Effective Uses of Trusts in Estate Planning: The Depth and Breadth of Trusts

Effective Uses of Trusts in Estate Planning: The Depth and Breadth of Trusts

Blair P. Dwyer, Dwyer Tax Lawyers

  

Portions of this paper were originally presented at a conference entitled “Trusts: The Multi-Faceted Estate Planning Tool”, presented in Vancouver, British Columbia on October 19, 2012 by the Continuing Legal Education Society of British Columbia.  Those portions have been updated.

Table of Contents

I.          General          1

II.          What is a Trust?          2

III.               Terminology               3

IV.               Testamentary Trusts               4

           A.          GENERAL          4

           B.          UPCOMING CHANGES          5

           C.          GRADUATED RATE ESTATES          6

           D.          MULTIPLE GRADUATED RATE ESTATES?          10

           E.          TAXATION YEAR          12

           F.          OTHER CHANGES          13

           G.          WHITHER TESTAMENTARY TRUSTS?          16

V.          Will Alternatives          18

           A.          GENERAL          18

           B.          ALTER EGO AND JOINT SPOUSAL TRUSTS          20

           C.          SELF-BENEFIT TRUST          29

           D.          QUALIFYING DISPOSITION TRUST          34

           E.          SPOUSAL TRUST          35

           F.          BARE TRUST          36

           G.          PRINCIPAL RESIDENCE TRUST          37

VI.               Estate Freezes               39

           A.          GENERAL BACKGROUND          39

           B.          THE FAMILY TRUST          43

           C.          A NOTE ON ESTATE FREEZE TERMINOLOGY          44

           D.          INVESTMENT POWERS          44

           E.          IDENTITY OF TRUSTMAKER          45

           F.          CHOICE OF TRUSTEE          51

           G.          BENEFICIARIES          54

           H.          MAINTENANCE OF THE TRUST          61

           I.          EFFECT OF THE TRUST          64

VII.               Charitable donations               65

           A.          GENERAL          65

           B.          2014 FEDERAL BUDGET CHANGES          65

           C.          LIVING TRUST ISSUES          66

           D.          CHARITABLE REMAINDER TRUSTS          67

VIII.              Conclusion   70

I.                   General

The Income Tax Act (the “ITA”) contains references to various types of personal trusts, each with special income tax attributes.  This paper will deal with the following types of personal trusts.

1.                  Testamentary Trusts.

2.                  The following types of living trusts (inter vivos trusts for those who like Latin tags).

(i)                 Alter Ego Trusts.

(ii)               Joint Spousal or Common-Law Partner Trusts.  I will refer to these simply as “Joint Spousal Trusts”.

(iii)             Self Benefit Trusts.  This is not a term used in the ITA but seems to be the best way of describing these types of trusts.

(iv)             Qualified Disposition Trusts.

(v)               Bare Trusts.

The paper will also deal with specific uses of personal trusts, such as the family trust used in the context of an estate freeze and trusts that hold principal residences.  These are not specific types of trusts recognized as such by the ITA.  Rather, these are ordinary trusts used in specific contexts and for specific purposes.

Another use for trusts is in charitable giving, such as through a charitable remainder trust.  While much has been written about charitable remainder trusts, this type of trust is not specifically recognized in the ITA and exists primarily due to Canada Revenue Agency (“CRA”) administrative policy.

The paper will not deal with the trust that governs the estate of a bankrupt.  Neither will the paper deal with non-resident trusts,[1] trusts with cross-border complications, mutual fund trusts, unit trusts or commercial trusts.

II.                What is a Trust?

A trust is a relationship that exists in respect of property.  At its simplest, a trustee holds the legal title to property but holds that property for the benefit of others (the beneficiaries of the trust).  The trustee has legal control over the trust property and can pass good title to a third party even if the trustee is committing a breach of trust (provided that the third party is not aware of the breach of trust).[2]

To create a trust, one must make sure that the three certainties are present.

(a)        Certainty of intention.  There must be an intention to create a trust and not some other relationship, such as agency.

(b)        Certainty of subject matter.  It must be possible to identify the property that is subject to the trust and to distinguish that property from other property.

(c)        Certainty of objects.  It must be possible to identify the beneficiaries.

Filing a T3 Trust Income Tax Return is not one of the three certainties.

While the above should be familiar to everyone, we can sometimes confuse the tax treatment of trusts with the actual legal concept of a trust.  The Income Tax Act taxes a trust only if the trust in fact exists.  If the trust relationship has been successfully created, the trustee is taxed as if the trust were a separate individual and as if the trust were a separate taxable entity with its own income.[3]  This income tax treatment is a legal fiction that is useful for calculating the income of the trust separately from the income of the trustee.  However, this income tax fiction – while useful for income tax purposes -- has no effect on the law of trusts.[4]  Even though a trust is treated as if it were a legal entity for income tax purposes, a trust is not a legal entity at law.

The separate entity treatment that applies for income tax purposes tends to creep into the way that professionals think of trusts in other contexts.  For example, I have seen many documents that purport to be signed by a trust in the following manner.

The XYZ Trust, by its trustees

_____________________________
Authorized Signatory

The above signature is a corporate-style signature in which an authorized signatory is signing on behalf of a corporation, which is a separate legal entity.  This form of signature line is completely inappropriate for a trust because, as mentioned, a trust is not a separate legal entity.  A trust is a series of obligations imposed upon a trustee.  Consequently, the signature line should be as follows.

_________________________________________
John Smith, acting as a Trustee of The XYZ Trust

The above distinction has practical significance. 

Whereas a director of a corporation is not liable for defaults of a corporation (except in specific instances of statutory liability or a liability arising because the director was negligent in managing the corporate entity), a trustee is personally liable for all obligations entered into by the trustee.  This is because the trust is a type of special pocket in which the trustee holds specific assets governed by specific rules.  If Bob is the trustee, it is Bob (and not some separate trust entity) who is personally responsible for all matters dealing with the trust.  If something goes wrong, it is Bob who is liable.  Unless Bob has somehow taken steps to limit his liability, anyone with a claim can satisfy that claim out of the trust assets and (if the trust assets are insufficient) the personal assets of Bob.  This will be expanded on in one of the other papers at this conference.  I mention this here in order to caution the reader to carefully distinguish between the special rules that income tax law applies in respect of trusts and the actual legal principles applicable to trusts.

III.             terminology

Because lawyers are trained to respect precedents, we tend to use terms long after they have outlived their usefulness.

When speaking of trusts, lawyers tend to talk of a “settlor” who “”settles” a trust or who engages in a “settlement” of property on a trustee.  For most clients, however, a “settlement” is a new community founded by those who have trekked across the prairies in Red River carts (we have to use Canadian imagery).  As well, “settlor” sounds too much like “settler” -- being a person who moves into the settlement.

I find that clients have an easier time of it if I refer to a “trustmaker” “establishing” a trust and will use those terms in this paper.[5]

IV.             Testamentary Trusts

A.    GENERAL

The big development over the past two years is the forthcoming change in the taxation of testamentary trusts.[6]

At the moment, the ITA defines a testamentary trust as a trust that arose on, and as a consequence of, the death of an individual.[7]  This would generally include a trust established under the will of a deceased and a trust that is initially funded by the death benefit payable under a life insurance policy.[8]

The ITA contains various rules under which a testamentary trust can lose its status as such.[9]  For example, assume that a trust is created under a will.  If a living person (perhaps a friend of the deceased) gifts any amount (even $1) to that trust, the trust loses its status as a testamentary trust.[10]

Under current law, a testamentary trust is considered to be a separate individual for income tax purposes.  As a result, income taxed inside the trust is taxed under a separate set of graduated rates.  This provides scope for income splitting.  A beneficiary in a high tax bracket can have trust income taxed inside the trust at a separate set of graduated rates and thereby pay less tax than if the income generated inside the trust had simply been additional income of the beneficiary. 

For example, assume that the after-tax value of the estate is $1 million and that this amount is invested at a 5% rate of return (annual income of $50,000).

If the $50,000 in income were all taxed at the top rate, the total tax payable would be $22,850.

Instead, assume that the $50,000 is split among two separate testamentary trusts (i.e. one for each of two children and their descendants).  Each trust would have $25,000 of income and would pay tax on this income at the lowest of the marginal rates (22.06% for a British Columbia resident in respect of interest income).  As a result, the total income tax on the $50,000 of income would be $11,030.

This results in an annual tax savings of $11,820, assuming that the income would have been taxed at the top rate if earned by the children directly.

After payment of the tax by the trust, the trust could then distribute the after-tax amount to the children on a tax-free basis.  This distribution would have to occur in a subsequent fiscal year of the trust.  Alternatively, the trust could invest the income in order to generate more income in the trust and increase the income-splitting potential of the trust.

Actual income tax savings would depend on the income earned by the trusts and the rate of tax payable by the children on non-trust income.

B.     UPCOMING CHANGES

Much to the surprise of income tax practitioners, the 2013 budget announced that the Federal Government was going to change the rules so that testamentary trusts became subject to the same rules as are applicable to inter vivos trusts.  Most significantly, income taxed inside a testamentary trust would now be taxed at the top marginal rate applicable to that income (as if the testamentary trust were a high-income taxpayer).

The Federal Government proceeded to issue a “discussion paper” in which it outlined its plans.  I understand that the discussion paper provoked lots of submissions.  In the 2014 Federal Budget, however, the Minister of Finance indicated that the government would proceed with the original proposal and would end graduated rate taxation for testamentary trusts effective in 2016.[11]

Two significant exceptions apply.[12] 

(a)        In response to various submissions, graduated rate taxation will continue to apply to trusts “having as their beneficiaries individuals who are eligible for the federal Disability Tax Credit”.

(b)        Graduated rate taxation will be available for the first three years of an estate.

As of the time of preparation of this paper, the government has not yet released details of the exception for trusts “having as their beneficiaries individuals who are eligible for the federal Disability Tax Credit”.  Specifically, it is unclear whether it will be sufficient for only one beneficiary to qualify for the Disability Tax Credit.  In order to guard against erosion of provincial disability benefits, many testamentary trusts established for disabled individuals include non-disabled siblings as discretionary beneficiaries (so that the disabled individual cannot be said to be ultimately entitled to all trust assets).

Based on the wording in the Budget papers, it seems that this exception will apply only if a beneficiary’s disability qualifies the beneficiary for the Disability Tax Credit.  If the disability is not severe enough to allow such a claim, the exception will not apply.  In the case of a child who is simply not wise in handling money or who is an easy target for scammers, the exception will likely not apply.

The exception for the first three years of an estate, in contrast, is fully developed in the 2014 Budget Motion.  It comes about through the introduction of the concept of a “graduated rate estate”.[13]  The Department of Finance chose 36 months on the basis that most estates are fully administered during their first 36 months.  If an estate is not fully administered by the end of the 36 months, it will cease to be a graduated rate estate at the end of the 36th month.

The inapplicability of graduated rates means that testamentary trusts (other than graduated rate estates) will pay tax on the same basis as living trusts: a flat tax rate that is equal to the top marginal rate of income tax for the type of income in question.[14]  Unless the beneficiaries pay tax at the top marginal rate, therefore, it will generally be advantageous to have the non-graduated-rate-estate testamentary trust flow its income out to its beneficiaries.

C.     GRADUATED RATE ESTATES

Graduated rate taxation and many of the other benefits now enjoyed by testamentary trusts will continue to be enjoyed by graduated rate estates.  This is the estate during the first three years of its existence.  The actual definition will read as follows.

“graduated rate estate”, at any time, means an estate that arose on and as a consequence of a death, if that time is no more than 36 months after the death and at that time the estate is a testamentary trust.

An estate can qualify for graduated rates only during the first 36 months after death.  As well, the estate has to continue to qualify as a testamentary trust throughout those 36 months.  Accordingly, the testamentary trust concept will still be relevant.  The estate cannot accept any contributions of property from a living person and has to be careful about the types of debt that it incurs.  For example, it is not uncommon for a beneficiary to advance funds to the executor for the payment of probate taxes so that a grant of probate can be issued.  Some financial institutions require the grant of probate before the institution will allow the executor to have full access to the financial accounts of the deceased.

If a beneficiary pays the probate tax within 12 months of death so that the grant of probate can issue, the executor must repay the beneficiary in full within 12 months of the payment by the beneficiary.  If this is not possible for some reason (for example, the estate assets consist primarily of real estate and other illiquid assets that do not sell quickly), the executor can apply to the CRA for an extension of the 12-month period but must submit the application before the end of the 12 months (ideally, in sufficient time for the approval to be issued before the expiry of the 12 months).[15]

An estate is or is not a “graduated rate estate” as of a specific moment in time.  At any specific time, a graduated rate estate must have arisen no more than 36 months prior to that time in order to qualify as such.[16]

ITA section 248(1) provides that the word “estate” has the meaning assigned by ITA subsection 104(1).  If one looks at ITA subsection 104(1), however, that provision does not actually define “estate” in the normal way that one thinks of a term being defined.  Section 104(1) reads as follows.

In this Act, a reference to a trust or estate (in this subdivision referred to as a “trust”) shall, unless the context otherwise requires, be read to include a reference to the trustee, executor, administrator, liquidator of a succession, heir or other legal representative having ownership or control of the trust property, but, except for the purposes of this subsection, ... a trust is deemed not to include an arrangement under which the trust can reasonably be considered to act as agent for all the beneficiaries under the trust with respect to all dealings with all of the trust’s property unless the trust is described in any of paragraphs (a) to (e.1) of the definition “trust” in subsection 108(1).

Section 104(1) defines the term “trust” in the usual manner but does not define the term “estate” in the usual manner.

Many practitioners interpret section 104(1) to mean that there is no difference between a trust and an estate for income tax purposes.  However, this is an oversimplification.  While the word “trust”, when used in subdivision k (sections 104 to 108), also imports the concept of an estate, a legal difference remains between an estate and a trust.[17]

When an individual dies, the estate consists of the assets of the deceased at the time of death.  The executor of the will is concerned with winding up the deceased’s affairs and distributing the deceased’s assets to the beneficiaries.  The estate lasts only as long as is required to complete this task.  If the will creates a trust, the trust is considered as separate from the estate because the trust can survive for any number of years (depending on the terms of the trust) and can survive past the ultimate distribution of all the assets of the estate.  Indeed, some of the estate assets will usually be contributed to the trust as part of the distribution of the estate assets. 

Given that a graduated rate estate means an “estate”, graduated rate taxation will cease to apply if assets are distributed out of the estate into a trust created under the will and that distribution occurs within 36 months after death. 

For example, assume that an individual dies on June 1, 2020.  The 36^th month after death would end on May 31, 2023.  Accordingly, the estate can enjoy graduated rate taxation until May 31, 2023 (assuming that the estate takes that long to administer).  However, assume that the executor contributes property to a testamentary trust created in the will and that the property is contributed to the trust on June 1, 2021 (the first anniversary of death).  If income is earned inside the testamentary trust between June 1, 2021 and May 31, 2023, will that income qualify for graduated rates?  Presumably not, as one could then create multiple access to graduated rates for up to three years after death.  One has to presume that this is not intended.

As noted, section 104(1) states that the word “trust” refers to both a trust and an estate in subdivision k.  Even though the single term “trust” refers to both a trust and an estate, however, this does not eliminate the distinction between a trust and an estate.  For income tax purposes, it might be said that all estates are (by definition) to be treated as trusts for subdivision k purposes.  However, the converse is not true:  not all trusts are estates.  While an estate is a type of testamentary trust for income tax purposes (so that all estates are testamentary trusts), not all testamentary trusts are estates.[18]

There is some confusion in this area.   For example, if one reads the Hess[19] decision in a cursory manner, one might conclude that a trust can indeed be an estate.  However, this overlooks the fact that the case turned on a problem with the pleadings.

Hess (an informal procedure case) dealt with the imposition of penalties on a Canadian beneficiary of a US trust.  The beneficiary had not filed an information return about the non-resident trust.  In reading the case, one can immediately sense that the court sympathized greatly with the taxpayer in question.  The taxpayer had suffered from medical issues that affected the taxpayer’s ability to pursue his career.  As well, the taxpayer seems to have made an effort to comply with his tax obligations but seems to have been the victim of an accountant who was dilatory in the preparation of the required returns.

Under the statutory provision in question, the penalties did not apply if the “trust” in question was “an estate that arose on and as a consequence of the death of an individual”.[20]  Consequently, the penalties depended on whether the taxpayer had an interest in a non-resident trust or a non-resident estate.

In filing the Reply to the Notice of Appeal, the Minister assumed that the United States trust was an ongoing testamentary trust.  As noted by the court, however, ITA section 108(1) defines a testamentary trust as a “trust or estate”.  Consequently, the assumption that the trust was a testamentary trust did not preclude the trust from in fact being an estate.

While the taxpayer had assumed that the estate in question had been terminated and that the trust in question was not an estate, no parallel assumption had been made by the Minister.  Specifically, the Minister had not made any assumption that the estate had terminated or that the trust was administered separate and apart from the estate.[21]  At the trial, nobody had presented any evidence as to the terms of the will in question or the status of the estate.[22]  If the Minister had assumed that the trust was not an estate, it would have been up to the taxpayer to prove that the trust was indeed an estate.  Given that the Minister had not made the necessary assumption, there was no onus on the taxpayer to prove otherwise.  As there was no evidence as to whether the estate was or was not still in existence, the court concluded that the Minister had not proven that the penalties were applicable.

The court certainly proceeded on the basis that “estate” and “trust” are two distinct concepts.  The taxpayer avoided the penalties because the Minister had neglected to assume that the trust in question was not an estate.  If the Minister had pleaded his case correctly, the case may well have turned out differently.

Lipson[23] was a general procedure decision of the Tax Court.  It again involved the imposition of penalties.  At the end of the case, the court expressed frustration that the CRA attempted to assess almost $19,000 in penalties and interest against two non-residents living in California when no tax liability was triggered by the transactions in question.  Obviously, the sympathy of the court was not with the CRA. 

The case dealt with a Quebec estate that made capital distributions to various beneficiaries, including the two non-residents.  The executor complied with the clearance certificate requirements of ITA section 116 only in respect of the final of five distributions.  The CRA assessed penalties for failing to send a notice in respect of the other distributions. 

In order to justify the imposition of the penalties, the Minister argued that the non-residents had disposed of capital interest in a trust and accordingly had an obligation to send the notices. 

The court disagreed.  Section 104(1) does not actually define the word “trust” and merely provides that a trust or estate is to be referred to as a “trust” as a matter of labelling.  In other words, the word “trust” is used in subdivision k rather than continually referring to a “trust or estate”.  As neither an estate nor a trust is a separate legal entity, the word “trust” is used as a shorthand for the trustee, executor, administrator, liquidator or other personal representative, but that does not meant that an estate is to be considered a trust for all purposes of the Act. As there was no disposition of an interest in a trust in the case at hand, the court concluded that the penalties were not applicable. 

Based on the Hess and Lipson cases, as well as on the general law, the concept of a “graduated rate estate” contemplates only the estate.  Once estate assets are contributed to a testamentary trust that is separate from the estate, the graduated rate taxation presumably ceases. 

I anticipate that many estates will take at least three years to administer once the new regime come into effect in 2016.  As the CRA generally did not start asking questions about why the estate was taking so long to administer until after the estate had been in existence for 36 months, I presume that the CRA will not be expecting estates to wind up earlier than this 36-month period of time.

Given that a graduated rate estate has to be an estate, what is the status of an insurance trust that is initially funded by the death benefit payable under a life insurance policy?  Such a trust would not be an estate, as the death benefit would never have belonged to the deceased (even if the deceased was the owner of the policy).  A life insurance trust would seem to be a trust from inception and to never be an estate.  Depending on the rules that are eventually established for testamentary trusts “having as their beneficiaries individuals who are eligible for the federal Disability Tax Credit”, it may be that insurance trusts will simply not qualify for graduated rates of tax.

D.    MULTIPLE GRADUATED RATE ESTATES?

It would presumably still be possible for a deceased to have more than one estate.  Indeed, probate tax can be reduced by having one will that deals with assets that will require probate and a separate will (with a separate executor) to deal with assets that might not require probate (such as shares of a private corporation, assuming that the successor directors are willing to recognize the will without probate).

Normally, dual wills are mirror-image documents and are used solely for the purpose of reducing probate tax.  In that case, even though there are two separate estates, both estates would normally be taxed as a single entity under ITA section 104(2).  If there were two estates, the Minister would be able to designate the two estates as a single trust (for income tax purposes), the property of which consisted of all the assets of the two estates and the income of which consisted of all the income of the two estates, if the following apply. 

(a)        Substantially all the property of the various trusts (or estates) has been received from a single person (usually the deceased); and

(b)        The various estates are conditioned so that the income accrues or will ultimately accrue to the same beneficiary or group or class of beneficiaries.  

If a probate and non-probate estate are set up as mirror-images of each other as far as the beneficiaries are concerned, of course, section 104(2) will apply. 

It would theoretically be possible to set up the two estates so that each estate benefits a separate part of the family.  For example, assume that one of the children is the heir apparent in respect of the private corporation.  It might be that the non-probate will would leave all the shares of the private corporation to an estate of which that child was the sole beneficiary.  The probate will would deal with the other assets and leave them to the children who are not involved in the business.  In that case, one would arguably have two separate estates at law even though all property would have been contributed by the one deceased.

Whether the separate wills create separate estates or a single estate administered under two separate wills is an unresolved seminal question.  The issue was considered in an Ontario case, Kaptyn Estate. [24] The deceased had used separate wills in order to reduce exposure to probate tax.  The case concerned the interpretation of the wills and how they related to each other.

An initial question which divides the parties on this application is whether the execution of multiple wills creates two distinct estates or leaves one estate administered under two separate wills. Little commentary appears to exist on this point.

[...] the extent to which the assets governed by each multiple will are to be administered together or separately will depend upon the intention of the testator as expressed in the multiple wills.  The use of multiple wills does not give rise to questions of asset ownership -- the “primary assets” and “secondary assets” are both those of the testator -- but may give rise to issues about how the two sets of assets are to be administered.  So, then, it is open to a testator to use multiple wills to create separate silos of assets, divided by an impenetrable wall and administered completely separately, if that be his wish. The appropriate drafting language can be used to achieve that result. On the other hand, a testator may wish to minimize probate fees by splitting his assets into two pools, but draft his multiple wills in such a way that a degree of interdependence exists in the administration of the two pools of assets. In sum, the degree of relatedness or separateness of assets governed by multiple wills turns on the intention of the testator as expressed in the language of his wills.

The court did not answer the theoretical question but rather treated the issue as an interpretive one.

If the executors are different, one presumably would have two different estates (given that neither executor would have power in respect of the assets of the other estate).  To my knowledge, this question has not yet been definitively answered.[25]

Assuming that one has two separate estates at law, and assuming that the beneficiaries of each respective estate are different, the second requirement for the application of ITA section 104(2) would not be met.  Of course, this assumes that the deceased has sufficient assets to set up two separate estates and that neither set of beneficiaries feels deprived.  If the value of the private corporation was significantly higher than the assets in the probate estate, the beneficiaries of the probate estate might end up bringing an action under the wills variation provisions of the Wills and Estates Succession Act.  This would of course require probate of the will dealing with the private corporation shares and would defeat the plan for probate avoidance.

The probate estate could presumably include some of the shares of the corporation in question if that was necessary to equalize distributions.  The question is whether this amount of planning is justified for three years’ worth of multiple access to graduated rates.

E.     TAXATION YEAR

Currently, testamentary trust trustees can select a taxation year that is not the calendar year.[26]  As the taxation year of an estate and testamentary trust begins with the death, the executor and trustee will often choose a taxation year that ends shortly before the first anniversary of death.  Of course, the executor and trustee can choose any earlier date that is suitable.

Under the new regime, only a graduated rate estate will be able to use a taxation year that is not the calendar year.[27]

Existing testamentary trusts that do not use the calendar year will have a deemed taxation year-end on December 31, 2015, and will have to use the calendar year as its taxation year for 2016 and subsequent taxation years.[28]

For an estate that is in existence at the end of 2015 but has not yet been in existence for 36 months, the estate will be able to use an off-calendar year-end until the end of that 36th month.  At the end of the 36th month, the estate will have a deemed year-end and will then have to convert to a calendar year taxation year and flat-rate taxation.[29]  Of course, this assumes that the estate continues to qualify as a testamentary trust until the end of the 36 months.

F.      OTHER CHANGES

The changes to the taxation of testamentary trusts go beyond the loss of graduated rates and fiscal years.

Testamentary trusts currently benefit from various other special rules that do not apply to living trusts.  Under the new regime, testamentary trusts will no longer benefit from the following special rules.

·         Currently, testamentary trust trustees do not have to make income tax instalment payments.[30]  Under the new rules, testamentary trusts (including in this case a graduated rate estate) will be subject to the same instalment payment obligations that apply to any individual.[31]  Of course, there will be no instalment obligation in the initial taxation year of the estate because its instalment base will be nil.

·         Currently, a testamentary trust has a basic $40,000 exemption from alternative minimum tax (so that the trustee needs to deal with the minimum tax calculation only if income exceeds $40,000).[32]  This is the same basic exemption that is available to an individual.  Under the new regime, this $40,000 exemption will be available only to a graduated rate estate for the 2016 and subsequent taxation years.[33]

·         ITA Part XII.2 imposes a special tax on designated income of certain types of trusts that have at least one designated beneficiary.[34]  The purpose of this tax is to ensure that a non-resident beneficiary is taxed on trust distributions that arise from designated income in the same manner as if the non-resident had earned the designated income directly.  Designated income includes capital gains from dispositions of taxable Canadian property as well as income from Canadian real estate and businesses carried on in Canada.  If a trust is subject to Part XII.2, the trust pays a special 36% tax on its designated income.  While this distributes the amount that the Trust can distribute, the trustee can apportion the tax payment to certain beneficiaries (for example, individuals resident in Canada) so that those beneficiaries are treated as having paid the tax (and can claim a refund of the tax in some cases).  Currently, testamentary trusts do not have to worry about complying with the Part XII.2 rules.[35]  Under the new regime, only graduated rate estates will enjoy this immunity.[36]

·         For income tax purposes, a trust is either a personal trust or not a personal trust.  Personal trusts enjoy special advantages, such as the ability to transfer assets to Canadian-resident beneficiaries on a tax-deferred basis.[37]  Under the current rules, a testamentary trust is automatically a personal trust and can never lose that status (unless the trust ceases to be a testamentary trust).[38] Presumably, the Department of Finance is worried that a trust established under a will could convert into a commercial trust.  As of 2016, only a graduated rate estate will automatically qualify as a personal trust.[39]  Other testamentary trusts will have to qualify as a personal trust under the same rules that apply to living trusts:  that no capital or income interest was acquired for consideration paid to the trust or to anyone who has contributed property to the trust (for example, the deceased).  In determining whether an interest has been acquired for consideration, ITA section 108(7)(b) provides a special deeming rule for living trusts in certain cases if all beneficiaries are related.  The 2014 Budget Motion does not extend this deeming rule to testamentary trusts.  Therefore, it may be prudent to caution grateful willmakers against creating a testamentary trust and providing a family member with an interest “as repayment” for something that had been provided to the deceased during his or her lifetime.

·         Like any taxpayer, a trust is eligible to claim investment tax credits.  Whereas a living trust cannot make the tax credit available to a beneficiary, a testamentary trust currantly can.[40]  Under the new regime, only a graduated rate estate will be able to designate investment tax credits to a beneficiary.[41]

·         Like an individual, a testamentary trust can consent to having the CRA reassess a statute-barred year (a year that is beyond the normal reassessment period) for the purpose of having the CRA pay a tax refund or to reduce an amount owing under the ITA, provided that application is made within 10 years from the end of the taxation year in question.[42]  This is used frequently in connection with fairness applications.  As of 2016, a graduated rate estate will be the only type of trust able make this application.[43]  Once an estate passes beyond its 36th month, therefore, it will lose this ability.

·         A taxpayer has 90 days in which to file a Notice of Objection to an assessment.  An individual and a testamentary trust, however, can file a notice of objection at any time before the expiry of one year after the taxpayer’s filing due date for the year.[44]  As of 2016, a trust will be able to take advantage of this extended objection period only if the taxation year being objected to was a year in which the trust was a graduated rate estate.[45]  Based on the wording, the extended objection period should be available even if the year being objected to is the year that ends at the end of the 36th month after death and the graduated rate estate is no longer a graduated rate estate at the time that it seeks to rely on the extended objection period.  Otherwise, a testamentary trust would have to apply for an extension of time in which to file a Notice of Objection.[46]

Other than the estate during the first three years of its existence, testamentary trusts will be treated the same as living trusts effective as of 2016.

G.    WHITHER TESTAMENTARY TRUSTS?

Once the new rules come into effect in 2016, will there be any point in establishing testamentary trusts?

If a beneficiary is able to claim the Disability Tax Credit, a testamentary trust may well continue to have significant advantages.  This will depend on the exact wording of the amendments that will make accommodation for such testamentary trusts.

In its 2013 Discussion Paper,[47] the Federal Government suggested that the proposals would not affect the tax position of disabled individuals.

The income tax provisions contain special rules (i.e., the preferred beneficiary election rules and the rules for trusts for minor children) that suspend or lessen the effects of high flat-rate taxation on income accumulating in a trust for certain disabled persons or minor children.  These special rules allow (subject to certain anti-avoidance rules) income to be recognized for tax purposes in the beneficiary’s hands (i.e., taxed at the beneficiary’s marginal rates) even though the income actually accumulates in the trust.  The proposed measures on graduated rates would not change the preferred beneficiary election rules or the rules that apply to trusts for minor children

As has presumably been pointed out in various responses to the discussion paper, the preferred beneficiary election rules do not really assist disabled beneficiaries if the trust itself does not pay graduated rates of tax.  In order to avoid paying tax inside the trust, the trust makes a preferred beneficiary election so that its income is taxed as if the income had been distributed to the disabled beneficiary.  However, the election results in the income being included on the personal income tax return of the disabled beneficiary.  This means that provincial government assistance programs will likely treat the disabled beneficiary as having received the income.  Consequently, any tax savings from use of the preferred beneficiary election might well be eaten up by reduced availability of government assistance.

As noted, we will have to wait to see what exact measures the government is proposing to deal with disabled individuals.

As the future is never certain, there may be an advantage in establishing testamentary trusts in case of a future disability arising among the descendants of the deceased.  Again, this will depend on the exact rules that will be put into place. 

Otherwise, the income tax advantages formerly associated with testamentary trusts will be limited to the first three years of the estate.  Beyond those first three years, the advantages of a testamentary trust will, to a large extent, be the same as the advantages that apply in the case of a living trust.  While there will be no income tax rate advantage for income that is taxed inside the trust, the trust will afford more flexibility and more security for the beneficiaries.  Those continuing advantages include the following.

·         If income-producing assets are left to a specific individual, the income generated by those assets will be income of that individual.  If the assets are held inside a discretionary trust, the trustee will be able to allocate that income among the respective beneficiaries in the manner desired (including a tax-efficient manner).

·         For example, income could be allocated to grandchildren or great-grandchildren of the deceased during the years that they attend university.  That will allow the income to be distributed with very little tax burden given that the student recipient will probably have no other income and will have the usual deductions associated with attending university. 

·         The trusts could be divided along family branch lines with a family branch consisting of a specific child of the deceased and the descendants of that child.  This allows each respective surviving child of the deceased to manage the assets of his or her trust for the benefit of the child and his or her descendants without any interference from uncles and aunts.

·         If assets are left to a specific individual, those assets become the assets of that specific individual and are subject to claims from creditors of that specific individual.  If assets are held inside a discretionary trust, the assets do not belong to any specific individual.  As a result, it is more difficult for creditors of a specific individual to attach any such assets.  In the case of a testamentary trust, the assets will have been placed into the trust by the deceased rather than by a living individual.   Consequently, it should be difficult for a creditor to claim that the creation of the trust was a form of fraudulent conveyance.  While trusts are not completely bulletproof, they provide more protection than individual ownership provides.

·         If assets are left to a surviving spouse and the surviving spouse remarries, there is more risk that unanticipated events could result in assets not passing to the children of the deceased on the death of the spouse.

·         A spousal trust can ensure that the spouse is taken care of and that the assets still pass to the children on the death of the spouse (even if the spouse remarries).

·         One still has capital gains tax deferral to the extent that assets pass to a spousal trust for a surviving spouse.

·         The surviving spouse has to have a right to all income of the spousal trust but does not have to have any right to any of the trust capital.  For this purpose, “income” largely means income as determined for trust law purposes and not income as determined for purposes of the ITA.[48]  A deemed dividend arising on the redemption of shares of a private corporation would be capital for trust law purposes and so would not be part of the “income” to which the surviving spouse must be entitled as of right.

·         While it is permissible for the spousal trust to allow for capital encroachments in favor of the surviving spouse, it is also permissible for the trust to prohibit such encroachments.

V.                Will Alternatives

A.    GENERAL

In 2000, the ITA introduced new forms of living trusts that could serve as will substitutes.  The most common forms of such trusts are the Alter Ego Trust (an “AET”) and the Joint Spousal or Common-Law Partner Trust (a “JST”).  Both of these trust require that the trustmaker be at least 65 years old at the time that the trust is created.  There is also a third type of trust that does not require that the trustmaker be at least 65.  This third type of trust does not have a formal name in the ITA but will be referred to in this paper as a “Self Benefit Trust” (a “SBT”). 

All three types of trusts are living trusts.  As a result, any income taxed inside the trust is taxed at a flat rate equal to the top marginal rate for that type of income.  As a result, most income is passed out of the trust.  In many cases, attribution rules will ensure that income is taxed as income of the person who contributed the assets to the trust.

Assets held inside one of these trust would not have to pass through the probate process.  As a result, holding assets inside one of these trusts was often a probate-avoidance technique.  In most cases, however, the probate tax avoided was relatively minor compared to the annual income tax savings that could be achieved by placing assets inside a testamentary trust (or, even better, several separate testamentary trusts).  The probate tax savings was a one-time saving equal to 1.4% of the value of the assets in the probate estate.  In contrast, the income-splitting advantages available through testamentary trusts were the gifts that kept on giving, producing annual income tax savings for as long as the trusts were kept in place.  These annual income tax savings could often be repeated for 20 years or more.  Accordingly, the preference was often to pay the probate tax and have assets pass into testamentary trusts.

AETs and JSTs were largely restricted to instances in which the parents anticipated that one or more children might bring an action under the former Wills Variation Act (the “WVA”) (now the wills variation provisions of the Wills, Estates and Succession Act (“WESA”)).[49]  If this was the case, income tax savings usually took a back seat and assets were placed into a JST or an AET in order to protect the assets from litigation.  Now that testamentary trusts will no longer pay income tax at graduated rates (except possibly trusts with disabled beneficiaries) and the graduated rate planning is limited to the first three years of the estate, one can expect that there will be more use of JSTs, AETs, and possibly even SBTs.

This may move estate planning more toward the model used in the United States.  In the United States, individuals generally hold their assets inside living trusts in order to avoid the (generally higher) rates of probate tax in some states.

In British Columbia, the main advantage of using a JST, AET or SBT would be as follows:

·         Assets held inside the trust would not pass through probate.

·         No probate tax would be payable on the assets.

·         There would be no need to file an affidavit listing the value of the assets.  A Disclosure Statement filed as part of a probate application is a court document and is available to be viewed by any member of the public on payment of the applicable (nominal) fee.  While young people are often anxious for the whole world to know how much wealth they have, older, wiser, and more mature individuals generally try to be as circumspect as possible about wealth.  Avoiding public disclosure of the value of assets held at death can become a significant objective.[50]

·         In the event of incapacity, assets in the trust would continue to be managed by the trustees (a change of trustees might be required).  As will be seen later, however, this does not mean that no power of attorney will be necessary.

·         If properly structured, assets inside the trust are less likely to be challenged under the WVA.  In order for this advantage to apply, however, the trust must clearly be a living trust rather than a disguised will.  If the trustmaker retains too much power over the assets (for example, by being the sole trustee), the trust document might be attacked as a disguised will on the basis that the document really depends for its vigor and effect on the death of the trustmaker.[51] The argument would be that the trust really comes into effect only on the death of the trustmaker.

If avoidance of the WVA is a consideration, reference should be made to Jane Milton’s paper on trends in estate litigation.

B.     ALTER EGO AND JOINT SPOUSAL TRUSTS

1.                  General

Normally, the contribution of assets to a trust results in a disposition of the assets at fair market value.  The contribution is a gift and gifted assets are deemed to be disposed of at fair market value.[52]

An AET is an exception to this rule.  An individual (the “alter-ego individual”) who is resident in Canada and who is at least 65 years of age can elect to transfer assets on a tax-deferred basis to an AET established for the sole benefit of that alter-ego individual.  By “sole benefit”, I mean that the alter-ego individual must be the sole beneficiary of the AET during the lifetime of the alter-ego individual.

A JST is another exception.  The JST is very similar to an AET, except that the initial (and only) beneficiaries are the spouses or common-law partners at all times prior to the death of the survivor of them.  For brevity, I will use “spouses” to include both legal spouses and common-law partners.

In short, the AET is for the single individual aged 65 or over, whereas the JST is for the married (or in a relationship) individual aged 65 or over.  Because of the similarity between the two trusts, it is best to deal with them together.

2.                  A Note on Terminology

When discussing AETs, I will use the term “alter-ego contributor” to refer to the individual who is 65 or over, who is the sole beneficiary of the trust prior to that individual’s death, and who is contributing assets to the trust on a tax-deferred basis.  This will almost always be the trustmaker of the trust but using “trustmaker” might cause confusion.

I will use the term “alter-ego individual” to refer to the above person as the initial beneficiary of the AET (in other words, when not speaking of the act of transferring property to the AET).

When discussing JSTs, I will use the term “transferring spouse” to refer to the spouse who is 65 or over, who (together with the other spouse) is the initial beneficiary of the trust, and who is contributing assets to the trust on a tax-deferred basis.  I will simply refer to “spouse” to refer to either spouse (the transferring spouse and the spouse of the transferring spouse).

I will also use the term “Relevant Death”.  In the case of an AET, the Relevant Death is the death of the alter-ego individual.  In the case of a JST, the Relevant Death is the death of the surviving spouse.

3.                  Contribution of Assets

Strictly speaking, any individual can set up an AET or a JST by contributing some nominal amount of property (such as a $10 bill) to create the AET.  However, it is only the alter-ego individual (65 years old or older) who can contribute assets to the AET on a tax-deferred basis.  Similarly, it is only the spouse (65 years old or older) who can contribute assets to a JST on a tax-deferred basis.

For this and other reasons, one does not usually use a nominee trustmaker when establishing an AET or a JST.  If the trust is being established to prevent a wills variation challenge, for example, a nominee trustmaker might not have the necessary strength of intention to create a valid trust.  In that case, it is usually better to have someone who will be sufficiently motivated to definitely have the intention to create the trust.

4.                  Age and Residence

In order to benefit from a tax-deferred roll-in of assets, the person contributing the assets must be an initial beneficiary of the trust and at least 65 years old.  As well, both the contributor and the trust must be resident in Canada.

AET	JST
The alter-ego contributor must be at least 65 years of age.[53]	The transferring spouse must be at least 65 years of age.[54]
Both the alter-ego contributor and the trust must be resident in Canada.[55]	On the contribution of assets, both the transferring spouse and the recipient trust must be resident in Canada.[56]

In a JST, there is no need for both spouses to be at least 65 years of age.  If one of the spouses is under age 65 and the other is 65 or older, the rollover will simply not be available on a contribution of assets by the younger spouse.  However, the younger spouse can still be a beneficiary.

The younger spouse could in theory transfer assets under the spousal rollover provisions to the older spouse so that the older spouse is in a position to contribute the assets to the JST on a tax-deferred basis.  However, one would have to be able to show that the older spouse was not acting as agent of the younger spouse and that the two transactions were independent of each other.

5.                  Income Arising Before the Relevant Death

The initial beneficiary (the alter-ego person in the case of an AET and the spouses in the case of a JST) must be entitled (as of right) to receive all income of the AET that arises before the Relevant Death.  In the case of an AET, the Relevant Death is the death of the alter-ego individual.  In the case of a JST, the Relevant Death is the death of the surviving spouse.

AET	JST
The alter-ego individual must be entitled (as of right) to receive all income of the AET that arises before the death of the alter-ego individual.[57] In other words, the trustee cannot have any discretion to withhold any income from the alter-ego individual.	Some combination of the spouses must be entitled (as of right) to receive all income of the JST that arises before the death of the surviving spouse.[58]

For this purpose, “income” largely means income as determined for trust law purposes and not income as determined for purposes of the ITA.[59]  A deemed dividend arising on the redemption of shares of a private corporation would be capital for trust law purposes and so would not be part of the “income” to which the trustmaker must be entitled.

I have seen several situations in which the lawyer created the AET from a discretionary trust precedent and forgot to change the discretionary provisions.  As a result, the trust deed provided that the trustmaker was entitled to “all or so much of the Net Income derived from the Trust Fund as the Trustees in their uncontrolled discretion may determine”.  This discretionary power prevented the trust from being an AET and meant that significant capital gains were triggered when the trustmaker gifted assets into the trust.  If there is sufficient evidence of the intention to create an AET, it should be possible to obtain a court order that retroactively rectifies the trust deed.

For a JST, there can be flexibility as to which of the two spouses receives the income while both spouses are living.  The trustee cannot have any discretion to withhold any income from distribution, but can have a power to allocate income between the spouses as long as the trustee must allocate all income to some combination of the spouses.  While both spouses are living, the trustee can have the power to distribute all JST income to only one spouse if desired (but must have a duty to distribute all income).  After the first spouse has died, of course, the survivor must be entitled (as of right) to all JST income that arises between the death of the first spouse and the death of the survivor.

6.                  No Other Beneficiaries before the Relevant Death

No person other than the alter-ego individual (in the case of an AET) and the spouses (in the case of a JST) can benefit from the trust prior to the Relevant Death.

AET	JST
No person other than the alter-ego individual may receive or otherwise obtain the use of any income or capital of the AET prior to the death of the alter-ego individual.[60]	No person other than the spouses may receive or otherwise obtain the use of any income or capital of the JST prior to the death of the surviving spouse.[61]

The AET or JST Deed can name contingent beneficiaries who become such on the Relevant Death, but none of those beneficiaries can take any benefit from the AET prior to the Relevant Death.  This is what makes the AET and JST such viable will substitutes in appropriate cases.  However, this restriction can also cause issues.

If the alter-ego individual wishes to gift an asset to a child, the trustee must first distribute the asset to the alter-ego individual as a capital distribution and the alter-ego individual must make the gift to the child.  It would be possible for the alter-ego individual to ask the trustee to transfer the asset to the child directly as a directed payment, but the documentation must clearly show that the trust first distributed the asset to the alter-ego individual, who then gifted the asset to the child.

This means that the alter-ego individual still needs to appoint a power of attorney even if most assets are in the AET.  As well, that power of attorney should specifically authorize the making of gifts.  If the alter-ego individual is incapacitated and does not have a power of attorney (or has only a “standard” power of attorney that does not specifically authorize gifts),[62] the alter-ego individual might not be able to gift assets to his or her children.

The same applies to the spouses of a JST if they want to have any of the JST assets transferred to anyone other than one of the spouses.

While AETs and JSTs are effective vehicles for the management of assets, it is incorrect to say that they completely avoid the need for a power of attorney.  It is best to have a power of attorney in place just in case.

Given that AET funds cannot be used for the benefit of anyone else prior to the death of the alter-ego individual, the AET trustee should not be authorized to acquire a life insurance policy on the life of the alter-ego individual.  Any trust funds that are used to pay the life insurance premium will arguably have been used during the alter-ego individual’s lifetime to pay an amount that can only be for the benefit of someone other than the alter-ego individual, given that the death benefit can be paid only after the death of the alter-ego individual.[63]  Similarly, a JST trustee should not be authorized to pay premiums on a life insurance policy that pays out on the death of the surviving spouse.[64]

7.                  Deemed Disposition on Relevant Death

Normally, a trust is deemed to dispose of all its capital assets every 21 years.  In the case of AETs and JSTs, however, the operation of the 21-year deemed disposition rule is deferred until the Relevant Death.

AET	JST
If the alter-ego individual makes a tax-deferred contribution of assets, all capital assets in the AET are deemed to be disposed of on the death of the alter-ego individual (but not before).[65]	All capital assets in the JST are deemed to be disposed of on the death of the surviving spouse (but not before).[66]

In the case of a JST, the age of the younger spouse is not relevant.  A significant tax deferral can arise if the younger spouse is considerably younger than the spouse who is 65 or over.  This can be useful in the context of a wasting estate freeze, as it can give more time to redeem the fixed-value estate freeze shares.

The deemed disposition of assets occurs inside the AET and the JST.  This means that any resulting capital gain will be taxed at a flat rate of about 22% of the gain.  The deemed disposition capital gain cannot be allocated out to a beneficiary and taxed at the beneficiary’s rate.[67] If the alter-ego individual or the surviving spouse dies on the first day of a calendar year and does not have any income that is included in the individual’s date-of-death return, there may be a loss of access to graduated income tax rates.  This might eat into the probate tax savings from the AET or JST assets not passing through probate.  In most cases, however, the deceased will have statutory income inclusions for the value held inside a registered retirement income fund or will have a deemed disposition of assets held outside of the AET or JST.  This will usually use up at least a portion of the graduated rates available to the deceased in the year of the Relevant Death.  If not, the probate tax savings would usually be higher than the tax cost of not having graduated income tax rates apply to the capital gain triggered inside the AET or JST.  However, this needs to be considered when establishing the trust.

The deemed disposition on the death of the alter-ego individual or surviving spouse means that capital gains tax is crystallized at the Relevant Death.  There is no rollover to a surviving spouse, for example.  Accordingly, spouses would usually set up a JST rather than each spouse setting up a separate AET.  If the wife sets up an AET, any assets inside the AET will be deemed disposed of on the death of the wife (even if the husband survives and becomes the sole beneficiary on the death of the wife).

This deemed disposition rule means that some property should not be held inside an AET or a JST.

If farm property is eligible for the intergenerational property rollover, that rollover is lost if the property is held inside an AET on the death of the alter-ego individual or inside a JST on the death of the surviving spouse.  Accordingly, it is best to have such property held individually (even if it means paying probate tax).

Of course, any capital losses realized personally by the alter-ego individual or surviving spouse on death cannot be used against capital gains realized in the AET or JST (and vice-versa).

If trust assets include active business corporation shares, qualified farm or fishing property or other assets that can qualify for the capital gains exemption, a significant tax cost can arise if the shares are held inside an AET on the death of the alter-ego individual or inside a JST on the death of the surviving spouse.  An AET cannot claim the capital gains exemption in respect of capital gains that arise on the death of the alter-ego individual.  Similarly, a JST cannot claim the capital gains exemption in respect of capital gains that arise on the death of the surviving spouse.  As the capital gain on the Relevant Death cannot be allocated out to any beneficiary, the capital gains exemption may be lost on any increase in value that occurs inside the AET or the JST.

This is in sharp contrast to the situation that prevails in the case of a testamentary or inter vivos spousal trust.  ITA section 110.6(12) allows the capital gains exemption of the spouse to be used against deemed capital gains arising on the death of the spouse—but only in a testamentary spousal trust situation.  The provision specifically excludes an AET and a JST.  If the property in question could qualify for the capital gains exemption, it may be better to hold that property in an ordinary spousal trust.  However, this could accelerate the deemed disposition given that the deemed disposition inside an ordinary spousal trust will be on the death of the spouse who is the beneficiary (even if that spouse is the first spouse to die).

Given that the capital gains exemption is now tied to inflation, it is no longer possible to fully use up the exemption before contributing the property to an AET or a JST.

If the trustee has a power to encroach on capital and the trust disposes of the capital-gain-exemption eligible assets during the lifetime of the alter-ego individual or the spouses, the trustee could make the taxable capital gain payable to the alter-ego individual or the spouses so that the alter-ego individual or the spouses can claim the exemption personally.  The alter-ego individual or spouses could then contribute the proceeds back into the AET or JST, as long as capacity to do so was not an issue (or if there is a power of attorney that authorizes gifts).  However, this cannot be done in the case of an unexpected death of the alter-ego individual or the surviving spouse.

8.                  AET Only:  Electing out of the Deemed Disposition on Death

An AET (but not a JST) can elect out of the deemed disposition of assets that would otherwise occur on the death of the alter-ego individual.[68]  This election must be filed in the AET’s initial income tax return (the return for the first taxation year of the AET).  If any assets are transferred to the AET on a tax-deferred basis, however, this election cannot be made.[69] Therefore, electing out of the deemed disposition on the death of the alter-ego individual precludes the ability to transfer assets to the AET on a tax-deferred basis.  If the trustee elects out of the deemed disposition on death, the deemed disposition rules will instead apply on each 21^st anniversary of the AET.  This might make sense in the right circumstances.  If the alter-ego individual has capital losses available and his life expectancy is less than 21 years, it might be prudent to trigger a fair market value disposition and to elect out of the deemed disposition on death.  This will allow assets to be rolled out to the contingent beneficiaries (who become beneficiaries on the death of the alter-ego individual). 

9.                  Electing out of the Tax-Deferred Transfer-In

When contributing property to an AET or a JST, the alter-ego individual or transferring spouse can elect out of the roll-in rule and can choose to transfer the assets in at fair market value.[70] This election can be made on a property-by-property basis.  For example, the alter-ego individual may have capital loss carry-forward amounts that can be applied against a capital gain triggered by the contribution of assets.  If the alter-ego individual is transferring all his or her assets to the AET, of course, the alter-ego individual will not likely have any future capital gains against which to use those losses—so it would in that case be best to use them up on the contribution of the assets.[71]  As noted, the deemed disposition on death occurs inside the AET or JST and is not a capital gain of the alter-ego individual or surviving spouse.

In order to trigger a fair market value disposition, the alter-ego individual or transferring spouse would simply report the fair market value disposition in the T1 return that includes the date of the transfer. 

10.              Taxation of Trust Income and Capital Gains Prior to Relevant Death

In most cases, the reversionary trust rules will apply to the AET or JST and all income and capital gains from contributed property will be attributed back to the alter-ego individual during the lifetime of the alter-ego individual or to the transferring spouse during the lifetime of the transferring spouse.[72]  This is not necessarily the case, however.  If the AET does not provide for encroachments on capital in favour of the alter-ego individual or the transferring spouse (so that the contributed property cannot revert back to the alter-ego individual or the transferring spouse), the reversionary trust rules would not apply and would not result in the attribution of income and capital gains on the contributed assets.

In most cases, the alter-ego individual is reluctant to cut off future access to the trust capital.  Remember that no person other than the alter-ego individual can benefit from the use of the AET capital during the lifetime of the alter-ego individual.  Accordingly, it is not possible for the trust to distribute capital to some other person and have that other person gift the amount to the alter-ego individual.  It might be possible to give the trustee the power to lend funds to the alter-ego individual on an interest-bearing basis but many alter-ego individuals will be uncomfortable with having to “borrow” their own capital back at interest.

In a JST, it would be possible to avoid the reversionary trust rules by having two separate criss-cross JSTs rather than having both spouses contribute assets to a single JST.  In this criss-cross structure, the wife would contribute her assets to one JST (the “Wife’s JST”) that provides for encroachments of capital in favor of the husband but not in favor of the wife.  As the wife cannot receive capital from the Wife’s JST, the reversionary trust rules would not apply to the Wife’s JST.  At the same time, the husband would contribute his assets to a separate JST (the “Husband’s JST”) that provides for encroachments of capital in favor of the wife but not in favor of the husband.  As the husband cannot get his property back, the reversionary trust rules would not apply to the assets in the Husband’s JST.  During the joint lives of the two spouses, the capital in both trusts is fully accessible.  The Wife’s JST can distribute capital to the husband and the Husband’s JST can distribute capital to the wife.  If the husband dies first, the Husband’s JST would still be able to distribute capital to the wife.  However, as of the husband’s death the wife would not be able to access the capital inside the Wife’s JST.  Accordingly, only part of the capital would be accessible after the death of the first spouse. 

Attribution of income and capital gains back to the alter-ego individual or transferring spouse is not necessarily bad, however.  Attribution prevents the income and capital gains from being taxed inside the AET at the flat rate payable by a living trust.  Usually, the trustees would distribute all income to the alter-ego individual or some combination of the spouses at the end of each taxation year in any event.  The alter-ego individual or spouses could then re-contribute any unneeded income back to the trust.  This avoids having to distinguish between income on contributed assets and income that has been earned by reinvesting attributed income.[73]

If the alter-ego individual or both spouses are consistently in the top tax bracket, however, there may be some advantage in avoiding the reversionary trust rules and having the trust reside in a province with a lower top marginal tax rate so that income and capital gains realized inside the trust on contributed assets are taxed at the lower rate applicable in that other province (for example, Alberta).  In the case of an AET, the alter-ego individual has to be comfortable with not being able to access the trust capital.  If the AET holds shares of a private corporation, however, this may be less of an issue because the private corporation could always pay dividends and deplete the corporate assets through the payment of dividends (which produces AET income that must be distributed to the alter-ego individual).  In the case of a JST, the spouses could set up criss-cross JSTs so that there is continued access to trust capital and an ability to have income taxed inside the trust.

Even if the reversionary trust rules apply during the lifetime of the alter-ego individual or the transferring spouse, no such attribution applies on the capital gain that arises on the deemed disposition that occurs on the Relevant Death.  The deemed disposition occurs at the end of the day on which the alter-ego individual or surviving spouse dies[74]; attribution under section 75(2) occurs only during the existence of the alter-ego individual or the transferring spouse.[75]  Usually, the alter-ego individual or a surviving transferring spouse will not die precisely at the stroke of midnight.  As noted, this means that the deemed capital gain will be taxed inside the trust at the top marginal rate applicable to a capital gain.  If the trust is resident in a lower-rate province, however, the capital gains tax will apply at the lower rates applicable in that lower-rate province.  If the trust is resident in Alberta, for example, the top marginal rate on capital gains will be 19.5% as opposed to the 21.85% rate in British Columbia (22.9% if the death occurs in 2015 or 2016 and the “temporary” high-income surtax applies).  Of course, this requires that the trust actually be managed and controlled in Alberta and that the Alberta trustees not be merely order-takers or agents.[76] Many clients will be reluctant to place their assets under the control of persons in another province in order to save a few percentage of tax points for the benefit of their heirs.  Usually, the Alberta trust option is possible only if the client already has an existing relationship with someone in Alberta.

C.     SELF-BENEFIT TRUST

The ITA does not use the term “self-benefit trust”.  I am using this term to describe a trust that can be established by a person under age 65 and to which the person can contribute assets on a tax-deferred basis.

It seems that the SBT provisions were put in place to authorize blind trusts that are set up by holders of high political office in order to avoid conflicts of interest.[77] The provision allows the holder of political office to place assets into the blind trust without triggering a disposition for income tax purposes.  The question is whether the SBT provisions can be used for other purposes.

The SBT is similar to an AET in that the SBT must have only one beneficiary during the lifetime of the individual who contributed the assets on a tax-deferred basis.[78]  The significant differences are as follows.

·         The contributor (self-benefit individual) can be under the age of 65.  [79]

·         The contribution of assets must not result in a change in the beneficial ownership of those assets.  After the transfer, there must be no absolute or contingent right of any person (other than the self-benefit individual) or partnership as a beneficiary of the SBT.[80] This restriction means that the SBT Deed cannot name contingent beneficiaries who will become beneficiaries on the death of the contributor of the assets.

In determining whether a trust qualifies as an SBT, ITA section 104(1.01) applies in determining whether any other person has an absolute or contingent right under the trust.[81]  Under this provision, a person or partnership is deemed not to have such a right if the person or partnership is beneficially interested in the trust solely because of any of the following rights (irrelevant items excluded).

·         A right that may arise as a consequence of the terms of the will or other testamentary instrument of an individual who, at the time, is a beneficiary under the trust. 

·         A right that may arise as a consequence of the law governing the intestacy of an individual who, at the time, is a beneficiary under the trust.

·         Any combination of the above rights.

ITA section 104(1.01) seems to contemplate that future beneficiaries can be named in the will of the self-benefit individual or in some other “testamentary instrument” of the self-benefit individual.  As a testamentary instrument is an instrument that depends on death for its vigor and effect, the reference to “other testamentary instrument” would presumably include any power of appointment that comes into effect on the death of the self-benefit individual (whether the power is exercised in a will or in some other testamentary stand-alone document).

It should be possible to use an SBT in order to avoid the payment of probate tax.  This will depend upon third parties being willing to recognize the way in which the power of appointment has been exercised.  If the power of appointment can be revoked and revised at any time before death, for example, a third party may wonder if the document in question is actually the latest exercise of the power.  However, it should be possible to deal with this by having the trust deed set out a specific procedure for exercise of the power in a specific form of testamentary instrument.  For example, one could provide that the testamentary instrument must be lodged with the SBT trustee and acknowledged by the trustee in order for the document to be effective on the death of the individual exercising the power.  The trustee would then be in a position to certify that the document in question was the last document lodged with the trustee.  Any subsequent document that had not been lodged with the trustee would be an invalid document and would not have to be recognized by the trustee.

If the power of appointment must be exercised in the will of the self-benefit individual, the situation is murkier.  Technically, the assets are held in the trust and would become part of the estate of the self-benefit individual only if the power of appointment is not validly exercised.  Valid exercise of the power of appointment should prevent the trust assets from becoming part of the estate.  However, it would seem more prudent to use a stand-alone testamentary instrument that is not part of a will.

Is the manner of exercising the power of appointment subject to the wills variation provisions of WESA?  In other words, could a disappointed child bring a wills variation action in respect of assets held inside an SBT on the basis that the disposition of those assets is governed by a testamentary power of appointment? 

Strictly speaking, a power of appointment is a personal power to direct what is to be done with a specific asset.[82]  The asset in question is not owned by the holder of the power, as ownership of the asset would include the right to dispose of the asset.  If the holder has the power to appoint in favor of the holder of the power, the power in that case would be “tantamount to ownership” and might in some cases be viewed as equivalent to ownership.[83] However, ITA section 104(1.01) does not require that the power be an unlimited one.  The trust deed could specify that the power is a limited one that may be exercised in favor of only a specific class of individuals (such as the spouse and descendants of the self-benefit individual) or anyone other than the self-benefit individual and the estate of the self-benefit individual.[84] That should avoid any argument that the power is tantamount to ownership.

The issue then comes down to whether the self-benefit individual retained so much control over the assets that the will variation provisions of WESA should apply.  The holding of the power of appointment certainly gives the self-benefit individual control over the ultimate destination of the assets in question.

ITA section 104(1.1) requires that the power be held by the self-benefit individual and not by some other person.  Quaere whether the trust deed could require that some other person have the ability to veto the way in which the power is exercised.  Under trust law, it is possible to provide that a power is exercisable only with the consent of a third party.[85] The question is whether that would satisfy the ITA section 104(1.1) requirement that the right of the other beneficiary arise as a consequence of the terms of a testamentary instrument of the self-benefit individual.  If the consent of some other person is required, the right would presumably arise by virtue of the consent of that other person.

Even if a power of appointment is testamentary in nature, however, does that make the assets in question part of the estate of the holder of the power?

Section 60 of WESA provides that a court may order that provision be made out of the “will-maker's estate”.  Section 1(1) defines “estate” to mean “the property of a deceased person”.  If a power is a mere right in respect of property held by another and is not property under trust law, it would seem to follow that the court would not have any power to make an order that affects the property of the trust. 

Using another analysis, section 1(1) of WESA defines “will” as including “an appointment by will or by writing in the nature of a will in exercise of a power”.[86]  If the document in which the testamentary power of appointment is exercised is a writing “in the nature of a will”, what is the effect of this?  Would this give the court an ability to vary the power of appointment?  Under this approach, the argument would be as follows.

·         The document exercising the power of appointment is a will, so the person exercising the power is a willmaker.

·         The power of appointment document does not make adequate provision for the proper maintenance and support of the spouse or children of the person exercising the power.

·         The court may order adequate provision be made out of the willmaker's estate.

This gets one back to the WESA definition of “estate” and whether the assets that are the subject of the power are included in the estate of the deceased individual.  WESA does not provide the court with any explicit authority to actually vary the way in which the appointment was exercised.  The relief is limited to ordering that adequate provision be made out of the “will-maker’s estate”.[87]  So even if the document exercising the power is a will, it may be that the court has no power to do anything in respect of the assets inside the SBT.

Even if the SBT allows one to avoid probate tax and the wills variation provisions of WESA, however, income tax issues remain.  While the 21-year deemed disposition rule does not apply during the lifetime of the self-benefit individual, the assets in the SBT will be subject to a deemed disposition on the death of the self-benefit individual.[88]  Unlike an AET, the SBT trustee cannot elect out of this deemed disposition.[89]

Given that the deemed disposition occurs inside the SBT, there is no rollover to a surviving spouse.  This seems to be the case even if the assets flow from the SBT to the estate of the self-benefit individual (in other words, the power of appointment mechanism is not used).  The spousal rollover provision in ITA section 70(6) applies only if the property in question would otherwise be subject to a deemed disposition under ITA section 70(5)—the “usual” deemed disposition on death provision.  Assets in the SBT, however, are deemed to be disposed of under ITA section 104(4)(a.4).

The SBT also suffers from the other problems that can arise for assets held inside an AET or JST.  For convenience, I will repeat those issues here.

·         If farm property is eligible for the intergenerational property rollover, that rollover is lost if the property is held inside an SBT.  Accordingly, it is best to have such property held individually (even if it means paying probate tax).

·         Any capital losses realized personally by the self-benefit individual on death cannot be used against capital gains realized in the SBT (and vice-versa).

·         If SBT assets include active business corporation shares, qualified farm or fishing property or other assets that can qualify for the capital gains exemption, a significant tax cost can arise if the shares are held inside an SBT on the death of the self-benefit individual.  An SBT cannot claim the capital gains exemption and the capital gain that arises on the death of the self-benefit individual cannot be allocated out to any beneficiary.

A technical issue also arises if one uses the power of appointment technique.  For income tax purposes, “property” includes “a right of any kind whatever”.[90]  As the power of appointment is a right, is the power of appointment also subject to a deemed disposition on death?  Presumably, this would not be the case given that the assets themselves are deemed to be disposed of inside the SBT.  Technically, however, the rule against double inclusion of the same amount would not apply because the deemed disposition of the assets occurs inside the SBT whereas any deemed disposition of the power of appointment occurs outside the SBT.[91]  Presumably, the value of the power would not be significant if the power is a limited one.[92]

D.    QUALIFYING DISPOSITION TRUST

ITA section 107.4 provides for a tax-deferred transfer of property to a trust if the transfer is a “qualifying disposition”[93] (hence the name “Qualifying Disposition Trust”).

In the context of an individual contributor, the Qualifying Disposition Trust is very much like the Self-Benefit Trust except that the rollover applies to any type of property (not just capital property).  Accordingly, one could roll resource properties and land inventory to a Qualifying Disposition Trust.

In order to have a qualifying disposition, the following must apply.

·         The transfer of legal title to the trust must not result in a change in beneficial ownership.  In making this determination, the same rules apply as for an SBT.  This seems to contemplate the use of a testamentary power of appointment to identify beneficiaries who become such on the death of the contributor.

·         The Qualifying Disposition Trust must be resident in Canada (but the transferor could be a non-resident).

·         The proceeds of disposition are not determined under any other provision of the ITA (disregarding sections the non-arm’s-length transfer rule in section 69 and the rules in section 73 for transfers to AETs and SBTs).

·         ITA section 73(1) does not apply to the disposition and would not apply even if certain requirements of that provision were not met.

The Qualifying Disposition Trust can also be used in the context of trust-to-trust transfers if the Trust Deed of the transferring trust allows for such a transfer.  In this case, however, the power of appointment technique cannot be used to have new beneficiaries arise on the death of someone.[94]

For an individual who has resource properties or land inventory, the Qualifying Disposition Trust can be thought of as a Self-Benefit Trust for property that is not capital property.  If the goal is to avoid probate tax, the testamentary power of appointment technique should allow one to avoid probate.  If the goal is to avoid will variation provisions, the same issues arise as are present with a Self-Benefit Trust.

The preceding paragraph is a bit of an over-simplification, however, as the Qualifying Disposition Trust provisions contain some additional rules.  However, these additional rules would usually not be relevant if the goal is merely to transfer non-capital assets to a Self-Benefit Trust.

E.     SPOUSAL TRUST

For the sake of completeness, this paper will also mention the spousal trust.[95] In an inter vivos context, this tends to be set up only in a separation or a divorce context.  One spouse (say the husband or former husband) can set up a trust for the other spouse (say the wife or former wife) and contribute assets to the trust on a tax-deferred basis.

In the above example of the husband setting up the trust for the wife, the wife must be the sole beneficiary during her lifetime and must be entitled to all income of the trust that arises prior to her death.  There may or may not be a power to encroach on capital but nobody other than the wife can take any benefit from the trust at any time prior to the wife’s death.  On the death of the wife, there is a deemed disposition of assets inside the trust.

Because the deemed disposition of assets arises on the death of the one spouse (the wife in my example), most married couples (as long as one spouse is 65 or over) will prefer to establish a JST so as to defer the deemed disposition until the death of the surviving spouse.  Placing assets into a spousal trust for just one spouse runs the risk of accelerating the deemed disposition on death.

If the client wants a trust to hold property that will qualify for the capital gains exemption, a spousal trust will preserve access to the exemption on the death of the spouse.[96] Of course, this may accelerate the triggering of the capital gain given that the spouse beneficiary might be the first spouse to die.  If the trust holds fixed-value shares, however, and the full value of those shares will qualify for the exemption on the death of the spouse, a spousal trust may be an option.  This might be the case after an estate freeze if the aggregate value of the freeze shares is less than the available capital gains exemption.  In an estate freeze, of course, the individual’s interest would be fixed and one any additional exemption room that arises in future through inflationary adjustments to the exemption level would not be a factor.

F.      BARE TRUST

For income tax purpose, a so-called “bare trust” is not considered as a trust if the trustee can reasonably be considered to act as a mere agent of the beneficiaries in respect of all dealings with the assets of the trust.[97] As a “bare trust’ is not a trust for income tax purposes, there is no need to find a specific rollover provision to avoid capital gains tax when assets are placed into a bare trust arrangement.  For income tax purposes, the bare trust is ignored.

A bare trust arises if the beneficiaries have the right to call for the property on demand and the trustee has no active duties to perform in respect of the property (except for the duty to maintain it and to hand it over to the beneficiaries on demand).[98] For example, this can arise if the trustee is to hold property until a specific beneficiary reaches age 35.  Once the beneficiary reaches age 35, however, the trustee usually does not distribute the property right away.  The trustee would usually require the issuance of a clearance certificate to make sure that the trustee can distribute the assets without incurring any personal liability for any unpaid tax that might be owing by the trust.  While the trustee has a duty to deliver the asset (which has now vested), the trustee usually has some administrative matters to clear up first.

The more usual use of a bare trust arises when a corporation holds bare legal title to real estate on behalf of beneficial owners.  This structure is sometimes used to avoid payment of the provincial land transfer tax on changes in title.  Usually, beneficial interest in the real estate would be conveyed without any change in title as shares of the nominee or bare trustee corporation would be conveyed at the same time to the purchaser for a nominal amount.  The purchaser would then control the nominee or bare trustee corporation and so would control the title to the real estate.  In this situation, the nominee or bare trustee corporation would never have had any active duties to perform in respect of the trust property (other than the duty to hold the asset for the beneficial owner).

Whether a bare trust is more of a trust or more in the nature of agency is an interesting question.[99] That question is no longer relevant for income tax purposes, but the question in other contexts will ultimately depend on intention.  Was the intention to create a trust or an agency relationship?  If the intention is to have a nominee corporation hold title as agent of the beneficial owner, the relationship may be one of agency only.

If the intention is to create a trust, it may be possible to use the bare trust to avoid probate taxes if the will does not otherwise have to be probated.  If the will has to be probated for some other reason, however, one has to then deal with the value of the beneficial interest held by the beneficial owner in the trust.  If the trust is a bare trust, that beneficial interest would presumably have a value equal to the value of the trust asset given that the beneficial owner has the right to demand that the trustee deliver the asset to the beneficial owner at any time.  The beneficial interest cannot disappear immediately prior to death, as that would be a non-bare trust due to the setting up of a remainder interest at the time of the creation of the trust.  If the remainder interest was granted just before creation of the bare trust, of course, that would likely have triggered a capital gain at the time of the creation of that remainder interest.[100]

G.    PRINCIPAL RESIDENCE TRUST

While a principal residence is exempt from capital gains tax, some clients ask about holding their principal residence in a trust in order to avoid probate tax on the value of the residence.  While this can result in avoidance of probate tax, great care must be taken so that the client does not create capital gains tax problems.

A principal residence trust is simply a trust that holds a property that is used as a principal residence.  The only tax requirement is that no corporation (other than a registered charity) or partnership be beneficially interested in the trust.[101] As the applicable term is “beneficially interested”, the trustee cannot have a power to add a non-charity corporation as a beneficiary.[102]

As long as no corporation or partnership is beneficially interested in the trust, the trust can claim the principal residence exemption if the trust property includes a housing unit that is used as a personal residence by one of the beneficiaries.  The concern, however, is that a principal residence exemption claim by the trust can prevent other beneficiaries from claiming the principal residence exemption on their own homes.  If a trust claims the principal residence exemption, each specified beneficiary of the trust is deemed to have claimed that property as the principal residence of the specified beneficiary for each year that the property was the principal residence of the trust.[103]

The definition of “specified beneficiary” can be a trap for the unwary.[104] A “specified beneficiary” includes each individual who is “beneficially interested” in the trust and who

(a)        ordinarily inhabited the housing unit in the year, or

(b)        has a spouse, common-law partner, former spouse or common-law partner or a child who ordinarily inhabited the housing unit in the year. The age of the child does not matter.  The child could be under 18 or over 18.

This can cause a problem if the trust holds a family cottage that is used by the extended family.  To illustrate this, assume that the trust has held the family cottage for 21 years and that four siblings use the cottage on a rotating basis each year.  The 21st anniversary of the trust is coming up, so the trust claims the principal residence exemption to avoid paying tax on the deemed capital gain.  As a result, each of the four siblings is deemed to have claimed the cottage as the principal residence of that sibling for each year that the trust claimed the cottage as its principal residence.  No sibling (or the spouse of a sibling) can claim the principal residence exemption on the sibling’s own home.  As a result, one principal residence exemption was claimed and four were lost (net of minus 3).

Now take the same example but assume that the siblings have no interest in maintaining the cottage and decide to let their respective children use the cottage instead.  I will refer to the children of the children as the cousins.  The cousins (children of the siblings) are also beneficiaries of the trust.  Each respective cousin takes turns using the cottage each year.  If the trust claims the principal residence exemption, each cousin will be deemed to have claimed the cottage as the principal residence of that cousin.  However, the inability to claim the principal residence exemption also extends to the siblings, because each sibling was a beneficiary of the trust and had a child (albeit an adult child) who ordinarily inhabited the cottage each year.  As a result, one principal residence exemption was claimed and any number were lost (1 for each sibling and one for each cousin).  This makes the plus-minus really bad.

Problems can arise in all sorts of ways.  Assume that a Grandma and Grandpa decide to hold their house in a trust and have made their children the beneficiaries of the trust effective on the death of the survivor of Grandma and Grandpa.  They have a favorite grandchild (Junior) who is very fond of his grandparents and visits them every summer vacation.  Of course, the grandparents insist that Junior stay with the grandparents.  The surviving grandparent dies and there is a deemed disposition of the house -- so the JST Trustee claims the principal residence exemption.  This means that Junior’s father cannot claim his house as his principal residence, because Junior’s father had a beneficial interest in the JST (the contingent interest effective on the death of the surviving grandparent) and had a child who ordinarily resided in the grandparent’s house each summer.

As is the normal rule for a principal residence, a family unit can claim only one principal residence per year.  If the property is owned by a trust, however, the "family unit" is in essence expanded to include each beneficiary who “ordinarily inhabits” the property during the year in question or who has a child who “ordinarily inhabits” the property in the year in question.

While one can explain this rule to the clients, they will not likely retain that information (especially if a grandchild is coming for the summer).

If a residence is already held inside a trust and a principal residence claim by the trust would cause problems for other homeowners, it might be possible to remedy the situation (or at least reduce the harm).  Usually, the trust can distribute the residence to a beneficiary on a tax-deferred basis.  If that occurs, the recipient beneficiary will be deemed to have owned the residence while it was owned by the trust.[105] Provided that the recipient ordinarily resided in the property while it was held inside the trust, the recipient will be able to claim the principal residence exemption by virtue of actual residence and deemed ownership.  If the individual recipient sells the property and makes the exemption claim, this will not have any adverse effect on the ability of other beneficiaries to claim the principal residence exemption on the sale of their own residences.  Of course, the recipient beneficiary will not be able to claim any other property as a principal residence for the period covered by his claim on the property that he received from the trust.

VI.             Estate Freezes

A.    GENERAL BACKGROUND

In a typical estate freeze, parents will hold a valuable asset (such as real estate or shares of a corporation).  That asset will have increased significantly in value.  The parents will have reached the stage in life at which the parents are primarily concerned with cash flow and less with asset value.  In fact, any future increase in the value of the asset means that the estate of the surviving parent will have a larger capital gain on death.  Any such larger capital gain will result in the payment of additional capital gains tax.  The additional capital gains tax could result in a forced sale of the asset, meaning that the asset itself (and the income generated by that asset) will not pass to the next generation.  While the next generation will have the after-tax proceeds of a sale of that asset, the income generated by investing those after-tax proceeds of sale may not be as lucrative as if the asset had been retained.

In this situation, the parents will typically engage in an estate freeze in order to prevent their interest in the asset from growing in value.  If the asset is common shares of a corporation (“Freezeco”), the parents might exchange those common shares for fixed-value redeemable retractable shares with an aggregate redemption value equal to the value of the shares owned by the parents.  If the common shares held by the parents have an aggregate value of $1 million, the parents are left with shares with a fixed value of $1 million.  Assuming that capital gains tax rates do not change, the parents now know how much capital gains tax will be payable on the death of the surviving parent.  As the parents are no longer dealing with a moving target, they may now find it easier to take steps to fund that capital gains tax liability.  In essence, the parents will have capped the value of their estate.  Consequently, one could refer to an “estate cap” transaction.  Canada being a northern country, however, we have adopted the term “estate freeze”. 

The fixed-value shares taken back by the parents are shares at law but are akin to a demand promissory note.  This quasi-debt status arises primarily (but not solely) from the holder’s right of retraction -- in other words, the holder of the shares can demand at any time that the corporation redeem the shares and cash the shareholder out.  Because of these special attributes, the shares act like a sponge and “soak up” all the value of Freezeco.  This allows Freezeco to issue new shares to the next generation (i.e. the children or the trust) for a nominal price.[106]  Any future growth in value will now accrue to the new common shares held by the next generation and will be a problem for the members of the next generation at some point in the future.  Assuming that the next generation survives the parents (as is usually the case), however, this defers the taxation of that future growth in value to a time that is later than the death of the surviving parent.

As noted, the fixed-value shares taken back by the parents need to have specific attributes that are required for income tax purposes in order to avoid the conferral of a benefit on the shareholders who subscribe for new common shares immediately after the estate freeze.  In 2008, the Canada Revenue Agency (the “CRA”) was asked whether the retractability feature was the sole absolutely essential feature of estate freeze shares.  The CRA response indicated that it could not boil the essential attributes of estate freeze shares down to just a single attribute.[107]

[...] the CRA is normally disposed to accept that the FMV [fair market value] of estate freeze preferred shares of the capital stock of a corporation is equal to the FMV of the common shares of the corporation that are exchanged for the preferred shares, when the estate freeze preferred shares summarily have the following attributes:

*          redeemable at the option of the holder at a redemption price equal to the FMV of the common shares exchanged, plus any declared and unpaid dividends;

*          no dividend can be paid on other classes of shares for an amount that would reduce the FMV of the preferred shares below their redemption price, or that would result in the corporation not having the necessary net assets for the redemption of the preferred shares;

*          they must have, at least, voting rights on any matter involving a modification to the attributes attached to them (these voting rights can be provided by the relevant corporate law or the articles of incorporation);

*          absolute priority on all other classes of shares in the event of the distribution of the assets of the corporation on a winding-up or a dissolution of the corporation or any other distribution of its assets, up to the redemption price, plus any declared and unpaid dividends;

*          absolute priority on all the other classes of shares with respect to the redemption of the shares, and the corporation cannot acquire shares of others classes before the redemption of all the preferred shares;

*          no restriction with respect to the transfer of the preferred shares (other than the restrictions required, if applicable, by the relevant corporate law in order to qualify as a private corporation); and

*          containing a price adjustment clause for the redemption price of the preferred shares which is applicable when the redemption price agreed to by the parties is not equal to the FMV of the common shares exchanged, and also containing other appropriate adjustments when the shares have already been redeemed at the time of an adjustment of the redemption price.

Moreover, the FMV of estate freeze preferred shares containing the above attributes, cannot be reduced because of the existence of a shareholders agreement.

It is obviously impossible to anticipate all the possible variations with respect to the attributes of estate freeze preferred shares, and consequently, we cannot give you specific examples of cases where the redemption right at the option of the holder could be omitted for estate freeze preferred shares.  However, the general principle is that the redemption right at the option of the holder could be omitted only if the FMV of the estate freeze preferred shares would still be equal to the FMV of the common shares exchanged, notwithstanding the absence of this redemption right. 

Consequently, one cannot generally maintain that the only essential attribute that estate freeze preferred shares must contain is that they are redeemable at the option of the holder.

To this point, this paper has been describing an estate freeze carried out in winter -- or, more precisely, the winter of one’s life.  This rather poor attempt at poetic imagery is a way of bringing up the issue of the proper time for an estate freeze.  The time cannot be too late in the winter of one’s life because the estate freeze assumes that the parents (or, more accurately, at least one parent) will survive the estate freeze long enough so that value accrues to the common shares held by the next generation.  If the parents were to die the day after the estate freeze, the estate freeze will have accomplished nothing because no capital gains tax will have been deferred (the new common shares would not have had the time to grow in value).  Consequently, the estate freeze always assumes that at least one parent has some life expectancy remaining and that Freezeco will continue to grow during that remaining life expectancy.

The parents have to be comfortable that they have enough value in the new fixed-value shares to see them through to the end of their days.  Generally, the parents will be more interested in cash flow rather than value growth.  However, they will still be concerned to make sure that they have control over that cash flow and that the cash flow will be sufficient.  For example, one would generally not conduct an estate freeze if the parents are in their 50’s.  I have heard of some situations in which estate freezes were conducted too early and the children ended up being worth more than the parents.  This situation was not terribly comfortable for the parents.

Of course, it is possible to do an estate freeze-type of transaction in order to introduce new shareholders to a corporation without capping the interest held by the parents in that corporation.  In this case, the purpose of the “estate freeze” is not to permanently cap the value of the estate of the parents but is rather to introduce at least one new shareholder without that new shareholder having to pay fair market value for his or her shares.  Back when income-splitting with minor children was more popular (in other words, before introduction of the “kiddie tax”), it was a common technique to implement an estate freeze type of reorganization for the purpose of having a family trust subscribe for new shares.  In this situation, the parents (as well as the children) were generally beneficiaries of the family trust.  Dividends paid to the family trust were then sprinkled among the various family members in the most tax-effective manner.  This structure is still available for university-aged children and for the purpose of multiplying access to the capital gains exemption on a future sale of shares of an active business corporation.

B.     THE FAMILY TRUST

When considering whether to establish a family trust as part of an estate freeze, one has to first determine whether a family trust is warranted.  This involves consideration of the various reasons that might exist for establishing a family trust.  What purpose does the family trust serve?  That purpose will generally determine the terms and conditions of the family trust.

In some cases, the family corporation will involve an actual operating business and the parents will not have decided which child will be taking over control of the business.  If this is the primary reason for establishing the family trust, one will want a fully discretionary trust so that the parents can decide at a later time as to how the future value (and control of Freezeco) will be allocated among the children.  In too many cases, however, no child is actually interested in (or capable of) taking over the business and the parents use the discretionary nature of the family trust as a way of not having to deal with that issue.  By doing the freeze and setting up the trust, the parents will have taken an estate planning step -- but only one step.  Too often, however, the parents think that they do not have to proceed beyond that first step to the subsequent steps of dealing with the actual issue of who is to take over the business and how the transition is to be managed.

Parents will often establish a family trust so that they can continue to have control over the trust and that future growth in value.  This is in many cases a legitimate concern.  However, the parents also need to have some kind of a plan for passing on control at some point in the future.  The plan should have specific time frames and specific ways of involving the children.  For example, the children could become more involved in the decisions taken by parents as trustees.  Whether or not the children actually become co-trustees, there is no prohibition against the trustees considering the views of beneficiaries.  Too often, the parents hang on to exclusive control and do not involve the children at all.  This means that control passes on the death or incapacity of the last parent and there has been no opportunity for the parents to see how the children will deal with the assets or with the decision-making process.

The family trust is often established because the parents do not know who their children will marry or have concerns about an existing marriage.  The desire is generally to have the family assets pass down to direct lineal descendants and not to have any of those assets go to a separated or divorced spouse.  In the past, trusts have been fairly useful in preserving assets for the benefit of direct lineal descendants.  There have been cases in which the courts have mused about possibly treating a beneficial interest as a family asset.  Courts may make an adjustment in the division of assets to account for the value that will likely arise to the person who is a beneficiary of the family trust.

With the adoption of the new Family Law Act, considerable uncertainty exists as to the treatment of interests in a family trust in a matrimonial context under that new legislation.  Until the full effects of the new legislation become clear, reliance should probably be placed on pre-nuptial and marriage agreements rather than on the existence of the trust itself.  This will be dealt with in more detail in one of the other papers.

If no child is really in a position to take over the business, it may still be worthwhile to set up the family trust so as to multiply access to the capital gains exemption by having the children hold some of the future value of Freezeco.  In that case, however, the parents have to start thinking about marketing Freezeco because actually selling a private corporation can take from 5 to 10 years.  This means that the estate freeze is really a way of introducing additional shareholders in anticipation of a future sale of the corporate shares.  This is a case in which an “estate freeze” might be accomplished while the parents are still fairly young and active in the business so that additional value can add up while the parents are in the process of selling the business.

C.     A NOTE ON ESTATE FREEZE TERMINOLOGY

As noted above, I will use the term “Freezeco” to refer to the corporation that is being frozen as part of the estate freeze.

I will base relationships on the parents who are implementing the estate freeze.   A reference to children means the children of those parents.  A reference to a grandparent, however, means a grandparent of the children of the parents (meaning the parents of the parents) because a reference to a parent of the parents looks too much like a typo.

D.    INVESTMENT POWERS

Typically, the shares of Freezeco will be the sole investment asset of the family trust (the initial trust property will be the only other asset).  As a result, it is necessary to modify the statutory investment powers.

The Trustee Act adopts a “prudent investor” standard in determining the type of investments that can be held inside a trust.[108]  It is doubtful that a prudent investor would hold shares in an illiquid private corporation.  Certainly, a prudent investor would attempt to diversify investments and would not put all the trust’s eggs into a single basket.

In order to make sure that the family trust can hold shares of Freezeco, the investment powers in the trust deed should expressly authorize the trustee to hold shares of Freezeco as the sole investment asset of the trust (without any need to diversify into other investments).

As the Trustee Act provides default rules that apply only if the actual trust document is silent on the matter, it is possible for the investment powers in the trust deed to override the prudent investor standard.[109]  If the trust deed fails to insert provisions overriding the prudent investor standard, however, the trustees could be committing a breach of trust by acquiring shares of Freezeco.

E.     IDENTITY OF TRUSTMAKER

In an estate freeze, it is important to carefully consider the identity of the person who will actually establish the trust.  More often than not, this is a grandparent or a family friend or some other person who will have nothing to do with the operation of the trust and who will never be a beneficiary of the trust.

When selecting a trustmaker, one is most often concerned to avoid specific income tax attribution rules.  Most specifically, one wants to avoid the application of subsection 75(2) of the Income Tax Act (the “ITA”).

Subsection 75(2) is often thought of as a rule that applies to reversionary trusts.  However, it is much broader than that.  The rule applies if a person (call that person the “contributor”) contributes property to a trust and certain conditions apply.  In order to illustrate the rule, assume that the contributor gifts a $100 bill to the trust.  Subsection 75(2) will apply if any one of the following conditions applies.

·         It is possible for the $100 (including any property for which the $100 has been substituted) to revert back to the contributor.

·         For example, this can arise if the contributor is a beneficiary of the trust and the trustees have the power to distribute the $100 to the contributor as a distribution from the trust.

·         It can also arise if the $100 is used to buy shares of the family corporation (after the freeze) and the trustees can distribute any of those shares to the contributor as a distribution from the trust.  This is because the shares have been substituted for the $100 (i.e. the $100 was used to buy the shares, which means that the $100 was replaced by the shares).

·         The $100 (or any substituted property) cannot be disposed during the lifetime of the contributor without the consent of the contributor.

·         The CRA takes the view that this will be the case if the contributor is one of two trustees, as the contributor then has a veto over any distribution decisions of the trustee.

·         The CRA also takes the view that this will be the case, of course, if the contributor is the sole trustee.

·         This will arise if the contributor has any kind of a veto power over decisions of the trustee in respect of the $100 or substituted property.

·         The contributor can, during his or her lifetime, direct who is to receive the $100 or substituted property.  This can apply if the contributor has a power of appointment.

If any one of the above conditions apply, the Canadian tax result is as follows.

·         Any income or capital gain from the $100 (or substituted property) is treated as income and capital gain of the contributor.

·         This is the case even though the income and capital gain belongs to the trust and even if the income and capital gain is distributed to some other person.

·         For example, assume that the trust uses the $100 to buy new common shares of Freezeco after completion of the estate freeze.  Because the shares are substituted property, any dividends on the shares are taxed as income of the contributor.  As a result,the contributor ends up paying tax on all dividends generated by the common shares.

·         If any capital property (not just the $100 and property that has been substituted for the $100) is distributed from the trust during the lifetime of the contributor, the distribution can be made on a tax-deferred basis only if the property is distributed to the contributor or the spouse of the contributor.  A distribution to anyone else (even a Canadian resident) will be treated as a sale at fair market value.

·         If the capital gain is realized on shares that were purchased with the contributor’s $100, of course, that capital gain will be taxed as a capital gain of the contributor.

·         If the capital gain is realized on some other property, there will still be a capital gain.

There are clever and complicated techniques for getting around the above rules, but the safest course of action is to make sure that the rules do not apply in the first place.  This means careful selection of the trustmaker.

In an estate freeze context, the trust does not need a significant capital base in order to purchase the new common shares of Freezeco.  Remember, those shares are considered to have only a nominal value.  For that reason, the trust can be established with only a minor amount of initial property.  This is often a gold coin, a silver coin or simply a $100 bill.  To establish the trust, therefore, one does not have to find someone with deep pockets.

In order to steer a wide berth around subsection 75(2), I suggest following these simple rules.

·         The trustmaker should be an individual who will have nothing to do with the trust after establishment of the trust.  The trustmaker should be considered as the one person in the world who can never receive anything from the trust, who can never act as a trustee and who can never exercise any other function in respect of the trust (other than starting the trust).

·         As a backup, the only purpose of the initial trust property is to establish the trust.  The initial trust property should be placed in an envelope, should be stapled to the trust deed and should remain stapled to the trust deed until future termination of the trust.  The initial property should be the last piece of trust property that is distributed and should not change form at all during the existence of the trust.[110]

·         Tell the parents that they must not reimburse the trustmaker for the initial trust property.  The trustmaker must contribute the initial trust property as a gift.  If the parent reimburses the trustmaker for the gift, there is a risk that the trustmaker will have acted as agent of the parent and that the parent will be considered to have contributed the initial trust property.

If one uses the initial trust property solely to establish the trust, how does the trust buy new common shares of Freezeco after the estate freeze?  The usual technique is for the trustees to borrow funds from a third party (not the trustmaker) and agree to pay a reasonable rate of interest on the loan.  The trustees then use the borrowed funds to buy the shares.  After about a month, Freezeco pays a small dividend to the trustees and the trustees use that dividend to repay the loan and the accrued interest.  It is important to remember to actually repay the loan.

While the interest expense will be deductible in computing the income of the trust, there is no deduction for the portion of the dividend that is used to repay the loan principal.  As a result, the trust will have a small amount of taxable income and will have to pay a small amount of income tax.  This is not a bad thing, of course, as it helps to establish the existence of the trust for income tax purposes.[111]

In one sense, it is best to use a family friend as the trustmaker because the family friend is not related to any of the trust beneficiaries.  However, I prefer to use a grandparent if one is available.  A grandparent is a lineal ascendant of the beneficiaries.  If one of the beneficiaries becomes disabled, and if that beneficiary is a direct lineal descendant of the trustmaker, it will be possible for the trust to make a preferred beneficiary election in respect of the beneficiary.  By making the preferred beneficiary election, income earned by the trust can be taxed at the tax rate of the disabled beneficiary-even if the disabled beneficiary is under the age of 17.  As long as there is no actual distribution of income to the disabled beneficiary, the “kiddie tax” does not apply and the trust can, in a subsequent year, use the capitalized income for the benefit of that disabled beneficiary.  By “disabled beneficiary”, I mean somebody who qualifies for the Disability Tax Credit.

If one of the trust beneficiaries is currently disabled, of course, one will want to use a grandparent as the trustmaker so as to make sure that the disabled beneficiary is a preferred beneficiary.  If the children of the parents are adults, however, one should consider the possibility that the children of the parents will produce grandchildren prior to termination of the trust.  It is of course possible that one of those grandchildren could be disabled.

Even though the trustmaker is often somebody who should not have any involvement with the operation of the trust, the role of the trustmaker is crucial.  In order to establish a trust, the trustmaker must intend to establish a trust.  If there is no intention to create a trust, there is no trust.  Consequently, it is not just a question of having somebody supply some initial property and sign some documents.  The trustmaker has to realize that the trustmaker is setting up a trust.  If the trustmaker does not have this realization, of course, the trustmaker cannot have any intention to set up a trust and the trust will of necessity fail.

This is not just a theoretical concern. A court will look at the fundamentals of trust law and the intention of the trustmaker.  This was illustrated by the Federal Court of Appeal in its 2010 judgement in Antle.[112]  The appellant in that case signed documents that seemed to establish a spousal trust resident in Barbados and then signed documents contributing shares of a Canadian corporation to that trust.  The plan was to take advantage of provisions of the Canada-Barbados Tax Treaty in order to avoid tax on the sale of the shares to a third party.

The plan failed to get past first base.  The Federal Court of Appeal upheld the following finding of the Tax Court judge in the matter.[113]  The emphasis in the following passage was inserted by Noël JA, writing the judgement for the Federal Court of Appeal.

I reach the inevitable conclusion that [the appellant] did not truly intend to settle shares in trust with [the trustee]. He simply signed documents on the advice of his professional advisers with the expectation the result would avoid tax in Canada. I find that on December 14th, he never intended to lose control of the shares or the money resulting from the sale. He knew when he purported to settle the Trust that nothing could or would derail the steps in the strategy. This is not indicative of an intention to settle a discretionary trust. Frankly, I have not been convinced [the appellant] even fully appreciated the significance of settling a discretionary trust, beyond an appreciation for the result it might provide. I conclude that his actions and the surrounding circumstances cannot support a conclusion that signing the Trust Deed, as worded, reflects any true intention to settle shares in a discretionary trust. I do not find that [the appellant] is saved by the language of the Trust Deed itself, no matter how clear it might be. It does not reflect his intentions.

There was no magic in the elaborate and finely-crafted documents.  It all hinged on a failure to observe the basic principles of trust law.

Interestingly enough, the appellant in Antle did not dispute that he never intended to grant the trustee control of, or discretion over, the shares in question.[114]  The appeal had to be based on a question of law, so the appellant argued that the Tax Court was not permitted to look beyond the wording of the documents themselves.  The Federal Court of Appeal made it quite clear that the court can take the actions of the parties into account in order to determine whether the purported trustmaker actually had an intention to create a trust.  As there was no intention in this case, there was no trust.  The elaborate documentation was nothing more than a sham because they described a trust that did not exist.[115]

If one reads the Tax Court judgement, the absence of intention was based on timing of signatures, some acts that were inconsistent with the trust having been established, and a lack of actual transfer of the property to the trustee.[116]

Ideally, the lawyer should actually meet with the trustmaker and make sure that the trustmaker realizes that the trustmaker is setting up a trust.  This requires that the trustmaker understand the basic concept of a trust and understand that the trustmaker is making a gift that will be managed by a trustee for the benefit of selected individuals.  The trustmaker does not have to be an expert on trust law but has to understand this basic feature of a trust.  Given that the trustmaker is the one establishing the trust, the draft trust deed should be sent to the trustmaker for review by the trustmaker.  There is a tendency to send the trust documents to the parents and to deal with the trustmaker as an afterthought or as a mere “technical detail” of the trust establishment.  In actual fact, the trustmaker is the linchpin of the trust.

It follows, of course, that the trustmaker must know who he or she is naming as beneficiaries of the trust.  I like to use a trustmaker who has some connection with the family such that it would not be considered unusual for that individual to make a gift for the benefit of the family.  Ideally, the trustmaker should be someone who has assisted the family in the past.  Setting up the trust is like making a Christmas gift to the family.

The lawyer has to consider whether the lawyer is acting for the trustmaker in setting up the trust.  Indeed, the instructions for the trust have to come from the trustmaker or there is no trust.  As a result, the lawyer has to take instructions from the trustmaker.  In doing so, therefore, the lawyer should clearly indicate whether the lawyer is providing legal advice to the trustmaker or whether the trustmaker has to obtain independent legal advice from some other source.  As a practical matter, the trustmaker will usually be an accommodating party and will not be thrilled about incurring expense for independent legal advice.  Given that the lawyer has to make sure that the trustmaker has the necessary intention to create the trust, the lawyer should approach the trustmaker as if the trustmaker were a client.  Certainly, the lawyer is going to owe some kind of a fiduciary duty to the trustmaker and needs to explain to the trustmaker exactly what the trustmaker is doing.

Given that the lawyer will be structuring the trust document, the lawyer also has a duty to make sure the trust document is structured in such a way that the trustmaker will not suffer any adverse impact from having created the trust.  Specifically, this means making sure that none of the attribution rules will apply so as to attribute trust income to the trustmaker.  This is another reason for not using the initial property to purchase the new common shares of Freezeco.  If the trustmaker is a grandparent or other person related to the beneficiaries and the initial trust property is used to acquire the new common shares, dividends on those common shares could in some circumstances be attributed back to the trustmaker.[117]  It is best to avoid any possibility of this happening.

Ensure that the trustmaker is a resident of Canada and that the trustmaker is not subject to the general tax laws of any jurisdiction outside of Canada.  Having a non-resident act as trustmaker may seem like a way around the income tax attribution rules and may even sound exotic, but it may end up subjecting the trust to the tax laws of a foreign jurisdiction.  It at least obligates you to consider the tax laws of that foreign jurisdiction and how those laws might apply to an “offshore” trust -- being a trust established by a tax resident of that other jurisdiction in a place outside of that other jurisdiction.  If a Canadian resident were to establish a trust in the United States for the benefit of relatives in the United States, that United States trust could easily be a deemed resident of Canada under our still-draft offshore trust rules.  The same may apply in reverse if the trustmaker is a citizen of the United States.[118]  France is introducing special reporting requirements that will apply if a trust has a French trustmaker, trustee or beneficiary.[119]

F.      CHOICE OF TRUSTEE

In an estate freeze context, the parents usually want to act as trustees in order to keep control over the trust assets (the future growth and value of Freezeco).  An issue is whether a third trustee should be involved.

Having a third trustee involved helps to formalize the trust because it is not just the parents making decisions over the dinner table and then not bothering to formalize the decisions.  Once a trust is properly established, the trust has to be maintained.  The danger is that maintenance is often sloppy or non-existent (especially if the trustees choose to maintain their own trust records).  Having a third trustee involved can make it more likely that trustee decisions will be formalized due to the necessity of involving that third trustee.  However, merelyhaving a third trustee is not a panacea.  If it is not easy to get together with the third trustee, it becomes more likely that trustee documentation will be non-existent.

If a third trustee is involved, there is a better chance of continuity for the trust if the parents were to die in an accident while the trust was still in existence.  This is probably not as important a factor as one might think, however, as long as a professional advisor is involved in the operation of the trust.  For example, an accountant will be up to speed on the details of the trust if an accountant has been preparing the trust income tax return.

I have been referring to a “third trustee” (meaning someone beside the parents) rather than a “third party”.  The third trustee can be one of the adult children as a way of preparing at least one of the children to manage the family asset.  Or it could be some other relative of the parents (as long as the parents are comfortable with that relative knowing about the family wealth).

A third trustee could be a professional adviser.  If a professional adviser is a trustee and the professional adviser controls some other corporation (such as the adviser’s professional corporation), however, the adviser’s position as third trustee could in some circumstances result in Freezeco being associated for income tax purposes with the professional’s corporation.  This is because the trustees hold common shares of Freezeco.  If the parents (the other two trustees) die in an automobile accident and the professional is left as the sole trustee of the trust, the professional could end up having actual or deemed control of Freezeco until such time as other trustees are appointed.  Two corporations are associated for income tax purposes in a taxation year if they are associated at any time in the year -- even for a millisecond.  The professional (as sole trustee) will have deemed control of Freezeco if the trust holds common shares of Freezeco and the value of those Freezeco common shares have more than 50% of the value of all issued Freezeco common shares.[120]  Typically, the trust will hold all the common shares.[121]  In determining the value of common shares for this purpose, all common shares are considered to be non-voting.[122]

A third trustee could also be a friend or some other person unrelated to the family.  Having an unrelated trustee, however, brings up acquisition of control issues.

For example, assume a corporation has non-capital (business) losses that are being carried forward from prior years.  The corporation wants to use those losses against future income once the economy recovers and the corporation once again starts to make a profit.  If the corporation  undergoes an acquisition of control before it returns to a profitable position, however, the losses carry-forwards are “streamed” and can be used by the Company only to the extent that the future profit is from the same or a similar business.  If there has been an intervening acquisition of control, the corporation cannot use the losses against income from a new business that it starts in an attempt to respond to the gloomy economy.

In the above context, a 2005 CRA technical interpretation comments on the following fact situation.[123]

- Lossco is a Canadian-controlled private corporation ("CCPC") as defined in subsections 125(7) and 248(1) of the Income Tax Act (the "Act"). The sole shareholder of Lossco is a discretionary trust for the members of Family A ("Trust 1");

- There are three trustees of Trust1: Trustees B, C and D;

- The trustees are not related to each other or to members of Family A;

- The decisions of the trust are made by a simple majority of the trustees;

- Lossco has non-capital and net capital losses.

The CRA took the position that a change in any of the trustees would result in an acquisition of control of Lossco.  The CRA justified this position on the following basis.

The test of de jure control contemplates the ownership of shares that give the holder the ability to elect a majority of directors. Where a trust is a shareholder, case law has referred to the trustees in assessing corporate control, since the trust is not a legal entity, but a relationship between the trustees and the beneficiaries. (See M.N.R. v. Consolidated Holding Company Limited, 72 DTC 6007 (SCC)). Where a trust has multiple trustees, the determination as to which trustee or group of trustees controls the corporation can only be made after a review of all the pertinent facts, including the terms of the trust instrument. However, in the absence of evidence to the contrary, we would consider there to be a presumption that all of the trustees would constitute a group that controls the corporation.

The above position is likely based on the CRA tendency to view small groups of shareholders as always acting in concert.[124]  Whether any two or three holders of shares actually act in concert to control a corporation is a question of fact, however, and not a rule of law.[125]  While trustees all have to act in the best interests of the beneficiaries, each trustee is independently responsible for fulfilling that duty and cannot just “go along” with the view of another trustee.  Unrelated trustees are more akin to unrelated shareholders in the sense that each is working toward a common objective but each has independent reasons for wanting to achieve that objective.  As a result, I am not sure that the CRA can be as dogmatic on this issue as the CRA appears to be.

That having been said, clients often want to avoid being test cases and will for that reason have to be cautioned about bringing in an unrelated trustee.  Even if the corporation does not have loss carry-forwards to worry about, the CRA view can result in a change of trustee triggering a deemed year-end of the corporation.  Of course, one can ask a trustee to resign as of the end of a corporate fiscal year but that may not be possible due to the personal circumstances of the unrelated trustee.  For example, the trustee may end up becoming a non-resident of Canada prior to the end of the fiscal year.

In a family trust context, the trust is inevitably a domestic trust that is resident in Canada for income tax purposes.  In order for the trust to be resident in Canada, the trust has to be managed in Canada.  Practically speaking, this will require that the trustees reside in Canada.

One does not want the family trust to become subject to the tax laws of any non-Canadian jurisdiction, so it is best to make sure that the trustees not only reside in Canada but that the trustees are not subject to the tax laws of any jurisdiction outside of Canada.   The United States imposes tax on the basis of citizenship, so you will want to make sure that no trustee is a US citizen.  If a trustee is a US citizen, you will have to consider potential cross-border issues.  As this is a complex area, it is best not to go there unless it is absolutely necessary.

It may be necessary to change trustees during the existence of the trust.  It is useful for the trust deed itself to set out a clear procedure for trustee succession.

This procedure could name specific successors, but situations change over time.  A successor named in the deed may have moved to another location by the time that the successor is called upon to take up his or her duties as trustee and may no longer be an appropriate choice for that reason.  Consequently, it may be better to insert a specific procedure for the appointment of successor trustees rather than naming successors.

Various possible procedures exist.  If a person’s judgment was trusted enough for that person to be named as a trustee, it might be appropriate to simply allow that person to appoint his or her successor.  That way, the choice of successor can be modified from time to time.  However, the choice of successor must actually be made in order for this method to be effective.  As part of the process of creating the trust, the initial trustee should appoint a successor.  That choice of successor should be reviewed annually (at tax return filing time) to make sure that the choice is still appropriate.

Of course, the trustmaker (or anyone else who has contributed to the trust) should never be appointed as a successor trustee.  Having the trustmaker act as a trustee risks the application of the rules in ITA subsection 75(2) and 107(4.1), as discussed above.  As the clients are likely to forget this sage advice, I usually have the trust deed itself prohibit the trustmaker from ever taking up the position of trustee.

G.    BENEFICIARIES

Trust law requires that the beneficiaries be clearly identified or identifiable.

One approach is to describe the beneficiaries as a class.  For example, the class might be “the children and other descendants of the marriage of X and Y”.  It is probably preferable to refer to the children of the marriage or to the children of both spouses rather than to just the children of one spouse.  One does not want to have to inquire about possible children born out of wedlock.  Referring to the children of just one parent could result in an unintended beneficiary.

In the case of blended families, however, you will have to raise the question whether the beneficiaries are to include just the children of the new marriage or also children from prior marriages.  It may also be prudent to name all the existing children and then to provide for future children (if that is a possibility) as children of the specific couple in question.

If naming specific individuals, of course, it is important to spell the names correctly.  I prefer to use full legal names and to include nicknames if applicable.  Sometimes, everyone knows a specific individual by a name that has nothing to do with the individual’s legal name.

The tendency is to have a broad class of beneficiaries.  However, there may be a need to impose some restrictions on the breadth of that class.

This will be the case if the estate freeze involves a corporation that is not a small business corporation or that may become a small business corporation at some time during the existence of the trust.  In order to be a small business corporation, a corporation needs to use substantially all its assets (measured by fair market value) in the pursuit of an active business carried on in Canada.  The CRA generally regards “substantially all” as meaning at least 90%.  This administrative simplification of the test is not the law but is a benchmark that one generally tries to meet.

If Freezeco owns rental property that is not used in an active business carried on by an associated corporation, Freezeco will not be a small business corporation.  Even if Freezeco is a small business corporation at the time of the freeze, Freezeco may cease to be a small business corporation at some time in the future.  For example, Freezeco may own real estate that is leased by a related corporation for use in the active business of the related corporation.  If the active business ceases or the active business is sold, however, Freezeco will no longer qualify as a small business corporation.

Deemed income can arise under section 74.4 if Freezeco is not (or later ceases to be) an active business corporation, the estate freeze involves a transfer of property by an individual to a corporation, a purpose of the transfer is to income split and the trust beneficiaries include “designated persons” in respect of the freezor.  Designated persons include the following.[126]

·         A spouse of the freezor.

·         A person who is under 18 years of age and who

·         does not deal at arm’s length with the freezor (i.e. is related to the freezor or does not deal at arm’s length as a matter of fact); or

·         is a nephew or niece of the freezor.

An estate freeze will almost always involve an income splitting purpose, so one can be sure to avoid this deemed income provision only if the trust does not include “designated persons” as beneficiaries while the individuals have the “designated person status”.

For children and other descendants, it is fairly easy to avoid section 74.4.  The trust can simply provide that a child or other descendant will not be a beneficiary while the child or other descendant is under the age of 18 and the transferor is living.[127]  Given that kiddie tax applies in respect of dividends paid to a child who is under 17 at the start of a taxation year, and given that the emphasis will be on redeeming the fixed-value shares held by the parents in the early years of the estate freeze, this is not usually a significant restriction.  However, it is a significant restriction if the goal of the estate freeze is to multiply access to the capital gains exemption on a future sale of share to an arm’s-length buyer.  Kiddie tax would not apply to a capital gain realized on an arm’s-length sale of shares, so excluding minors as beneficiaries means that their capital gains exemptions cannot be used if the sale occurs before the minors reach age 18.

If multiplication of the capital gains exemption is the objective, the above restriction is a problem.  Excluding the transferor’s spouse as a beneficiary of the trust might also be problematic if income-splitting with the spouse is an objective and the spouse does not already own any shares in Freezeco.  In that case, it might be advisable to have the trust beneficiaries include minors and the spouse and ensure that Freezeco pays sufficient dividends on the fixed-value shares each year to eliminate the section 74.4 deemed income.  In this sense, section 74.4 is akin to a minimum tax rule in that it requires the transferor to receive a minimum amount of income on the fixed-value shares.  The minimum amount of annual income required will be determined by the applicable dividend gross-up rate and the CRA prescribed rate of interest, which is currently 1% and is likely to stay at 1% until the general economic situation improves.

If the fixed-value shares have a redemption value of $1 million and no promissory note has been issued as part of the estate freeze, the annual dividend required to eliminate the deemed income will be a dividend that, after application of the appropriate gross-up rate, will result in a grossed-up dividend equal to 1% of $1 million (in other words, $10,000).  For example, assume that Freezeco pays only ordinary taxable dividends that are grossed-up by 25%.  In that case, Freezeco would have to pay a dividend of $8,000.  After application of the 25% dividend gross-up, the transferor would report grossed-up dividend income of $10,000 (which is equal to 1% of $10 million).

If the plan is to redeem the fixed-value shares over time, this merely reduces the rate at which the fixed-value shares are redeemed.Only actual dividends count toward reaching the minimum income level for purposes of section 74.4.  Deemed dividends that arise on the redemption of fixed-values shares do not count for that purpose.  So if the transferor wished to extract $50,000 per year from Freezeco, Freezeco would pay an $8,000 cash dividend to meet the minimum dividend requirements and would redeem $42,000 worth of fixed-value shares.

Another way to avoid having to restrict the trust beneficiaries is to implement the estate freeze by way of a stock dividend.This can be accomplished by issuing a stock dividend to the current shareholders rather than having the current shareholders exchange their existing shares for fixed-value shares.

The shares issued on the stock dividend would be fixed-value estate freeze shares with a nominal par value.  As long as the stock dividend is paid to all holders of common shares and is paid proportionate to the values of those common shares, the amount of the stock dividend for income tax purposes will be the aggregate par value of the shares issued on the stock dividend.  This should be a nominal amount.  However, the full redemption amount of the shares may have to be included in income if the stock dividend shares are distributed to the common shareholders on anything other than a pro-rata basis.[128]

The issuance of shares on a stock dividend is an issuance of shares by the corporation and does not involve a transfer of any property to the corporation.  Accordingly, section 74.4 should not apply.

After the stock dividend, the shareholders will be left with common shares with only a nominal value.  Those common shares could be eliminated by having the corporation purchase the shares for cash consideration.   While this does involve a transfer to a corporation, the value involved is nominal.  If the corporation pays cash for the shares, there will be no non-cash consideration received by the individuals in respect of the transfer and therefore no non-cash consideration on which to base any deemed interest income.

The fixed-value shares issued on the stock dividend would contain a price adjustment provision so as to ensure that all the value of the existing common shares is taken up by the fixed-value shares.  The CRA has indicated that it will not accept a price adjustment clause as part of a stock dividend freeze because such a price adjustment clause would not comply with the CRA’s stated position on price adjustment clauses.[129]  However, I have never seen the CRA actually take any assessment action on the basis of this position.  It is difficult to see why a price adjustment clause would be respected if the clause is set out in the terms and conditions of shares issued on a share exchange estate freeze but not if the clause is set out in the terms and conditions of shares issued on a stock dividend.  Even if the CRA reassessed, a properly-drafted price adjustment provision in the share conditions should provide a basis for an application for a rectification of the director resolution setting the redemption amount of the shares issued on the stock dividend.

Of course, a stock dividend freeze will not be possible if an individual is transferring assets to a corporation.

A stock dividend freeze will also not be an option if the estate freeze involves the crystallization of a capital gains exemption.  In that case, the corporation will be an active business corporation so that section 74.4 will apply only if the corporation loses active business corporation status at some point in the future.

Another way to avoid section 74.4 is to have the corporation (“Oldco”) transfer its assets to a new corporation (“Newco”) in return for fixed-value shares of Newco.  This transfer would be effected on a tax-deferred basis under ITA section 85.  The new shareholders would hold shares of Newco.

While the shareholders of Oldco continue to hold common shares of Oldco, the value of Oldco is fixed because the value of Oldco consists entirely of its fixed-value shares in the capital of Newco.  As long as this is the case, the common shares of Oldco will not grow in value.

Section 74.4 would not apply in this situation because the shareholders of Oldco would not have transferred any property to a corporation.  This presumes, of course, that the transfer of assets from Oldco to Newco is not an indirect transfer of assets by the shareholders of Oldco.  This will be a question of fact.  If the shareholders of Oldco transferred assets to Oldco and then, as part of that same series of transactions, caused Oldco to transfer the assets to Newco, the transfer of the assets from Oldco to Newco would likely be an indirect transfer of assets by the shareholders of Oldco.  This will be a question of timing and other relevant circumstances.  The more time that elapses between the two transfers, the better – but no specific period of time will provide absolute insulation from this characterization.  It will all depend on the facts.

1.                  Beneficiaries Grow Up

Another beneficiary issue is that beneficiaries grow up and lead independent lives.  While all parents want this, it can introduce issues for the estate planner. 

Are any of the beneficiaries likely to move to some other country (such as the United States) in the future?  If a beneficiary becomes a United States Person for US tax purposes, a Canadian domestic trust will be viewed as an offshore trust by the US.  This could impose reporting obligations in respect of the trust and the corporation underlying the trust.  For this reason, it may be prudent for there to be a mechanism allowing for the exclusion of a person as a beneficiary.  Depending on the offshore trust laws of the jurisdiction in question, it may be necessary to actually remove the emigrant beneficiary rather than having the emigrant remain as a beneficiary and just not receive distributions.

The assumption will generally be that the beneficiaries are involved in the family business.  However, some beneficiaries may have chosen not to pursue the family business and may have pursued other lines of business.  For example, one of the children may have gone to law school and may have incorporated a law corporation.  If that child is a discretionary beneficiary of the family trust, the child’s status as a discretionary beneficiary could lead to the child’s law corporation becoming associated with the corporation of the parents.

Various complex rules apply to determine whether two corporations are associated.  One of those rules is that the two corporations are controlled by the same person.  The associated corporation rules go on to provide various deemed ownership rules.  In this context, ITA paragraph 256(1.2)(f) provides as follows.

(f)        where shares of the capital stock of a corporation are owned, or deemed by [ITA subsection 256(1.2)] to be owned, at any time by a trust,

(i)         [omitted, as this deals only with testamentary trusts],

(ii)        where a beneficiary's share of the accumulating income or capital therefrom depends on the exercise by any person of, or the failure by any person to exercise, any discretionary power, those shares shall be deemed to be owned at that time by the beneficiary, except [exception applicable only to a testamentary trust],

(iii)       in any case where subparagraph (ii) does not apply, a beneficiary shall be deemed at that time to own the proportion of those shares that the fair market value of the beneficial interest in the trust of the beneficiary is of the fair market value of all beneficial interests in the trust, except [exception applicable only to a testamentary trust], and,

(iv)       in the case of a trust referred to in subsection 75(2), the person referred to in that subsection from whom property of the trust or property for which it was substituted was directly or indirectly received shall be deemed to own those shares at that time;

In the case of a discretionary trust, subparagraph 256(1.2)(f)(iii) provides that each beneficiary is deemed to own all the shares that are held inside the trust.  This is the case even if the beneficiary is an adult child with his or her own active business corporation.

Assume that the child decides to pursue a career as a lawyer and incorporates a professional legal corporation in order to take advantage of the low corporate tax rate applicable to active business income.  Professional rules require that the child hold all the voting shares of his professional corporation.  If the child controls the professional corporation and is a beneficiary of a trust that controls Freezeco, the child is deemed to own all shares owned by the trust and accordingly will be deemed to control Freezeco.  As a result, the child’s law corporation will be associated with Freezeco for income tax purposes.  This means sharing the $500,000 limit on active business income.  It also means combining the capital of the corporations when considering whether the corporations are too large to qualify for the low corporate tax rate.

Having the family trust hold only non-voting shares of Freezeco does not necessarily solve this problem.  This is because of another deeming rule, which provides that a corporation can be deemed to be controlled by a person even if that person does not own voting shares.[130]  Specifically, a discretionary beneficiary will be deemed to control Freezeco if the trust owns

(a)        Freezeco shares having a fair market value of more than 50% of the fair market value of all the issued and outstanding Freezeco shares; or

(b)        Freezeco common shares having a fair market value of more than 50% of the fair market value of all the issued and outstanding Freezeco common shares

The latter of the above deeming rules is usually the problem, as the family trust usually owns all the common shares of Freezeco.  After all, the purpose of the estate freeze is to push future growth to the family trust and growth is a feature of common shares.[131]

The first of the above deeming rules would initially not be an issue because virtually all the share value will be in the fixed-value shares held by the parents in the years immediately following the estate freeze.  However, this deeming rule could become problematic down the road.  The corporation may be redeeming the fixed-value shares in order to reduce the inherent capital gain in those shares.  As the fixed-value shares are redeemed, the common shares may be growing in value.  There may eventually come a point at which the common shares held by the trust exceed the aggregate value of the unredeemed fixed-value shares.  The relative values of the two types of shares have to be monitored.

While discretionary trusts are very flexible, they have an inherent risk of causing inadvertent association of corporations.  This has to be constantly monitored because a beneficiary who is in university at the time of creation of the trust could start his or her own corporate entity at some time after establishment of the trust.

If association of corporations is an issue, it can be addressed by limiting the interest of that specific beneficiary to less than 25%.[132]If the child is deemed to own less than 25% (i.e. no more than 24.9%) of the shares held by the trust, this will usually solve the associated corporation issues.  However, this will require an exercise of discretion by the trustees and will have to result in limiting the interest of that beneficiary for all time.  The impact of this on the overall estate plan will have to be considered, however.  As well, the trust deed will have to provide the trustees with the power to limit the interest of a beneficiary.

H.    MAINTENANCE OF THE TRUST

Assuming that the family trust has been properly established, the trust also has to be properly maintained.  There needs to be clear agreement on who is to do that maintenance.

Unlike a corporation, a trust does not have to file an annual report with the Registrar of Companies.  If the trust is not receiving any dividends from Freezeco and has no capital gain, the trust does not even have to file an income tax return annually.[133]  It may still be prudent for the trust to file a nil income tax return each year, however, so that the return can be assessed and limitation periods can start to run.  In any event, the trust should file an initial income tax return as it will have to report and pay tax on the income that is used to repay the loan that was used to acquire the shares of Freezeco.

The trustees will have to file a copy of the trust deed when filing the initial income tax return of the trust.

If the trust is used to flow income to beneficiaries, however, it will be necessary for the trustees to decide how to deal with that income.  Most of the time, the income will be flowed through to beneficiaries. If that is the case, the trustees need to make that decision and need to record that decision in trustee minutes.  It is not sufficient to simply record the flow-through by having the trust report the distribution in the trust income tax return and to have the trust issue a T3 slip to the beneficiary in question.  Income tax filings do not create distributions.  An income tax return merely reports matters that are relevant to income tax liability.  If the trustees have not actually approved the distribution, an income tax return that reports a distribution is simply an inaccurate return.

Accordingly, the trustees need to keep a written record of decisions that involve an exercise of discretion (such as the distribution of income).  Whenever Freezeco declares a dividend on the shares held by the family trust, there needs to be a director resolution declaring that dividend.  It follows that a trustee resolution should be prepared at the same time dealing with that dividend if the dividend is being flowed through to beneficiaries.  At the very least, trustees should review the trust records at least once a year to ensure that trustee decisions have been properly recorded.

Written trustee records need to be kept in an organized fashion.  A trust minute book can be useful for this purpose.  The minute book can be in a loose-leaf binder format with separate tabs (similar to a corporate minute book) or can even be in the form of an accordion file with separate sub-files.  Either format works, as long as the records are maintained and organized.  Usually, records will be inserted in reverse chronological order so that the most recent documents are on top.

A trust minute book can be similar to a corporate minute book, although the documents kept in the two minute books will differ.

A trust minute book or file should contain at least the following information, separated into tabs or sub-files.

·         The original trust deed.

·         The initial trust property and documents confirming the proper establishment of the trust.

·         Original trustee minutes.

·         A register of trustees.

·         Original documents relating to the resignation and replacement of trustees.

·         Copies of tax returns and other tax material filed by the trustees.

·         The reporting letter on the establishment of the trust and any other legal advice received by the trustees.

If a professional is maintaining the trust minute book, the professional will have to check periodically with the trustees to make sure that the minute book is up to date.

In 2009, the CRA began a project that involved the audit of a number of family trusts.  The project seems to have started in Alberta.  The CRA initiated each review by posing the following written questions to the trustees.[134]

1)         How, by whom, when, and why was the trustee appointed? What is the trustee's relationship to the trust? Copies are requested of the trustee agreement and/or contracts the trustee entered into.

2)         What are the trustee's qualifications, expertise, and experience?

3)         Does the trustee receive a fee for his services? What is the fee's amount and how is it determined and paid? Copies are requested of all billings/invoices issued to the trust with regard to the fees during the periods under review.

4)         A list of the trustee's duties and responsibilities is requested.

5)         Does the trustee have control over the trust's investment portfolio and any other trust assets?

6)         What signing and/or contracting authority does the trustee have? Does the trustee have the power to contract and deal with the trust advisers such as accountants and lawyers?

7)         Is the trustee responsible for the management of any business or property owned by the trust and, if so, how is that done?

8)         Is the trustee responsible for banking and financing arrangements, for the trust and, if so, how is that done?

9)         Is the trustee responsible for preparing the trust's accounts and reporting to the beneficiary and, if so, how is that done? Copies are requested of all correspondence, memoranda, faxes, e-mails, handwritten notes, minutes, and/or records of meetings and conversations, etc. with respect to communications between the trustee, the settlor, and the beneficiary during the periods under review.

10)       How, where, and by whom are decisions made in relation to the trust property? Are the decisions documented, and who signs off on them? Copies are requested of all correspondence, memoranda, e-mails, handwritten notes, minutes, and/or records of meetings and conversations, etc. with respect to all decisions made by the trustee in relation to the trust property during the periods under review.

11)       By whom and where was the decision made to distribute income from the trust to the beneficiary and to elect to have the income taxed in the trust during the periods under review? Copies are requested of all correspondence, memoranda, e-mails, handwritten notes, minutes and/or records of meetings and conversations, etc. with respect to these decisions.

While this project focused on the residence of the trusts involved, the questions posed give an indication of the factors being examined by the CRA.  In particular, the questions focus on the trustee’s understanding of his or her role in respect of trust governance and asks for documentation of trustee decisions.  This stresses the importance of proper operation of the trust (as opposed to having nothing more than a really impressive trust deed).

I.       EFFECT OF THE TRUST

The parents have to realize that creation of the trust makes a difference.  While the parents are managing the future growth and value, they are not managing that future growth and value for themselves.  They are managing that future growth as fiduciaries and owe duties to the beneficiaries.

There is a danger here in overemphasizing the discretionary nature of the trust.  The trust document will inevitably include the following provisions.

·         A provision stating that the trustees have the same power in respect of the trust property as if the trustees were the sole beneficial owners of the trust property.

·         A statement that the trustees may exercise discretionary powers in the “sole absolute and unfettered discretion” of the trustees.

The above provisions are oxymorons, however, as the trustees do not in fact have beneficial ownership of the trust property and do not in fact have “unfettered discretion”.  Trustees always have a fiduciary duty to act in the best interests of the beneficiaries and to fulfill the purposes of the trust.  Indeed, if the discretion were actually unfettered or if the trustees actually had beneficial ownership of the trust property, there would be no trust.

Family trusts include family members as beneficiaries, so the trusts can sometimes be involved in the battles that sometimes take place within families.  While another speaker will deal with trust litigation, anyone interested in the types of family battles that can arise and lead to trust litigation can contrast two famous Ontario cases:  Fox[135], on the one hand, and Martin[136] on the other.  In Fox, the court ruled that the trustee could not use her unfettered discretion to exclude a beneficiary.  In Martin, the court allowed this to happen.  The factual context and the purpose behind the use of the power in question were signficant factors in each case.

VII.          Charitable donations

A.    GENERAL

It is possible to use a trust to make a charitable donation.  Before doing so, however, one must identify who is to make the donation and who is to claim the tax credit.

If I create a trust and provide the trustees with a discretionary power to make donations, I will have empowered the trustees to make donations so that the trust can claim the tax credit.  I will have no right to receive a tax credit, as I will have merely empowered the trustee to make the donation but will not have made the donation myself.

In contrast, the trustees will have no power to make donations if the trust deed does not explicitly provide that power.  The trustees must hold the property for the benefit of the beneficiaries.  Giving away property is hardly for the benefit of the beneficiaries.  Accordingly, the trustees need an explicit power to donate to a charity.  Otherwise, the charities can only distribute to the beneficiaries in accordance with the trust provisions.  It will then be up to the beneficiaries to be generous (or not).

If my trust creates a gift over to a charity on a failure of the trust, and the failure occurs due to an unexpected family tragedy, the distribution of the assets to the charity will not qualify as a charitable donation.  The trustees would not be making a gift, as they would be complying with their legal obligation under the trust deed.  I would have made a gift at the time that I set up the trust and created the contingent interest for the charity, but the possibility of the charity taking would have been so remote at that time as to be without value.

B.     2014 FEDERAL BUDGET CHANGES

The above rules have occasionally led to difficulty in respect of testamentary donations made by a deceased.  The 2014 federal budget will simplify the process for donations made in the normal testamentary manner.  However, these changes will not apply to donations made though an AET, JST or other form of inter vivos trust.

Current income tax rules provide that a donation in a will is treated as having been made immediately before death.  Similar provisions apply for charitable beneficiary designations made under a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), Tax-Free Savings Account (TFSA) or life insurance policy.  Under these rules, the donation tax credit must be used in the terminal tax return of the individual.  Any unused credit can be carried back to be used in the taxation year preceding death but cannot be used by the estate of the deceased.[137]

The new rules will provide considerable more flexibility starting in the 2016 and subsequent taxation years.  In other words, the new rules will apply only for deaths that occur after 2015.  Those new rules are as follows.[138]

·         Donations made by will or by designating a charity as a beneficiary of a registered plan or a life insurance policy will no longer be deemed to be made by the deceased as of the moment immediately before death.  Instead, those donations will be deemed to have been made by the estate when the donated property is actually transferred to the charity.

·         As long as the donated property is transferred to the charity within 36 months after the death in question, , the executor will have the flexibility to allocate the available donation credit among any of the following taxation years.

o   The taxation year of the estate in which the donation is made.

o   An earlier taxation year of the estate.

o   Either of the last two taxation years of the deceased.

·         The current limits that apply in determining the total donations that qualify for tax relief year will continue to apply.

·         In the case of a transfer from an RRSP, RRIF, TFSA or insurer, the existing rules for determining eligible property for designation donations will apply. In any other case, the donated property will be required to have been acquired by the estate on and as a consequence of the death (or to have been substituted for such property).

An estate will continue to be able to claim a tax credit in respect of other donations made in the year in which the donation is made or in any of the five following years.  That rule will apply, for example, if the estate executor has the power to make a donation and chooses to exercise that power (in other words, the donation is not mandated by the will).

C.     LIVING TRUST ISSUES

The new rules will not apply if the gift is made under the terms of a living trust (such as an AET or JST) even if the donation is triggered by a death.  This means that problems may arise in respect of gifts made through living trusts.

If a client wants his AET trustee to make a charitable donation on the death that triggers the deemed disposition of assets but wants the donation tax credit to be used against the tax that arises on the deemed disposition, the client has to provide the trustee with a power to make the gift and hope that the trustee honors the client’s wishes.  If the trust terms require that the trustee make the donation, the trustee is fulfilling the terms of the trust and is transferring the property to the charity pursuant to a legal obligation.  This is not a gift.  The client will have actually made the gift by providing the charity with an interest in the trust.  The question is then the present value of that gift at the time that the trust was created.  As we shall see when discussing charitable remainder trusts, that is a question of the life expectancy of the initial trust beneficiaries and (usually) whether the trustee has a power to encroach on capital that might result in the charity not actually receiving the property after the relevant death.

Assuming that the client has agreed to provide the trustee with a power to make donations and to trust (could not avoid that) that the trustee will make the donation, the client also has to make sure that he does not die at an inopportune time.  The deemed disposition on death occurs inside the AET at the end of the day on which the relevant death occurs.  However, the death does not trigger a deemed year-end for tax purposes.  Accordingly, the deemed disposition tax will become payable after the December 31 close of the normal taxation year.  If the client refrains from passing away late in the calendar year, all should work well as the trustee should have the necessary time to make the gift before the end of the year.  However, the trustee will have to act quickly if the client has too much Christmas cheer and ends up passing away after Christmas.  If the alter-ego individual parties too hard on New Year’s Eve and fails to make it to the start of Auld Land Syne, the trustee will simply not be able to complete the gift on time.  In order to claim the donation tax credit against the capital gain triggered by the death of the alter-ego individual, the charitable donation has to be made in that same year.

The rule that allows a gift to be carried back to year preceding the year of death applies only to a gift made by an individual in the year of the individual’s death.[139] While a trust is considered to be an individual for computing trust income, a trust terminates but does not die.

The same issues arise in respect of a JST on the death of the surviving spouse.

D.    CHARITABLE REMAINDER TRUSTS

1.                  General

The charitable remainder trust (a “CRT”) is a popular vehicle in the United States.  The CRT has also been written on extensively in Canada.[140]  However, it is not clear how extensively the CRT is used in Canada. 

CRTs have no special status under Canadian tax law.  They are essentially ordinary trusts used to effect a charitable gift in a manner that allows the client to have the benefit of income generated by the donated property up to a specific event (usually a death).

In a typical CRT, a client transfers property to the trust in which the client (or the client and spouse) holds an income interest so that the client (or the client and spouse) receives all income generated by the property.  The charity receives a residual interest in the trust but the use of that residual interest is deferred until the happening of a specific event (usually the death of the creator of the trust or the death of the spouse of the creator, whichever death occurs later).

The property that is donated to the charity is actually the residual interest in the trust (not the property contributed to the trust).  This gift of the residual interest is an immediate gift that is made as soon as the trust is created.  It is this gift of the residual interest that generates the charitable tax credit.

Given that the gift is the interest in the trust, all property should be contributed to the trust on the creation of the trust.  In other words, do not set up the trust in the same way as the typical family trust by having some third party contribute a $100 bill to establish the trust.  The client must establish the trust and contribute all the property in question as part of the initial (and only) contribution to the trust.

Contributing additional property to the trust at a later time would arguably not result in the granting of a new residual interest to the charity because the charity already has the residual interest.  The only result would be that the residual interest might increase in value.  However an increase in value in the residual interest would not result in a new charitable donation tax credit because there is no conferral of a new gift on the charity.  If the client later wants to donate other property by means of a CRT, a new CRT has to be created to receive that additional property.

2.                  Valuation Issues

Given that the gift is made at the time that the trust is created, it is important to be able to determine the value of the residual interest received by the charity.  The value will be based on the value of the contributed asset.  As the gifted property is the residual interest in the trust, however, the value of the gift will have to be discounted in light of the deferred enjoyment of the charity’s residual interest.  As the triggering event is usually the death of the last living income beneficiary, relevant discount factors will include the life expectancy of the income beneficiaries, current and projected interest rates and current and future economic conditions.  In other words, one has to determine the present value of the residual interest.  As a result, actuarial calculations will be important.

For this reason, it is better to create a CRT when one is older and has a lower life expectancy.  If the assets contributed to the CRT have an aggravate value of $100,000, the amount of the charitable contribution will of course be less than the $100,000 amount. 

Once the value of the residual interest (and the charitable donation) has been determined, the actual time of death of the income beneficiaries is irrelevant.  If the income beneficiaries died the next day, for example, the charity gets the benefit of the property earlier than expected but is not able to revise the charitable donation tax credit.  Similarly, if the income beneficiaries live longer than expected, there is no reduction in the charitable donation tax credit that was granted on the creation of the CRT. 

When setting up the trust, the trustmaker will have a disposition of the property that is transferred to the trust.  Accordingly, part of the charitable donation tax credit will have to be used to shelter the capital gain arising on that disposition.  While ITA section 118.1(6) allows an individual to designate an amount between cost and fair market value when donating property to a charity, this provision does not apply in the case of a donation to a CRT.  Usually, such a trust is not itself a charity because of the income interest of the income beneficiaries.  As an administrative matter, the CRA will allow this election to be made but this should be checked and confirmed before relying on the position.[141] In 2000, the CRA indicated that it was reviewing the position.  The CRA has not yet announced the results of that review.

A donor can donate publicly-traded securities to a charity without triggering a capital gain on the donated securities.[142] As a CRT is not a charity, however, this rule does not apply for property contributed to a CRT.  The CRA has not extended the administrative position in respect of ITA section 118.1(6) to cover gifts of publicly-traded securities.  In many cases, therefore, consideration should be given to donating the publicly-traded securities directly to the charity.

3.                  Taxation of Income and Capital Gains realized the the CRT

(i)                 Income

As noted, a CRT is not itself a charity.  Any income realized inside the CRT will be taxed in the normal manner as if the CRT were any trust.  This means that the income will be taxed inside the CRT except to the extent that the income is distributed to a beneficiary.

Normally, attribution of income and capital gains will not apply because the trust will not allow capital encroachments for the benefit of the trustmaker (or anyone other than the charity).  A right to encroach on capital for the benefit of anyone other than the charity would put the capital value of the residual interest into question.  Usually, there will be no right to encroach on capital for the benefit of the charity because the income beneficiaries will want to retain the capital intact for the purpose of generating income.

In most cases, of course, income will actually be distributed to the trustmaker or spouse in each year prior to the death of the survivor of them.  Accordingly, income will usually be taxed in the hands of the income beneficiaries provided that the income becomes paid or payable prior to the end of the trust’s taxation year.

(ii)               Capital Gains

Normally, the trust will invest only in income-generating investments that have security of capital.  If the trust were permitted to invest in the stock market, the valuation of the gift would have to take stock market volatility into account and that might result in an additional discount on the value of the gift.  As a result, it would be rare for the CRT to have significant capital gains.  If a capital gain does arise, the capital gain will be taxed inside the trust unless the trustee has the ability to distribute the gain to a beneficiary.

One possibility is to allow the trustees to distribute capital gains to the charity.  While this prevents taxation of the capital gain inside the trust, however, this does not provide the trustmaker with a charitable donation tax credit.  As noted, the gift was made on the creation of the trust.  Any distribution of capital gains to the charity is a distribution by the trustees to a beneficiary rather than a gift by the trustmaker.

While the trust deed cannot allow encroachments of capital, It should be possible to provide for distribution of capital gains to the income beneficiaries (even though capital gains are normally capital for trust purposes).  Distribution of a capital gain (a realized increase in value of the original capital) to the income beneficiaries would not impair the value of the remaining capital.  This would require that the trust deed specifically define income to include capital gains.  In order to protect the capital value, it may be necessary to provide that capital gains are income only to the extent that there has been no diminution in the value of the original capital assets.

VIII.       conclusion

This paper has been an overview of the way in which various trusts can be used in an estate planning context.

Due to the proposed changes in the taxation of testamentary trusts, I suspect that Canadian estate planning will start to move more towards the US model and include the creation of more living trusts as a way of avoiding probate taxes and the probate process.  While AETs, JSTs and other forms of living trusts can be useful in the right context, however, these forms of trusts are not always appropriate for every situation and cannot be used as an estate planning panacea.  If the property in question might qualify for the capital gains exemption, for example, it might be better to continue to hold the property individually.  At the very least, some plan would have to be adopted so as to monitor future changes in the capital gains exemption level and make use of any such changes.  If the trust will hold a principal residence, care has to be taken so that any principal residence exemption claim filed by the trust does not prevent other beneficiaries (including contingent beneficiaries) from claiming the principal residence exemption on their individually-owned principal residences.

This overview of the various types of available trusts should assist the conference delegates in dealing with the other more specific issues to be raised by the other speakers.

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[1]               Except to say the 2014 Federal Budget terminated the rules that allowed a new immigrant to Canada (an individual who had never before resided in Canada) to hold non-Canadian assets in a non-resident trust and enjoy a Canadian tax holiday in respect of those assets for up to five years.  These types of trusts were often referred to as five-year immigration trusts and were exempt from the deemed residence rules for up to 60 months after the new immigrant became a resident of Canada.

[2]               For a recent example, see Di Michele v Di Michele et al, 2014 ONCA 261.  The deceased left property to be divided equally among the children of the deceased.  After all debts had been paid, the property was not actually distributed but was retained inside the estate.  The estate trustee registered a mortgage against the property in order to secure some personal debts that had no connection to the deceased or the estate.  The mortgagee obtained a judgement against the estate trustee and moved to enforce the security.  The court allowed the mortgage to be enforced, as the mortgagee was a bona fide purchaser for value without notice of the breach of trust.  Of course, the beneficiaries would have an action against the estate trustee (see paragraph 72) but collecting damages might be difficult if the estate trustee does not have sufficient personal assets to satisfy the claim.

[3]               Section 104(2) of the ITA provides that a trust is taxed as if it were a separate entity for purposes of the ITA and without affecting the liability of a trustee for the trustee’s own income tax.  For income tax purposes, accordingly, it is as if the trust were a separate entity and as if the trustee were a separate person.  However, this treatment applies only for ITA purposes -- not for general legal purposes.

[4]               Given that trust law is an area of provincial jurisdiction under the federal division of powers, federal tax legislation simply has no power to affect actual trust law.

[5]               This may actually make it easier for me to switch to using the term “willmaker”, which is the new term for “testator” under the Wills, Estate and Succession Act (WESA for short).

[6]               These changes will also apply to grandfathered inter vivos trusts that were created before June 18, 1971 and that still enjoy graduated-rate taxation.

[7]               ITA section 108(1), definition of “testamentary trust”.

[8]               Of course, such a trust has to be funded exclusively by the death benefit.  While the terms of the trust can be set out in advance, the trust has to be an inchoate one until the death benefit flows into the trust.  If a living person contributes a silver coin to the trust to get it into existence before payment of the death benefit, the trust would never at any point be a testamentary trust due to the acceptance of the silver coin prior to the death of the life insured.

[9]               ITA section 108(1), definition of “testamentary trust”.

[10]             ITA section 108(1), paragraph (b) of the definition of “testamentary trust”.

[11]             In this paper, references to provisions of the “2014 Budget Motion” refers to the sections of the Notice of Ways and Means Motion to amend the Income Tax Act and other Tax Legislation, as set out in Annex 2 of the 2014 Federal Budget papers.

[12]             See page 330 of Annex 2 of the 2014 Federal Budget papers.

[13]             Section 24(3) of the 2014 Budget Motion introduces this concept into ITA section 248(1) effective as of December 31, 2015.

[14]             Section 16 of the 2014 Budget Motion will replace the portion of ITA section 122 that precedes paragraph (a), effective for the 2016 and subsequent taxation years.  The current version applies the flat-rate regime only to living trusts.  The new version will apply the flat-rate regime to all trusts other than graduated rate estates.

[15]             ITA section 108(1), definition of “testamentary trust”.  There are actually two different 12-month periods referred to in this provision.  Subparagraph (d)(iii) deals with any payment made by a beneficiary on behalf of a trust provided that the amount is repaid to the beneficiary within 12 months, as long as it is reasonable to conclude that the beneficiary would have been willing to make the payment on behalf of the trust if the beneficiary had been dealing at arm’s length with the trust.  Presumably, this means that the trust must agree to pay reasonable interest on the debt and perhaps needs to provide some form of security.  The arm’s-length condition does not apply, however, if one is dealing specifically with an estate and the beneficiary makes the payment on behalf of the estate within the first 12 months after death.  If the probate application is delayed for any reason beyond the 12th month after death, the executor can apply to the CRA for an extension of the 12 months provided that the executor makes the application prior to the end of the 12th month after death.  While I have referred to a beneficiary making the payment, the same rules apply if the person making the payment is a person or partnership that deals on a non-arm’s-length basis with any beneficiary.

[16]             ITA Section 248(1), as set out in Section 24(3) of the 2014 Budget Motion.

[17]             See generally Waters’ Law of Trusts in Canada (4th edition), at pages 47 to 56 (Toronto: Carswell, 2012).

[18]             This is similar to the assertion that Socrates is a man, but not all men are Socrates.  See also paragraph 17 of the Hess decision.

[19]             Hess v. R., [2011] C.T.C. 2176 (TCC).

[20]             ITA section 233.6(1).  See also paragraph 13 of the Hess decision.

[21]             Hess, at paragraph 12.

[22]             Hess, at paragraph 13.

[23]             Lipson v. R., 2012 CarswellNat 12 (TCC).

[24]             Kaptyn Estate v Kaptyn Estate, [2010] ONSC 4293, at paragraphs 56- 58.

[25]             The two-estate view is taken by Martin A. Rochwerg and Leela A. Hemmings, “Will Substitutes in Canada” (2008), Estates, Trusts & Pensions Journal, volume 28, at p 51.

[26]             ITA paragraphs 249(1)(b) and (c).

[27]             Section 25(1) of the 2014 Budget Motion will replace ITA paragraphs 249(1)(b) and (c).

[28]             Section 25(2) of the 2014 Budget Motion, which adds new section 249(4.1) to the ITA.  This provision comes into force on December 31, 2015 so that existing testamentary trusts (ones that are not graduated rate estates) have a deemed year-end on December 31, 2015 and a new taxation year that starts on January 1, 2016.    See in particular the wording of proposed ITA 249(4.1)(a)(i).

[29]             Section 25(2) of the 2014 Budget Motion, which adds new section 249(4.1) to the ITA.  See in particular the wording of proposed ITA 249(4.1)(a)(ii).

[30]             ITA paragraph 104(23)(e) provides testamentary trusts with an exclusion from the normal instalment obligations.

[31]             Section 15 of the 2014 Budget Motion will repeal ITA paragraph 104(23)(e) effective for the 2016 and subsequent taxation years.

[32]             Variable C in ITA section 127.51, when read with ITA paragraph 127.53(1)(b).  This $40,000 exemption has to be shared among multiple testamentary trusts that arose on the death of one individual.

[33]             Section 18 of the 2014 Budget Motion will replace the description of variable C in ITA section 127.51.  It will also repeal ITA section 127.53.  This repeal seems to indicate that it will not be necessary for multiple graduated rate estates to share the $40,000 basic exemption if the graduated rate estates are taxed as separate taxable entities.

[34]             ITA section 210.3(1) exempts a trust from the tax if the trust has no designated beneficiaries.

[35]             ITA section 210(2)(a).

[36]             Section 23 of the 2014 Budget Motion makes various changes to Part XII.2.  The changes include replacing ITA section 210(2)(a) so that it provides an exception only for graduated rate estates effective for the 2016 and subsequent taxation years.

[37]             ITA section 107(2).  The tax-deferred roll-out rule does not apply to a non-personal trust (such as a mutual fund trust, a unit trust or any other form of commercial trust.  Incidentally, the ITA does not use the term “commercial trust”.  For income tax purposes, a trust either is or is not a personal trust.

[38]             ITA section 248(1), definition of “personal trust”, paragraph (a).

[39]             Section 24(1) of the 2014 Budget Motion will replace paragraph (a) of the ITA section 248(1) definition of “personal trust” so that it refers only to a graduated rate estate.  As well, section 24(2) of the 2014 Budget Motion will make paragraph (b) of the definition apply to all trusts.

[40]             ITA section 127(7).

[41]             Section 17 of the 2014 Budget Motion will replace ITA section 127(7) so that it refers only to a beneficiary of a graduated rate estate or a beneficiary of a deemed trust that exists in respect of a communal religious organization.

[42]             ITA section 152(4.2).

[43]             Section 20 of the 2014 Budget Motion will replace the preamable of ITA section 152(4.2) so that it applies only to an individual (other than a trust) and a graduated rate estate.

[44]             ITA section 165(1)(a)(ii).

[45]             Section 22(1) of the 2014 Budget Motion.

[46]             ITA section 166.1.

[47]             “Consultation on Eliminating Graduated Rate Taxation of Trusts and Certain Estates”, issued by Finance Canada on June 2, 2013.

[48]             ITA section 108(3).  Certain actual dividends (such as capital dividends) are excluded from income for this purpose.

[49]             The wills variation provisions are now in Division 6 (sections 60-72) of the Wills, Estates and Succession Act, SBC 2009, c 13.

[50]             While this is an extreme example, Princess Diana’s Last Will and Testament became almost a bestseller in the United Kingdom after her death.  Many of her fans wrote to the probate office in order to obtain a copy of the Will as a desirable piece of memorabilia.  The text of the Will is still available on numerous web sites, including http://www.cnn.com/WORLD/9803/04/diana.will/.  A separate web site provides access to the wills of famous actors, actresses and musicians:  http://wills.about.com/od/celebrityestates/qt/Famous-Wills-And-Celebrity-Estates-Actors-Actresses-And-Musicians.htm.

[51]             See Waters, at footnote 14, at pp 218-226. See note 15. 

[52]             ITA section 69(1)(b)(ii).

[53]             ITA section 73(1.02)(b)(i).

[54]             ITA section 73(1.02)(b)(i).

[55]             ITA section 73(1).

[56]             ITA section 73(1).  This rule deals only with the tax deferral on the contribution of the assets.  It would theoretically be possible for the non-contributing spouse to be a non-resident of Canada but spouses generally tend to live in the same taxing jurisdiction.  If one of the spouses were a non-resident (or a US citizen), complications could arise under the law of the other jurisdiction.

[57]             ITA section 73(1.01)(c)(ii).

[58]             ITA section 73(1.01)(c)(iii).

[59]             ITA section 108(3).  Certain actual dividends (such as capital dividends) are excluded from income for this purpose.

[60]             ITA section 73(1.01)(c)(ii).

[61]             ITA section 73(1.01)(c)(iii).

[62]             Unless a power of attorney specifically provides otherwise, section 20(1)(c) of the Power of Attorney Act and section 3 of the Regulations under that Act limit the aggregate amount of gifts that the attorney can make in any one year. The prescribed limit is the lesser of $5,000 and an amount equal to 10% of the adult’s taxable income for the previous year.

[63]             See CRA Technical Interpretation 2006-0185551C6.  For a different view, see Robin Goodman, “Combining Trusts and Life Insurance in Estate Planning:  Tricks and Traps”, 2008 Canadian Tax Journal, Volume 56, Number 1, at page 188, in particular, pages 207-211.  The Goodman article discusses the issue in the context of a spousal trust, but the same concerns apply in the case of an AET.

[64]             Most policies for spouses are joint and last-to-die policies.

[65]             Unless the disposition is under a rule that is other than the 21-year rule.

[66]             Unless the disposition is under a rule that is other than the 21-year rule.

[67]             ITA section 104(6)(b)(i)(C).  This is not unique to an AET or JST.  This rule generally applies in respect of all deemed dispositions triggered by a death or by application of the 21-year deemed disposition rule. 

[68]             ITA section 104(4)(a)(ii.1). 

[69]             ITA section 73(1.02)(c).

[70]             ITA section 73(1).

[71]             Of course, capital gains could always be allocated out of the trust and used against capital losses of the individual if needed.

[72]             ITA section 75(2).

[73]             Attribution applies in respect of the contributed property and property that has been substituted for the contributed property (for example, proceeds of sale) but not on income that has been earned by the contributed property.  For example, assume that the trustmaker contributes shares of XYZ corporation to the AET and earns $150 in dividends on those shares.  If the AET is a reversionary trust, the $150 in dividends will be taxed as income of the trustmaker.  However, the $150 in cash is new property (not substituted property).  If the trust invests the $150 in a new investment and earns $75 in dividends on the new investment, that $75 is not attributed back to the trustmaker.

[74]             See the opening words of ITA section 104(4).

[75]             ITA section 75(2).

[76]             See Garron Family Trust (Trustee of) v. R., 2012 CarswellNat 953, 2012 DTC 5063 (SCC).

[77]             Catherine Brown, “Alter Ego, Joint Conjugal, and Self-Benefit Trusts Revisited: Some Troubling Tax Issues and a Search for Better Alternatives”,  2005 Canadian Tax Journal, Vol 53, Number 1, page 230.

[78]             ITA section 73(1.01)(c)(ii).

[79]             ITA section 73(1.02)(b).

[80]             ITA section 73(1.02)(b)(ii).

[81]             ITA section 73(1.02)(b)(ii).

[82]             See generally Waters, footnote 15, at pages 97 to 108.

[83]             See Waters, at footnote 15, at page 97 (including footnote 215 on that page).

[84]             An unlimited power of appointment (one which allows the holder to appoint to himself or herself) is often referred to as a “general power” whereas a limited power (one which does not allow the holder to appoint to himself or herself) is often referred to as a “special power”.  As suggested by Waters, I will refer to unlimited and limited powers.  See Waters, at footnote 15, at pages 97-98 (in particular, footnote 216 on page 98).

[85]             See Waters, at footnote 15, at page 98 (see footnote 216 on that page).

[86]             The WESA definition of “will” also includes “any other testamentary disposition” except for specific dispositions such as designations under benefit plans and designations of a beneficiary under a life insurance policy or under an accident and sickness insurance policy.  This raises the issue whether the power of appointment is a “testamentary disposition”.  If the power is exercisable only on death, that would make it testamentary in nature.  However, is a testamentary disposition a disposition of one's own property, or can it include directions as to deal with property of another?

[87]             WESA, section 60.

[88]             ITA section 104(4)(a.4).

[89]             The election in ITA section 104(4)(a)(ii.1) is limited to a trust described in ITA section 104(4)(a)(iv)(A).  The preamble to ITA section 104(4)(a)(iv) refers to the requirement that the trust be created by an individual who was at least 65 years old at the time that the trust was created..

[90]             ITA section 248(1), definition of "property", paragraph (a). 

[91]             ITA section 248(28).

[92]             Of course, there is nothing to prevent the holder of a power from accepting a payment to exercise the power in a specific way.  Even if the holder accepted such a payment, however, the value of the power itself would then be nominal as the holder would not be able to sell his exercise right to someone else.  While the trust deed could provide that exercise of the power is invalid if the holder accepts any consideration for exercising the power in a specific manner, such a provision would then make it impossible for third parties to know whether the power had been exercised validly.  CRA Technical Interpretation 2002-0129675 makes some general comments about the valuation of a power of appointment but does not come to any firm conclusions.

[93]             ITA section 107.4(1).

[94]             ITA section 107.4(1)(e).

[95]             ITA section 73(1).

[96]             ITA section 110.6(12).

[97]             ITA section 104(1).

[98]             Waters, at footnote 15, at pages 33-4.

[99]             See Douglas S. Ewens, Rosemarie Wertschek and James R. Wilson, “Income Tax Implications of Using Bare Trusts” (1989) 37 Canadian Tax Journal, Number 2, p. 499.  At the time that the article was written, ITA section 104(1) did not specifically exclude arrangements under which the trustee can reasonably be considered to act as an agent of the beneficiaries.  Notwithstanding the agency nature of the relationship, the authors take the view that a bare trust is nevertheless a trust.

[100]            ITA section 43.1 applies if the transferor retains a life estate in real property.

[101]            ITA section 54, definition of “principal residence”, paragraph (c.1)(iii).

[102]            ITA section 248(25).

[103]            ITA section 54, definition of “principal residence”, paragraph (f).

[104]            ITA section 54, definition of “principal residence”, paragraph (c.1)(ii).

[105]            ITA section 40(7).

[106]            For the reason behind this procedure, see Kieboom v MNR, 1992 CarswellNat 308, 92 D.T.C. 6382 (FCA).  If the parent simply allowed the new shareholders to subscribe for common shares at a nominal price without first doing the freeze, part of the value of the parent’s common shares would spill over into the new common shares.  This would result in the conferral of a taxable benefit.  That transfer of value would also be a transfer of property and could give rise to attribution of income on the new common shares back to the parent.

[107]            CRA document number 2008-0285241C6, being a response to question 23 at the 2008 Conference of the APFF (Association de planification fiscale et financière, based in Montreal).  Given that the focus of this paper is on family trusts, I was going to place the CRA comments in a footnote.  However, the footnote would have been too long.  I can justify placing the comments in the body of the paper because the share attributes are necessary in order to allow the family trust to subscribe for shares without the conferral of a taxable benefit.

[108]            Trustee Act, RSBC 1996, c. 464, section 15.1.

[109]            Footnote 5, section 21.

[110]            It is not strictly necessary to keep the initial property until the termination of the trust.  For example, the initial property could be distributed to one of the beneficiaries at any time (as long as some other property continues to be held in the trust -- if no property is held in trust, the trust ceases to exist as of that point in time).  However, CRA auditors like to see the initial property and it is easier to retain the initial property than to explain the intricacies of trust law.  As well, keeping the initial trust property stapled to the trust deed ensures that the trust continues to exist as it always has at least some property until the day that one makes the conscious decision to distribute the initial property as the final act of the trustee.

[111]            The portion of the dividend that is used to repay the loan principal cannot be made payable to a beneficiary and taxed as income of the beneficiary, of course, as the amount has been repaid to the lender. If one made the principal payment amount payable to the beneficiary, one would have to distribute some of the shares that had been purchased with that loan principal.  This would defeat the purpose of having established the trust in the first place.

[112]            Antle v The Queen (2010), 61 E.T.R. (3d) 13, 2010 CarswellNat 3894 (FCA).  For a purely Canadian trust that failed due to lack of intention to create a trust, see MNR v. Ablan Leon (1964) Ltd., 1974 CarswellNat 205, [1974] C.T.C. 610, 74 D.T.C. 6451 (FCTD).

[113]            Antle, note 6, at paragraph 8.

[114]            Antle, note 6, at paragraph 9.

[115]            Antle, note 6, at paragraphs 15 to 22.  There is no requirement for mens rea or an intent to deceive for documents to be a sham.  The documents are a sham if they describe a transaction as being other than what the transaction actually is.

[116]            The Tax Court of Canada judgment is reported at 2009 D.T.C. 1305, 2009 CarswellNat 2792.

[117]            Various attribution rules set out in sections 74.1, 74.2 and 74.3 of the ITA could apply in certain circumstances.  For more details, see my 2011 paper entitled “Income Tax Attribution Rules”, presented at the Conference on Tax Fundamentals for the Estate Practitioner, held in Vancouver, British Columbia on February 4, 2011.  The Conference was sponsored by the Continuing Legal Education Society of British Columbia.  The paper deals with the law as it stood on January 12, 2011.

[118]            The Canada-United States Tax Treaty does not contain any useful tie-breaker rules if a trust is considered to be a tax resident of both Canada and the United States.  In this case, the CRA and the IRS have to “negotiate” over which country the trust will be considered resident in for tax treaty purposes.  It is best not to go there unless absolutely necessary.

[119]            See Decree n° 2012-1050 of 14 September 2012, published on 15 September 2012, which details the reporting obligations applicable to trustees introduced by LFR 2011-900 of 29 July 2011.

[120]            ITA paragraph 256(1.2)(c)(ii).

[121]            In this context, common shares means common shares as defined in ITA subsection 248(1).  The ITA defines “common share” in the negative as follows.

...a share the holder of which is not precluded on the reduction or redemption of the capital stock from participating in the assets of the corporation beyond the amount paid up on that share plus a fixed premium and a defined rate of dividend.

[122]            ITA paragraph 256(1.2)(g).

[123]            CRA Views 2004-0087761E5, dated May 24, 2005.

[124]            See Interpretation Bulletin IT-64R4 "Corporations:  Association and Control [Consolidated]" (October 13, 2004), at paragraph 24.

[125]            Gestion Yvan Drouin Inc. v The Queen, [2001] 2 C.T.C. 2315, 2000 CarswellNat 3035 (Tax Court of Canada), at paragraph 84.  Paragraphs 61 to 96 summarize the case law in this area and provide a good analysis of when 50/50 shareholders can be considered to be acting in concert to control a corporation.  There is no general rule that 50/50 shareholders act in concert, however.  As stated in paragraph 89 of the judgement, “a distinction must be made between having a common goal and having a common interest”.

[126]            ITA subsection 74.4(5).

[127]            ITA subsection 74.4(4).  The CRA takes the position that this statutory exception is not applicable if the trust deed says that designated individuals are excluded from benefitting under the trust only at times that Freezeco is not a “small business corporation”.  This is presumably because such wording allows the designated individual to benefit from the trust while the person is a designated person and Freezeco is a small business corporation.  Paragraph 74.4(4)(b) applies only if the trust prohibits the individual from benefitting from the trust while the individual is a designated person (presumably whether or not the corporation is a small business corporation).

[128]            ITA section 15(1.1).

[129]            See CRA technical interpretation 2003-0004125, dated April 1, 2003, and Interpretation Bulletin IT-169, "Price Adjustment Clauses," issued August 6, 1974.

[130]            ITA section 256(1.2)(c).

[131]            The ITA definition of common shares applies for this purpose.  See footnote 15.

[132]            In the case of association by common shareholders, the person who controls the other corporation can own no more than 25% of the shares of the other corporation without causing association.  See ITA 256(1).

[133]            ITA subsection 150(1.1), which modifies the rule in ITA paragraph 150(1)(c).  For income tax purposes, a trust is considered to be an individual.

[134]            See Canadian Tax Highlights, Volume 17, number 7 (July 2009), article “Trust Residence Questioned”.

[135]            Fox v Fox Estate (1996), 10 E.T.R. (2d) 229, 1996 CarswellOnt 317 (Ont CA).

[136]            Martin v Banting (2001), 37 E.T.R. (2d) 270, 2001 CarswellOnt 405 (Ont SC).

[137]            ITA section 118.1(4) and (5).

[138]            2014 Budget Motion, section 32.  See also pages 332-3 of Annex 2 of the 2014 Federal Budget papers.

[139]            ITA section 107(4).

[140]            See Susana Lam, “Charitable Remainder Trusts” (2005), volume 53 number 2 Canadian Tax Journal, at pp. 506-538.

[141]            See IT-226R, paragraph 8, and CRA documents 2000-M020417 dated January 17, 2000 (response to question 2) and 1999-0006995 (dated February 15, 2000).  Like all other interpretation bulletins, the CRA web version of IT-226R has been archived pending full development of the new income tax folio system.  However, paragraph 8 continues to have the status of an interpretation bulletin until such time as the bulletin is actually cancelled or the CRA advises that its review of the position in paragraph 8 has been completed.

[142]            ITA section 38(a.1).

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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.