When you hear the phrase “discretionary family trusts,” you’ll probably first think of trust fund babies, offshore accounts, and tax havens – in other words, something used only by the ultra-rich. But surprisingly, family trusts can be a useful estate and tax planning tool for every family, not just for the wealthy. Here’s a look at the reality behind the myth, and how using a corporate beneficiary can help get around the non-resident tax trap.
A typical family trust is drafted as a discretionary trust for the benefit of a class of beneficiaries. Beneficiaries could include yourself, your spouse, and your issue (children, grandchildren, great grandchildren, etc.). In fact, a family trust can include as many family or friends as you would like (subject, of course, to certain tax considerations). Some trusts often include a class of secondary beneficiaries, such as further-removed family members or registered charities. These secondary beneficiaries would typically kick in if none of the primary beneficiaries were alive at the time the trust is wound up and the assets distributed.
Using a corporate beneficiary
One tax-planning tool I use is to allow for a corporate beneficiary. This could include a corporation to be incorporated (even at a later date), the shares of which are owned by any one or more of the primary beneficiaries. The use of a corporate beneficiary allows for some tax planning on the eventual distribution out of the trust, for example, if a beneficiary becomes a non-resident of Canada (more on that later).
If you want to set up a family trust, and you also want to contribute property to the family trust, then you cannot be a beneficiary of the trust. There is an attribution rule under the Income Tax Actthat would be triggered if property that is transferred to the trust by an individual could potentially revert back to the individual (i.e., by virtue of your being a beneficiary of the trust). This attribution rule will also kick in if the individual who contributes property to the trust is able to determine how the trust property is to be distributed (i.e., if he or she is the sale trustee or has a veto power as a trustee). In this instance, it does not matter if that individual is a beneficiary or not.
So, the general rule is that if you or someone else contributes or gifts funds or property to a trust, you or that particular person is not allowed to be a beneficiary or cannot make decisions on their own as to how the trust distributes the property. And to make matters worse, if this attribution rule is triggered for any moment in time (even if the situation is cured after the rule has applied), a second tax rule jumps in to prevent the distribution of the capital of the trust to a Canadian resident beneficiary without triggering capital gains tax.
There are, of course, certain ways to get around this rule. For example, case law has held that if you were to lend money (even without interest) or sell property to the trust at fair market value, this attribution rule will not apply. So if you are gifting funds or property to a trust, be very careful about whether you are included as a beneficiary (or even as a contingent beneficiary) or if you have too much control in determining who gets what out of the trust.
A second event that could trigger capital gains tax on a distribution of capital out of a family trust is if the beneficiary is no longer a Canadian resident. The general rule is that distributions of capital out of a family trust will not trigger any capital gains tax on the increase in value of any trust assets, provided that the beneficiary receiving the distribution is a resident of Canada at that time.
These days, this problem can arise more often than not, what with kids going to school in the U.S. and then staying south of the border permanently. Hence, the use of a corporate beneficiary would allow you to get around this problem: Simply incorporate a Canadian resident company of which the non-resident child is a shareholder, and distribute the trust capital to the company. Note that it would be important for the non-resident child to get proper tax advice in the country where they live, just in case there are other rules triggered under their jurisdiction.
Courtesy Fundata Canada Inc. ©2018. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.