed. If the trust invests the $100 at a 5% rate of return, then Allan, rather than the trust, is deemed to have received the $5 in income even though it’s not his income.

$5. Big deal. Now let's say the trust also owns that same painting of a big red stripe that is now worth $1.2 million (previously owned by the National Gallery of Canada). If the trust had purchased it for $1 million, the accrued gain on the painting would be $200,000. Because of Allan's $100 contribution to the trust (which caused section 75(2) to apply), the trust would not be able to distribute that painting to a beneficiary without the trust now paying tax. This is a big deal.

That $100 leads to a surprising consequence. The beneficiary ends up paying tax on a property received rather than property disposed of. Thankfully the Act provides ways to limit the application of the attribution rules. For example, Allan's wife and two others could replace him as trustees of the trust before Allan makes his contribution.

There are many other attribution rules which are also no fun, but trust me, there are ways to plan around them.

-- Devinder Sidhu

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.