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Why Still Family Trusts?

Aerial top view of a white boat moving on water

A Review and Assessment of Recent Legislative Changes

Many Canadians use inter vivos1  family trusts2  to hold assets such as private corporation shares, investments, and real property for the purposes of family and estate planning, as well as to access certain tax planning opportunities. These trusts are generally created by a settlor during their lifetime (including a third party settlor) for the benefit of beneficiaries or classes of beneficiaries.

While occasionally these trusts may have fixed entitlements in certain circumstances, family trusts are typically discretionary in nature, allowing the trustee(s) to exercise discretion (or not to exercise discretion) depending on the beneficiaries and the goals of the trust. In some cases, a family trust is used to move certain assets outside of an estate (and bypass probate taxes in most provinces). In these instances, family trusts may also be structured to trigger entitlements or distribute assets upon the death of a beneficiary in a manner that will tie in with the testamentary wishes of that beneficiary.

Recent federal tax legislation has been introduced that, collectively, may create a chilling effect on trust planning and affect whether these structures are considered prudent for as many Canadians as has been the case historically. Three changes of note are explored below:

1. ALTERNATIVE MINIMUM TAX (“AMT”)

AMT is a parallel tax calculation that applies where the application of other sections of the Income Tax Act (“ITA”) result in little or no tax. AMT applies a minimum flat rate tax after an exempted amount and allows limited access to various credits and deductions3.

If the parallel AMT calculation for a tax year exceeds the income tax otherwise payable under the ordinary rules under the ITA, an individual or certain trusts (including most family trusts considered in this article) would be required to pay the difference as an additional tax for the year. The amount of additional AMT paid in a year under these rules is generally available to be deducted from tax payable in the following seven taxation years, to the extent the tax otherwise payable in those years exceeds the applicable AMT in those years. AMT becomes permanent if not recovered within this period.

Budget 2023 raised the AMT rate from 15% to 20.5%, raised the “safe-harbour” exemption for individuals from $40,000 to $173,000, and changed the definition of “adjusted taxable income” to further limit “tax preferences” such as deductions, credits, and exemptions. Budget 2024 provided some additional legislative guidance and relief.

Trusts subject to AMT generally compute AMT in the same way as individuals; however, trusts will not benefit from a safe-harbour amount, meaning that trusts with taxable income would generally have greater exposure to AMT compared to individuals.

For the average family trust, this can be of particular concern as only 50% of interest expenses can be deducted (which may impact prescribed rate loan arrangements) and 80% of donation credits can be used for AMT calculation purposes. In order to have cash on hand to pay the AMT, this may mean more income taxed in the trust at the highest marginal rate, as unlike individuals, most trusts are not taxed at graduated rates depending on income. Thus, less income is distributed in the trust to its beneficiaries.

2. TRUST REPORTING RULES

Beginning in the 2023 tax year after several years of consideration, most trusts and trust arrangements with taxation years ending after December 30, 2023, are required to complete a reporting schedule (Schedule 15).

These rules seek the following information about the settlor(s), the trustees, the beneficiaries, and persons that can “exert influence” on the trust (through the Trust Deed or a “related agreement”):

  • Name
  • Address
  • Date of birth
  • Jurisdiction of residence, and
  • Taxpayer identification number (such as the SIN, business number, or account number given to a trust)

Non-compliant trusts may be subject to penalties for providing incomplete schedules, inaccurate information, or for not filing the prescribed form or trust return. In certain instances (knowingly or under circumstances amounting to gross negligence), these penalties can be as high as 5% of the highest FMV of the trust’s assets in the year under subsection 163(6) of the ITA.

It is generally the case that family trusts are subject to these rules, unless the trust meets one of the narrow exceptions found in ss.150(1.2) of the ITA. Even where it is unclear, filing a trust return with a reporting schedule may be more prudent than ignoring the issue, as a failure to file carries a very significant penalty that would most likely exceed any possible advantage if assessed. Notably, these penalties can be assessed to both trustees and tax return preparers.

Information gathering may be impacted where beneficiaries are unknown, difficult to ascertain (such as where a class of beneficiaries are broadly or vaguely defined), or are otherwise uncooperative.

For the average family trust, this means an increase in annual compliance costs, increased risks to trustees and tax preparers, and a decrease in privacy, as trustees will need to disclose beneficial interest to beneficiaries, even ones that they otherwise have no intention of gifting to, in order to make a good faith attempt at acquiring all the necessary information required under the ITA to satisfy the new reporting rules.

3. CAPITAL GAINS INCLUSION RATE INCREASE

Budget 2024 proposes to increase the capital gains inclusion rate from one half (50%) to two thirds (66.7%) for corporations and most trusts, and the portion of capital gains realized in the year that exceed $250,000 for individuals, graduated rate estates (GREs), and qualified disability trusts (QDTs). This is intended to be effective for capital gains realized on or after June 25, 2024.

For the average family trust, this means that not only is all income retained in the trust taxed at the highest marginal rate but all capital gains realized by the trust are also taxed at the highest capital gains inclusion rate. This works out to roughly a 10% increase in the rate of tax and roughly 30% in relative increases in taxation of capital gains, depending on the province/territory. For instance, Alberta’s capital gains tax rate increased from 24% to 32%, which is an approximate 33.3% increase.

One notable exception is where it is possible for the trust property to satisfy the requirements to be transferred out of the trust on a tax deferred basis to a Canadian resident beneficiary4 who then realizes the capital gain. Depending on the property, the terms of the Trust Deed, and the status of the beneficiaries, this may not always be possible.

SELECTED ARGUMENTS AGAINST FAMILY TRUSTS

Many Canadians settle trusts for their families for privacy purposes as well as to provide trustees the ability to gift to beneficiaries in their sole and unfettered discretion in accordance with the trust’s (and family’s) goals.

With the new reporting rules, trustees must disclose, in good faith, all possible known beneficiaries, trustees, and settlors (including subsequent contributors), as well as persons who can exert influence on a trust. This includes contacting beneficiaries who may never receive any benefit from a family trust (and may not be aware they are a beneficiary), persons who have become estranged, or those only named in remote and contingent instances, such as the death of all the “primary” beneficiaries.

This not only creates a significant and costly administrative burden to locate parties, and potential tensions when dealing with estranged persons, but also a need to address when parties refuse to comply. After all, in Canada, one does not need to consent to be named as a beneficiary of a trust; that consent is generally sought once a gift is offered.

From there, significant uncertainty remains on determining what may constitute the ability to “exert influence”, as well as what may be considered a “related agreement5.” All of this adds new costs in compliance and, in concert with increased taxes, may tip the cost/benefit analysis of the trust against some families relative to the outcomes and expectations they were intending.

From there, while it remains possible for family trusts to allocate income (and capital) to Canadian resident beneficiaries to access their graduated tax rates and capital gains inclusion rates6, this may increase the vulnerability of the trust assets to a family creditor claim upon dissolution of marriage or common law partnership.

Courts have held, in a family law context, that the assessment of a contingent beneficiary’s interest should properly take into consideration the historical pattern of use of the trust7. Courts have also noted that contingent interests that “have some degree of concreteness or solidity, or some degree of assurance that a party will actually derive or enjoy the benefit of those interests, are interests that are more susceptible to valuation”8. Other relevant considerations generally include the source of the trust property, the intentions of the settlor, the fiduciary responsibilities of the trustee(s), and the competing interests of other beneficiaries9.

Put another way, if there is a predictable and consistent income distribution to a beneficiary, such as a significant annual distribution intended to reduce the tax owing on the income earned in the trust, the value of this income, and the value of an ongoing income and capital entitlement may potentially be considered against the beneficiary during a property valuation upon separation of the parties. This is particularly so if there is no prenuptial or cohabitation agreement where the trust entitlements are explicitly excluded.

As many families create trusts to offer asset protection for their family member beneficiaries, an analysis of the family situation and impact of distributions with trusted advisors becomes increasingly prudent.

SELECTED ARGUMENTS IN FAVOUR OF FAMILY TRUSTS

While family trusts appear to enjoy fewer tax benefits than in years past, one significant benefit that can be found where family trusts own private corporation shares is the ability to “multiply” the lifetime capital gains exemption (“LCGE”) on qualified small business corporation (“QSBC”) shares without having to pay regular income tax on the resulting capital gain up to the lifetime exemption amount. As of June 25, 2024, this exemption amount is $1,250,000, representing a significant increase from the $1,016,836 amount pre-Budget 2024.

While a family trust itself cannot claim the LCGE, where there are multiple beneficiaries and where the criteria can be met10, the trust can allocate a portion of a capital gain realized by the trust on a disposition of QSBC shares to multiple beneficiaries in a manner that maximizes the use of each beneficiary’s available LCGE, provided that this is permitted in the Trust Deed and the required designations are made by the family trust under the ITA. This generally results in a

significant overall reduction of tax on the sale of the QSBC shares compared to an individual realizing the disposition alone (subject to, amongst other things, the updated AMT).

Even where a share sale is not imminent, the potential long- term savings for a family on the eventual disposition of QSBC shares that are expected to appreciate in value can be significant and can far exceed the increased costs and taxes paid in the interim.

With regard to trusts that encounter challenges adjusting to the legislative changes described above due to poorly defined trust terms or vague descriptions of beneficiaries, it may be possible to amend or vary terms and definitions. This may include, in some instances, clarifying who is and is not a beneficiary in line with the original intent of the trust. Not all trusts can be easily varied, even with the assistance of the Court, and this should only be undertaken with the advice and guidance of an experienced trusts lawyer. Significant amendments to the terms of a trust can result in a deemed re-settlement of a trust, with tax ramifications outside of the scope of discussion for this article.

Further, there remain many non-tax reasons to set up a family trust, and for families to keep an existing family trust. These include protecting and safeguarding funds for minor, disabled, and spendthrift beneficiaries, the ability to use the family trust as a voting shareholder for related corporations, and general planning flexibility for family members. These continue to have value that may exceed the costs of compliance and additional tax arising from recent legislation to many Canadian families.

Despite potentially opening up a question of trust interest valuation in certain instances as discussed above, family trusts also do remain effective asset protection tools where set up correctly. Even in the case of spousal/family creditors, the trust interests may potentially be excluded in many instances where properly executed prenuptial or cohabitation agreements are in place11 and other extenuating circumstances are not present to justify judicial relief.

CONCLUSION

While the selected legislation changes appear to represent a continued erosion of positive tax treatment for trusts, family trusts do remain valuable and effective planning vehicles. While these changes can be burdensome and costly in many instances, these changes alone may not be the deciding factor as to whether to settle or maintain an existing trust.

It is important to remember that changes in estate, trust, and tax legislation will continue to occur frequently. This requires a balanced and moderate approach with the assistance of qualified professionals, not only at the planning and implementation phases, but the ongoing administration phase as well.

  1. The term inter vivos is Latin for “between the living”.
  2. The term “family trust” is undefined in the Income Tax Act, for the purposes of this article, a family trust is a “trust” as defined in ss. 108(1) and a “personal trust” as defined in ss. 248(1), and for greater certainty, is not considered to be an “alter ego trust”, “joint partner trust”, or “spouse trust” as those terms are defined in the Income Tax Act.
  3. See s. 127.5 of the ITA.
  4. See ss. 107(2) ITA.
  5. See for additional commentary, “Disclosing Persons Who Exert Influence on Trustees,” Canadian Tax Focus, Volume 11, Number 2, May 2021
  6. Subject to TOSI and certain other relevant provisions in the ITA
  7. See for examples, Kachur v Kachur, 2000 ABQB 709, and Sagl v Sagl, 1997 CanLII 12248 (ON SC)
  8. Gordon v Nielson, 2018 SKQB 207 at para 155 citing Purtzki v Saunders, 2016 BCCA 344
  9. Gordon v Nielson, 2018 SKQB 207 at para 153 [“Gordon”]
  10. See s. 110.6 ITA.
  11. See for example, Gordon at paras 139-140.

 

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About the Author

Matt Trotta


Matt Trotta, JD (U.S.), LL.B., TEP

Vice President, Tax, Retirement and Estate Planning
CI Global Asset Management

Matt is a tax specialist and an estate planning lawyer called to the bar of Alberta in 2013. He specializes in post-mortem tax and estate planning, as well as tax planning for trusts and owner-managed businesses. Matt is a member of the Society of Trust and Estate Practitioners (STEP), holding the TEP designation, has completed Levels 1-3 of the CPA Canada In-depth Tax Program, and is a member of the Canadian Tax Foundation (CTF). Prior to joining CI, Matt worked in the tax and estate groups at regional and national law firms, as well as a tax boutique firm. Matt also acquired in-house legal experience at one of Canada’s largest trust companies, where he provided internal legal advice, and estate and trust planning guidance to clients, advisors, and trust officers.

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