TRUSTS & ESTATES: Transfering assets to your spouse or children
Trusts and Attribution
The attribution rules for trusts, transferors, and so on are given in Subsections 74.1(1) and 74.2(2) of the Canadian Income Tax Act (“ITA”). These rules are meant to attribute back to the transferor any income or capital gains generated from property transferred at less than fair market value consideration or for no consideration to a spouse of the transferor, as well as to attribute income, but not capital gains, on similar transfers to a non-arms length minor such as a child. Such rules apply in similar fashion to loans at less than fair market value interest. These rules are not applicable to the transferor to attribute any income, loss, taxable capital gains or allowable capital losses that relate to a period following the death of the transferor. Consequently, these rules are not applicable to a testamentary situation.
Subsections 74.1(1) and (2) of ITA refer especially to trusts. In the context of these provisions, the transfer of property is regarded as occurring not between the settlor/transferor and the trust as an individual, but rather, through the trust to the beneficiaries. In view of this, section 74.5(9) deems a loan or transfer to a trust in which a person is beneficially interested, to be a loan or transfer to that person. A person with a right, immediate or future, absolute or contingent or subject to discretion, to income or capital of the trust, is considered beneficially interested in the trust. If an individual loans or transfers property, for less than fair market value consideration, to a trust in which his or her spouse or a non-arm’s length minor is beneficially interested, attribution will apply unless the income is accumulated in the trust and taxed therein (which is taxed at the highest marginal rate).
The calculation for the amount of trust income that will be subject to attribution for purposes of subsections 74.1 and 74.2 is given in subsection 74.3(1) of the ITA. Usually, the income or loss which a spouse or non-arms length minor actually receives or suffers from the trust or is deemed to acquire from the trust under a preferred beneficiary election in respect of such property and substituted property, is deemed to be received by the individual who made the transfer or loan to the trust in the first place. Likewise, capital gains and capital losses which a spouse receives or is deemed to receive from the trust in respect of such property are deemed to be received by the individual who made the transfer or loan to the trust.
According to subsection 75(2) of the ITA, when a person contributes property to a trust and that property, or substituted property, goes back to that person or passed to persons to be determined by him or her subsequently, it provides that income or capital gains of the trust is to be attributed for tax purposes to the settlor (the original transferor).
This clause is a major tax disadvantage in most cases to the use of revocable inter vivos trusts (while the settlor/transferor is still living). Its terms are so widely drawn that it is not clear what its effective limits are. Consider the proposition of the CRA that subsection 75(2) of the ITA would apply where an individual creates an irrevocable discretionary trust to which he or she contributes property and such individual is the sole trustee, even though the individual is not included in the predetermined list of discretionary beneficiaries, M.N.R. Administrative Interpretation 9202455 (February 27, 1992).
Trust as a Taxable Entity
As a trust or estate is regarded by the ITA to be an individual for tax purposes, it is expected to compute its income under Division B of the ITA and will be allowed a deduction for all expenses incurred for the purpose of gaining or producing income from its business or property. So, if a trust or estate borrows money in order to invest in bonds or shares, any interest paid or payable by the trust in respect of the borrowed funds will be deductible in calculating the income of the trust or estate. It is essential to note that the trust or estate, like any ordinary taxpayer, is only permitted a deduction for expenses incurred for the purpose of gaining or producing income from a business or property. Personal expenses of the beneficiaries from the trust are not deductible.
When a trust or estate suffers a business or property loss, the loss cannot be transferred to the beneficiaries. In that event, the normal rules for carrying such losses backward or forward apply to the trust or estate. Moreover, according to subsection 122(1.1) of the ITA, inter vivos and testamentary trusts cannot claim the personal tax credits available to individuals. Also, if a trust or estate is resident in Canada, it will be taxed on its income for a taxation year from all sources, whether inside or outside Canada.
The exceptions to the rule above are as follows when:
1) The income of the trust or estate for the taxation year is actually paid to its beneficiaries;
2) Its income is payable (although not actually paid) to its beneficiaries, (subsection 104(24) provides that an amount is considered payable when the beneficiary can enforce payment thereof) (CRA, Interpretation Bulletin IT-286R2, “Trusts – Amount Payable”);
3) “Preferred beneficiaries” elect to assume the tax liability for their share of the trust’s income, even though the income remains in the trust; or
4) A taxable benefit (other than a distribution or payment of capital) is conferred by the trust on its beneficiaries because the trust or estate paid for the upkeep, maintenance or taxes on property used by the beneficiary.
These four amounts are treated as deductions from the income of a trust and are required to be included in the income of the beneficiaries concerned.
In this context, the definition of “preferred beneficiary” in subsection 108(1) of the ITA is important in determining whether any beneficiary can make a preferred beneficiary election so as to include his or her share of the accumulating income of the trust in his or her own personal income and permit the trust to deduct such amount when computing the trust’s taxable income.
A beneficiary is defined as a preferred beneficiary resident in Canada, who is:
1) The settlor of the Trust (i.e. the person who transferred his/her assets to the trust, hence created the trust);
2) The spouse or former spouse of the settlor;
3) A child, grandchild or great grandchild of the settlor or the spouse of any such person; and
4) An individual eligible for a disability tax credit or an adult beneficiary for whom a dependent tax credit can be claimed by another individual because of the beneficiary’s mental or physical infirmity.
Contact the lawyers at Levy Zavet PC (Levy Zavet), to discuss your estate planning concerns and how best to consider all angles of a tax efficient succession plan.
