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CCH Tax Notes/Estate Planner – January

The Trouble with Trusts

By: David Louis, J.D., C.A., Tax Partner
Minden Gross LLP, a member of MERITAS Law Firms Worldwide.

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In recent months, there has been a flurry of developments centered around the proper “execution” of tax planning arrangements involving trusts.

Of course, at ground zero are the Garron[1] and Antle[2] cases.  In case you’ve been out of the country, Garron involved the imposition of the central management and control test to trust residency.  Antle involved an attack on technicalities of the establishment of a trust, including defective settlement and lack of intention to create a trust.  While both cases involved aggressive tax structures and offshore trusts, many practitioners probably experienced some private angst over whether this sort of trust-busting approach might “spread inland”, putting more conventional structures at risk.

Actually, the aforementioned angst precedes these cases. Readers will remember the CRA questionnaire sent to prominent Alberta trustees last March, questioning the residence of Alberta trusts based on a central management and control concept - that turned out to be downright propitious.[3] 

A few weeks after the Garron and Antle cases were released, a Toronto law firm issued a “news flash” about CRA audits of domestic trusts in a number of suburban and outlying tax offices in the Golden Horseshoe area.  The warning, which is repeated in the December issue of Canadian Tax Highlights[4], pertains to possible CRA review of distributions paid with promissory notes that may be unenforceable under limitation rules, diversion of cash for the trustees’ own use,[5] the absence of proper accounting records or trustees’ minutes, inability to locate the original settlement property[6], as well as the monitoring of compliance with the 21-year rule.[7]

By the way, while many readers may think that tax cases attacking trusts are new developments, old timers (like me) will remember a number of cases in the 70s involving attacks on the validity of trust formation, including Leon[8], Atinco Paper Products[9], and one of my all time favourites, Kingsdale Securities[10], which involved an ultimately unsuccessful attempt to create a trust at a Bar Mitzvah in Regina.  (The most amazing point of the case: they actually have Bar Mitzvahs in Regina!).  In the 90s, the proper execution of transactions relating to trusts was called into question in Langer[11] and Romkey[12].      

 

Now What?

OK - so what do we do now – i.e., when it comes to the successful execution of conventional income splitting, freeze structures and the like, involving inter vivos trusts? 

 

Know the ground rules[13].  For starters, there should be an awareness of the technical “ground rules” pertaining to inter vivos trusts.  Dividends from a private corporation allocated to an individual who has not turned 18 in the year will trigger the kiddie tax (although dividends from public corporations will not).  Even if the trust has allocated all of the income, filing a T3 return is advisable.  If the trust controls a corporation, an appointment of a trustee might trigger the acquisition of control rules, including a deemed year-end, the loss streaming rules, and so on.  Consideration should be given to the impact of the association rules, especially for estate freezes.  The general rule is that transfers of assets into trusts trigger deferred tax exposure.  Distributions of property from a trust require professional assistance; in particular, distributions of trust assets to non-resident beneficiaries may trigger capital gains or other tax exposure, as well as compliance requirements under ITA section 116.  The 21st anniversary of the trust should not be forgotten, lest there be a deemed disposition of trust assets at that time (including the year of formation in the name of the trust provides a good reminder).  A substantial change in the terms of a trust – made either by a court order to vary the trust or pursuant to an amending provision (if one exists)– may result in the disposition of a beneficiary’s interest or, if the change is fundamental, a resettlement of the trust itself (including a deemed disposition of the trust’s assets)[14].  For further discussion of trusts, including applicable tax rules, see chapters 2 and 3 of Tax and Family Business Succession Planning, 3rd edition.[15]  

 

Who’s on first?  Especially in view of the Antle case, it is important that the participants in a trust be aware of the significance of their roles, including the settlor, the person entitled to appoint and/or remove trustees[16], and most important, the trustees themselves.  The trustees should be given at least a basic understanding of the trust (if not a clause-by-clause review) and should be apprised of significance of their fiduciary duties to beneficiaries.    Documentation of the foregoing is helpful.[17]    

 

Allocations and distributions.  In many cases, a trust will simply hold growth shares in a freeze structure.  If so, the income of the trust will be limited or non-existent; often the growth shares will not even pay dividends.  An income-splitting trust, on the other hand, requires annual allocations of income, investment decisions, and so on.  In these cases in particular, trustees must be prepared to keep records and do some paperwork.  If this is sloughed off, a CRA review could mean trouble.  Particularly in view of this possibility, it should be certain that allocations to beneficiaries are paid or payable by December 31st of each year.  The best way to do this is to make the distributions in cash – preferably, by a payment from the trust bank account to the beneficiary’s bank account prior to the end of the year (there should be a separate bank account for each beneficiary).  Allocations not paid in cash should be evidenced by promissory notes (dated no later than year-end).  In Ontario at least, under current rules, the limitation period on a demand note will not begin to run until demand is made; nevertheless, it is probably prudent to repay the notes fairly promptly. 

One of the most dangerous practices in an income-splitting trust could be where taxable allocations/distributions are made to children as beneficiaries and the parents simply scoop the proceeds for their own use.  In many cases, the parents get into a habit of doing this, perhaps intending to replenish the child’s bank account sometime in the future.  This is a bad habit which could end up being fatal to the tax plan.  Distributions to beneficiaries should be for their use.  If they are not invested on behalf of the beneficiary, then it is advisable to ensure that distributions are spent for items benefiting the particular child[18]. 

 

Trustees’ procedures.  If at all possible, the trustees should meet at least annually and prepare minutes or at least notes of their meetings[19].  If income is to be distributed, resolutions making irrevocable allocations to the beneficiaries should be prepared and equivalent funds should be distributed to the beneficiaries to be used for their exclusive benefit.[20]

Because of the possibility of the reversionary trust rules applying, payments made by beneficiaries on behalf of the trust, e.g., for professional fees, etc., are best avoided; otherwise, they should be accounted for as a loan to the trust rather than a capital contribution (and documented as such if at all possible).  Better still, such expenditures should be funded by dividends or other income received by the trust.

Now we get to the sixty-four dollar question.  What if the only asset of the trust is non- or limited-voting common shares which do not pay dividends?  The rights of the trustees to information may be limited, and the intent of the settlor may well be for the trust to simply hold on to the shares until its 21st anniversary[21].

What should the trustees do?  The representative of a leading trust company has informally suggested that the trustees would nonetheless have an obligation to turn their minds to this kind of investment on a regular basis[22].  It was also suggested that the trustees could review financial statements [even though they often provide limited information] and the portions of corporate books and records that are available under corporate law.[23]  Generally, questions might be asked as to concerns of the settlor and primary beneficiaries. 

Certainly, doing this sort of thing and keeping minutes to evidence this can’t hurt; whether the CRA will ever press the matter in a “passive freeze structure” remains to be seen.  Hopefully, it would not use lack of paperwork as an excuse to disrupt a garden-variety freeze, especially if the activities of the trustees would have amounted to an exercise in navel-gazing.

One possibility is to prepare “standardized minutes”.  But there could be great danger here if it can be established that the minutes were false: Mr. Louis did not meet in Toronto on December 26th - he was at a Bar Mitzvah in Regina. 

 

Don’t Forget about Estates!
 

Although the focus of both the tax cases and other developments has been on inter vivos trusts, there are also restrictions on dealings with a testamentary trust.  Testamentary trust status will be disallowed if property has been contributed to the trust otherwise than by an individual on or after the individual’s death, and as a consequence thereof.  There has been a long stream of CRA pronouncements as to which transactions are kosher. For example, where a trust has elected to pay tax on an amount payable to a beneficiary,[24] the payment to or on behalf of a testamentary trust by a beneficiary in respect of the trust’s tax liability will not result in a loss of testamentary trust status.[25]  The CRA has also indicated that where a beneficiary uses property owned by a testamentary trust and pays operating expenses as a condition of using the property, the payment of such expenses may be viewed as the equivalent of rent rather than a contribution to the trust which would cause it to lose its testamentary status.  However, capital expenditures made on behalf of the trust would undermine testamentary status[26], as would a reimbursement of medical expenses paid by a testamentary trust[27].  In general, therefore, caution should be exercised when making payments to or on behalf of a testamentary trust. 

Loss of testamentary trust status will mean that the trust will lose the benefit of graduated income tax rates.  In addition, the tainting of a testamentary trust triggers a year-end.  This may well result in the missing of tax filing and other deadlines; this appears to include transactions that would trigger a subsection 164(6) “carry back”, since this must arise in the first taxation year of an estate.  For further discussion, see ¶814 of Tax and Family Business Succession Planning.[28] 

 

—        David Louis, J.D., C.A., Minden Gross, Toronto, a member of MERITAS law firms worldwide. Thanks to Bill Cooper of Boughton, Vancouver and Ray Hupfer of McLennan Ross, Edmonton, also members of MERITAS.