The Estate Planner's Handbook, 3Rd Edition

The Estate Planner’s Handbook

3rd Edition

Robert Spenceley CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 1 Free lead: 145D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

TABLE OF CONTENTS

Page Chapter 1 — Wills Introduction ...... 2 Types of Wills ...... 2 Conventional (‘‘Attested’’) Wills ...... 2 Holograph Wills ...... 3 Notarial Wills — Quebec ...... 5 International Wills ...... 6 Formalities of Execution ...... 6 Alterations ...... 9 Codicils ...... 10 Memorandum of Personal Property ...... 11 Revocation of Wills ...... 12 Voluntary Revocation ...... 12 Effect of Marriage ...... 13 Wills Made in Contemplation of Marriage ...... 14 Election ...... 14 Effect of Cohabitation & Cessation Thereof ...... 15 Effect of Divorce ...... 15 iii CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 2 Free lead: 530D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

iv The Estate Planner’s Handbook

Page Life Insurance Designations ...... 17 Designations of RRSPs, RR IFs, and Other Registered Plans 19 Does the Testator Have the Required Mental Capacity? ...... 22 Absence of Suspicious Circumstances or Undue Influence ...... 24 Choice of Executors and Trustees ...... 26 Surviving Spouse ...... 26 Business Associate ...... 27 Lawyers, Accountants, Etc...... 27 Guardian of Dependent Children ...... 28 Persons Outside the Province ...... 28 Trust Companies ...... 29 Substitutes or Alternates ...... 31 An Executor’s Duties ...... 32 Number of Executors and Trustees ...... 35 Decision-Making ...... 35 Exculpatory Provision ...... 36 Foreign Executors and Trustees ...... 36 Common Problems in Will Drafting ...... 37 Abatement...... 37 Ademption ...... 39 Lapse ...... 42 Hotchpot or the Rule Against Double Portions ...... 43 ‘‘Issue’’ and ‘‘Children’’ — ‘‘Per Stirpes’’ and ‘‘Per Capita’’.... 44 Who is Going to Pay Debts and Taxes? ...... 45 Mirror Wills and Mutual Wills ...... 46 ‘‘Pour-Over’’ Trust Trap ...... 49 Storage of Will ...... 50 Periodic Review ...... 50 Concise Checklist for Reviewing a Will ...... 51 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 3 Free lead: 105D Next lead: 350D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Table of Contents v

Page Chapter 2 — Tax Planning the Will Introduction ...... 54 Importance of the Spouse/Common-Law Partner as Beneficiary ...... 54 Spouse Trusts ...... 55 Who Is Your Spouse? ...... 59 Low-Bracket Beneficiaries ...... 61 Skip a Generation ...... 61 The Estate Split ...... 61 Spousal Trust ...... 62 Trusts For Children ...... 62 A Trust for Each Child ...... 63 Trusts for Grandchildren...... 63 Life Insurance ...... 63 RRSPs and RR IFs ...... 64 ‘‘Financially Dependant’’ ...... 65 Spousal Trust As Annuitant ...... 65 The Tax Burden...... 66 TFSAs ...... 67 RESPs ...... 67 Debt Forgiveness ...... 69 Choice of Executors ...... 69 Association Rules ...... 70 Rights and Things ...... 74 The Principal Residence/Cottage...... 76 Farm and Fishing Property ...... 76 Charitable Donations ...... 77 GST ...... 79 International Considerations...... 79 Post-Mortem Planning To Avoid Double Taxation ...... 80 Probate Tax ...... 81 Administrative Powers Related to Specific Tax Issues ...... 81 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 4 Free lead: 65D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

vi The Estate Planner’s Handbook

Page Chapter 3 — Multiple Wills Introduction ...... 86 Ontario...... 86 Subsequent Case Law ...... 88 Other Provinces ...... 90 British Columbia ...... 90 Manitoba ...... 91 Nova Scotia ...... 92 Costs ...... 92 Income Tax Consequences ...... 93 Jurisdiction Shopping ...... 93 Preparing Multiple Wills ...... 94 Drafting Issues ...... 95

Chapter 4 — Will Substitutes Introduction ...... 100 The Benefits of Will Substitutes ...... 100 The Income Tax Consequences of Inter Vivos Transfers ...... 101 Transfer of a Joint Interest ...... 102 Rollover to Spouses, Common-Law Partners, and Certain Trusts...... 102 Transfer of a Remainder Interest ...... 103 Requirements of a Gift ...... 104 Methods of Making Gifts ...... 104 Proving and Documenting Inter Vivos Gifts ...... 105 Presumptions of Resulting Trust and Advancement ...... 108 Joint Ownership with Right of Survivorship ...... 111 Pecore v. Pecore ...... 113 Inter Vivos Gifts...... 114 Donatio Mortis Causa (‘‘Deathbed Gifts’’) ...... 115 Taxation...... 117 Inter Vivos Trusts...... 118 Beneficiary Designations ...... 119 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 5 Free lead: 105D Next lead: 350D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Tax-Free Savings Accounts ...... 120 Revocation of Beneficiary Designations ...... 121 Creditor Protection ...... 124 Liability to Disappointed Beneficiaries ...... 128 Appendix I: Provincial Creditor Protection of Registered Plans . . . 131 Appendix II General Comparison of Sole and Joint Ownership . . 133

Chapter 5 — Continuing Powers of Attorney Introduction ...... 136 Required Mental Capacity ...... 137 The Donor’s Name ...... 138 Choosing an Attorney ...... 139 Income Tax Complications ...... 139 When Should a Continuing Power of Attorney Come into Effect? 140 An Attorney’s Duties and Responsibilities ...... 142 The Attorney’s Powers...... 144 Beneficiary Designations...... 145 Stopping the Donor from Acting Improvidently ...... 146 Self-Dealing by the Attorney ...... 148 Preventing Abuse ...... 150 Estate Planning by an Attorney ...... 152 Inter Vivos Transfers to Ultimate Beneficiaries of Donor’s Estate...... 152 Estate Freeze...... 153 Establishing a Trust ...... 153 Beneficiaries Under the Donor’s Will ...... 154 Appointing More Than One Attorney ...... 156 Compensation ...... 157 Property in a Foreign Jurisdiction ...... 157 Revocation ...... 158 How Many Copies? ...... 159 Alter Ego and Joint Spousal Trusts as an Alternative to a Continuing Power of Attorney ...... 160 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 6 Free lead: 25D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Chapter 6 — Health and Personal Care by Proxy Introduction ...... 162 Continuing Powers of Attorney for Personal Care ...... 162 Health Care Directives...... 163 Ulysses Agreements...... 165

Chapter 7 — Some Basic Trust Law Concepts & Principles Introduction ...... 168 What is a Trust? ...... 169 Determining Whether a Trust Exists ...... 169 The Three Certainties...... 169 Absence of Certainties ...... 172 ‘‘In-Trust’’ Accounts ...... 172 Other Requirements in Creating a Trust ...... 173 Some Basic Types of Trusts ...... 174 Testamentary & Inter Vivos Trusts...... 174 Revocable & Irrevocable Trusts ...... 174 Discretionary & Non-Discretionary Trusts ...... 175 ‘‘Family Trusts’’ ...... 176 Spousal Trusts ...... 177 Constructive Trusts ...... 177 Resulting Trusts ...... 179 Bare Trusts...... 179 Qualif ying Disposition Trusts ...... 181 Trustees and Their Duties ...... 181 Duty of Loyalty to the Beneficiaries ...... 182 Duty of Reasonable Care ...... 182 Trust Investments ...... 182 Duty to Act Personally ...... 184 Duty to Act with an ‘‘Even Hand’’ ...... 185 The Trust Instrument Overrides the Common-Law Duties . . . 186 The Variation of Trusts ...... 186 The Rule in Saunders v. Vautier...... 186 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 7 Free lead: 105D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page The Variation of Trusts Act ...... 188 The Rules Against Perpetuities and Accumulations ...... 190

Chapter 8 — Taxation of Basic Trusts Used in Estate Planning Basic Concepts and Principles ...... 194 Residence of Trusts ...... 195 Inter-Provincial Tax Planning Using Trusts ...... 196 Transfer of Property to a Trust ...... 198 Consequences to Settlor ...... 198 Consequences to the Trust ...... 199 Testamentary Trusts...... 199 Computation of Trust Income ...... 199 Election Not To Deduct Distributions Made to Trust Beneficiaries ...... 200 Flow-Through of Trust Income ...... 201 Losses of the Trust ...... 202 Rollover of Capital Property of a Trust ...... 202 Preferred Beneficiary Election ...... 203 Upkeep, etc., of Trust Property ...... 204 Trusts and the Principal Residence ...... 205 Trust Holds More than One Property...... 207 Cottage Properties ...... 208 Planning Considerations ...... 208 Testamentary Trusts ...... 210 Introduction ...... 210 Status as a Testamentary Trust ...... 210 Loss of Testamentary Trust Status ...... 213 Pending Amendment Regarding Advances Made to a Testamentary Trust (or Estate) ...... 214 Income-Splitting Through Multiple Testamentary Trusts ..... 217 Meaning of ‘‘Spouse’’ and ‘‘Common-Law Partner’’ ...... 217 Pending Amendment ...... 219 Spousal Trusts ...... 219 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 8 Free lead: 105D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Introduction ...... 219 Testamentary Spousal Trusts ...... 220 Additional Requirements for Spousal Trusts ...... 221 Planning Considerations ...... 223 Trust ‘‘Tainted’’ by Payment of Testamentary Debts ...... 225 Caution Re Life Insurance ...... 226 Inter Vivos Spousal Trusts ...... 227 Inter Vivos Trusts for Minors ...... 228 Distribution of Trust Property to the Beneficiaries ...... 230 Deemed Disposition After 21 Years ...... 234 Date of Deemed Realization Date ...... 235 Planning for the 21st Anniversary ...... 239 Variation of the Trust ...... 241 Attribution Rules ...... 243 Exceptions to the Attribution Rules ...... 245 Tax on Split Income (the ‘‘Kiddie Tax’’)...... 246 The Reversionary Trust Rules — Attribution Under Subsection 75(2) ...... 248 The Trap — Key Words ...... 250 Restrictions on the Application of Subsection 75(2) ...... 253 Denial of Tax-Deferred Roll Out Where Subsection 75(2) Applies ...... 257 Appendix: Types of Trusts ...... 260

Chapter 9 — Certain Other Trusts Used In Estate Planning Alter Ego & Joint Partner Trusts ...... 262 Requirements of an Alter Ego Trust ...... 262 Basic Taxation of Alter Ego Trusts ...... 262 Requirements of a Joint Partner Trust ...... 263 Basic Taxation of Joint Partner Trusts ...... 263 Attribution Under Subsection 75(2) ...... 263 Potential Uses in Estate Planning ...... 264 Some Practical Issues ...... 269 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 9 Free lead: 530D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Self-Benefit Trusts ...... 274 Bare Trusts...... 277 Non-Resident Trusts ...... 277 Taxation Years Beginning Before 2007 ...... 277 Taxation Years Beginning After 2006 ...... 278 Non-Resident Immigration Trusts ...... 281 Asset Protection Trusts ...... 283 Some Situations Where an Asset Protection Trust May Be Beneficial ...... 285 Planning Considerations ...... 287 Insurance Trusts ...... 288 RRSP Trusts ...... 293

Chapter 10 — Charitable Donations Introduction ...... 298 The Charitable Donations Tax Credit ...... 299 ‘‘Split Gifts’’ ...... 300 Donations of Life Insurance Policies and Annuities ...... 302 Gifts of Cultural Property ...... 303 Gifts at Death ...... 303 Gifts of Insurance Policies, RRSPs, RR IFs, and TFSAs ...... 304 Gifts Made by Will ...... 305 Gifts of Capital Property ...... 306 Gifts of Securities ...... 309 Gifts of Non-Qualified Securities ...... 312 Gifts In Kind by Spouses ...... 314 Gifts of Personal-Use Property ...... 315 The Ongoing Saga of Art Donation Schemes ...... 315 Gifts of Remainder & Residual Interests ...... 317 Gifts of Services ...... 320 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 10 Free lead: 70D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Chapter 11 — Taxation at Death Introduction ...... 323 Deemed Disposition of Capital Property at Death ...... 323 Corporate Shares ...... 324 Effect of Buy-Sell Agreements on Fair Market Value ...... 324 Effect of Corporate-Owned Life Insurance on Fair Market Value...... 326 Double Tax on Death ...... 326 Principal Residence ...... 327 Spousal Rollover ...... 328 Rollover to a Child of Farm or Fishing Property ...... 335 Rollover to a Child of Family Farm or Fishing Corporation or Partnership ...... 337 $750,000 Capital Gains Exemption ...... 340 Exemption for Gains from Qualified Farm or Fishing Property...... 341 Exemption for Small Business Corporation Shares...... 343 Employee Stock Options Upon Death ...... 345 Capital Losses in the Year of Death ...... 346 Reserves for the Year of Death ...... 347 Paying the Tax from Deemed Gains in Instalments...... 348 Registered Retirement Savings Plans ...... 348 Post-Mortem Contribution To Surviving Spouse’s RRSP ..... 354 Home Buyers’ Plan ...... 355 Registered Retirement Income Funds ...... 356 RRSP and RR IF Losses Realized After Death ...... 357 Tax Liability Arising from Inclusion of an RRSP or RR IF in Income of Deceased ...... 358 Tax-Free Savings Accounts ...... 359 Treatment of Survivor ...... 359 Treatment of Deceased (and of Trust) ...... 361 Death Benefits ...... 362 Rights or Things ...... 364 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 11 Free lead: 65D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Medical Expense Credit ...... 365 Charitable Donations ...... 366 Election to Split Pension Income on Death ...... 367 Eligible Funeral Arrangements ...... 367 Taxation of the Estate ...... 369 Income and Taxation Year of the Estate...... 370 Deduction of Losses Realized by Estate ...... 371 Flow-Through of Trust Income ...... 373 Distribution of Property to Beneficiaries ...... 373 Distributions in Satisfaction of Income Interests ...... 374 The Executor’s Year ...... 374 Clearance Certificate ...... 376 Personal Liability of Legal Representative ...... 378

Chapter 12 — United States Estate & Gift Tax Introduction ...... 380 Domicile as Opposed to Residence ...... 382 U.S. Situs Assets ...... 383 Jointly Held Property ...... 385 Unified Transfer Tax System ...... 386 Gift Tax...... 386 Deductions, Exclusions, and Elections ...... 386 Gift Tax Rates, Credits, and Returns ...... 387 Estate Tax ...... 387 Gross Estate...... 387 Deductions ...... 388 Rates, Credits, and Returns ...... 388 Taxes Imposed on Death: Protocol to the Canada–U.S. Income Tax Treaty...... 389 Applicable Credit ...... 390 Spousal Transfers: U.S. Rules ...... 390 Tax Credit: Canada ...... 390 Spousal Rollover: Canadian Rules ...... 391 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 12 Free lead: 100D Next lead: 155D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Tax Credit: United States ...... 391 ‘‘De Minimis’’ Rule...... 391 Single Purpose Corporations ...... 391 Canadian Discretionary Trust ...... 393 Appendix: A Checklist of Planning Strategies ...... 395

Chapter 13 — Probate Introduction ...... 400 When Is Probate Necessary? ...... 401 Probate Planning ...... 403 Probate Fees by Province ...... 403 Appendix: Provincial Probate Fee Schedules ...... 405

Chapter 14 — Dependants’ Relief Introduction ...... 416 Dependants’ Relief in British Columbia...... 416 Planning for a Dependants’ Relief Claim ...... 419 Dependants’ Relief in Ontario ...... 426 Some Planning Considerations ...... 428

Chapter 15 — Spousal Property Rights in Ontario Introduction ...... 434 The Basic Approach of the Family Law Act ...... 434 Who Qualifies as a ‘‘Spouse’’? ...... 435 Division of Net Family Property ...... 436 Unequal Division of Net Family Property ...... 436 Electing on Spouse’s Behalf...... 437 Net Family Property Includes ...... 438 Net Family Property Excludes ...... 439 Matrimonial Home(s) ...... 440 Valuation Issues ...... 442 Consequences of Electing for Equalization ...... 443 Deemed Election after Six Months ...... 444 Payment of Statutory Entitlement ...... 444 CCH CANADIAN LIMITED ♦ NT PAGER Username: zulika Date: 18-AUG-09 Time: 12:56 Filename: D:\books\b170\toc.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 13 Free lead: 430D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Page Planning Considerations ...... 446 Domestic Contracts ...... 446 Choice of Estate Trustee ...... 447 Reducing Net Family Property ...... 447 The ‘‘Net Family Property Freeze’’ ...... 451 Planning by Parents ...... 451 Constructive Trusts...... 453 Chapter 16 — Planning for Disabled Persons Introduction ...... 456 Registered Disability Savings Plans ...... 456 RDSPs and Provincial/Territorial Disability Savings Plan .... 460 Lifetime Benefit Trusts ...... 460 Disability Tax Credit ...... 462 Eligibility for DTC ...... 463 Disability Support and Attendant Care Expenses ...... 465 Registered Education Savings Plans ...... 468 Canada Education Savings Grant and Canada Learning Bond . . . 472 Home Buyers’ Plan ...... 474 2009 Budget Proposals ...... 476 Tax-Free Savings Accounts ...... 476 Trusts for Disabled Persons: General Comments ...... 478 Choosing a Trustee ...... 479 Preferred Beneficiary Election ...... 481 Life Insurance Trusts ...... 482 Ontario Disability Support Program ...... 483 Substantial Physical or Mental Impairment ...... 483 ‘‘Henson’’ Trusts ...... 486 Tax Complications Re Henson Trusts ...... 489

Index ...... 491 CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 1 Free lead: 210D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Chapter 8

Taxation of Basic Trusts Used in Estate Planning

HIGHLIGHTS ● Basic Concepts and Principles ● Residence of Trusts ● Transfer of Property to a Trust ● Computation of Trust Income ● Trusts and the Principal Residence ● Cottage Properties ● Testamentary Trusts ● Meaning of ‘‘Spouse’’ and ‘‘Common-Law Partner’’ ● Spousal Trusts ● Inter Vivos Trusts for Minors ● Distribution of Trust Property to the Beneficiaries ● Deemed Disposition After 21 Years ● Attribution Rules ● Tax on Split Income (the ‘‘Kiddie Tax’’) ● The Reversionary Trust Rules ● Appendix: Basic Types of Trusts

193 CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 2 Free lead: 185D Next lead: 545D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

194 The Estate Planner’s Handbook

Basic Concepts and Principles

Taxed as Individuals Pursuant to subsection 104(2) of the Income Tax Act, a trust (which includes an estate) is considered to be an individual and is therefore subject to tax in the same manner as other individual taxpayers. However, not every provision of the Act relating to individuals necessarily applies to trusts.

Fiscal Years The fiscal year-end of an inter vivos trust is deemed by paragraph 249.1(1)(b) to be December 31. Pursuant to (proposed) subsection 249(5), the taxation year of a testamentary trust does not have to be on a calendar year basis; however, it cannot exceed 12 months. The fiscal year can be based on the year for which accounts have ordinarily been made up. The first fiscal period of a testamentary trust must end no later than one year from the death of the settlor. Subsection 104(13) provides that a beneficiary include in income the amount paid or payable by the trust during the year. The beneficiary includes that amount in income in the calendar year in which the trust’s taxation year ends.

Tax Rates Pursuant to subsection 122(1), inter vivos trusts are subject to a flat rate of 29%. Testamentary trusts are subject to the same marginal rates of tax as individuals.

Tax Credits Subsection 122(1.1) provides that no deduction may be made for personal credits in computing the tax payable by a trust for a taxation year under section 118.

Minimum Tax Trusts are subject to the minimum tax in respect of income that is not paid or payable to beneficiaries. The $40,000 exemption from the minimum tax is available only to a testamentary trust. The $40,000 exemption must be shared by all trusts that arise as a consequence of contributions to the trust by the same individual.1

1 Special rules apply where income is accumulated in the trust and a preferred beneficiary election has been made. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 3 Free lead: 65D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 195

Residence of Trusts Generally, a trust (including an estate) is considered to reside where the trustee or other legal representative who manages and controls the trust resides. However, where a substantial portion of the de facto management and control of the trust rests with a person other than the trustee (such as the settlor or beneficiaries), then the residence of this other person may be considered to be determinative of the residence of the trust, regardless of any contrary provisions in the trust agreement. In certain cases, more than one trustee may be involved in exercising management and control of the trust. If one such trustee clearly exercises a more substantial portion of the management and control than the others, the trust will reside in the jurisdiction in which that trustee resides. Where two or more trustees exercise relatively equal portions of the management and control of the trust, and trustees exercising more than 50% of such management and control reside in one jurisdiction, the trust will reside in that jurisdiction. The CRA has indicated2 that the trustee who has management and control of the trust, while he or she may not have physical possession of the trust assets, will be the person who has most or all of the following powers or responsibilities: ● Control over changes in the trust’s investment portfolio. ● Responsibility for the management of any business or property owned by the trust. ● Responsibility for any banking and financing arrangements for the trust. ● Control over any other trust assets. ● Ultimate responsibility for preparation of the trust accounts and reporting to the beneficiaries of the trust. ● Power to contract with and deal with trust advisors, e.g., auditors and lawyers. A leading case on the issue is Thibodeau Family Trust v. The Queen,3 which involved a family trust with three trustees. Two of the trustees were resident in Bermuda and the other was resident in Canada. Under the trust deed, the Canadian trustee had sole power to appoint other trustees. A majority decision on all matters of trustee discretion was required. All assets were held in Bermuda. Similarly, all meetings of the trustees were held in

2 See Interpretation Bulletin IT-447, Residence of a Trust or Estate. 3 78 DTC 6376 (F.C.T.D.). CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 4 Free lead: 90D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

196 The Estate Planner’s Handbook

Bermuda and decisions relating to the administration were taken at these meetings. The Minister argued that the trust was a resident of Bermuda and Canada on the basis that the Canadian trustee had sole power to appoint other trustees and that he took a very active role in investment programs of the trust. The Court held that the trust was resident in Bermuda only because the majority of the trustees were resident in Bermuda and the trust document permitted a majority decision on all matters of trustee discretion. The residency of the beneficiaries, therefore, is not material for determining the residence of a trust.4 The question of residence is important for a number of reasons: ● The rollover of capital property to a spousal trust applies only if the property is transferred to a trust resident in Canada and the flow- through of the source of income applies only to a trust resident in Canada. ● To make the preferred-beneficiary election, both the trust and the beneficiary must be resident in Canada. ● Section 116 imposes a withholding on the sale of certain types of property by non-resident trusts. And note that, where a trust ceases to be a resident of Canada, paragraph 128.1(4)(b) deems a disposition of all property,5 and both unlisted and listed shares (if one owns more than 25% of the class of shares) at fair market value. This could result in capital gains and/or recapture, and could happen inadvertently, if a trustee having ownership and control of the property leaves Canada.

Inter-Provincial Tax Planning Using Trusts The issue of the residence of a trust leads naturally to that of inter- provincial tax planning. The fact that provincial tax rates vary significantly gives a taxpayer incentive to shift income to a low-tax province. A Canadian resident individual earning investment income is subject to tax thereon by the province in which he or she resides. The same applies to trusts. Most individuals would be unwilling to move to a low-tax province (e.g., Alberta) solely to access its lower tax rates. However, if they were establishing a trust, they might consider establishing it in a low-tax province. In fact, in certain circumstances, they might consider establishing a trust precisely to achieve this objective. Although the transfer of assets to a trust generally results in a

4 See also MNR v. Holden (1933), 1 DTC 243 (S.C.C.).

5 Except taxable Canadian property as defined in paragraph 115(1)(b). There are special rules for taxable Canadian property in section 116, which result in any gain thereon being taxed at the time of actual disposition. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 5 Free lead: 5D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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deemed disposition at fair market value, with immediate tax consequences for the settlor, this can be avoided where the trust in question is an alter ego, joint partner, or spousal trust. Establishing a testamentary trust in a low-tax province can also be advantageous. The basic considerations that apply to determining the residence of a trust have been outlined above. A bit more specifically, the following steps have been suggested to ensure that a trust is considered resident in Alberta:6 (i) Establishing a new trust is generally preferable to moving an existing trust. (ii) The trustees should be individuals, and they all should reside in the Province of Alberta. (iii) If not all the trustees reside in Alberta, a majority should reside there. (iv) No trustee who resides outside Alberta should have any power to veto the actions of the trustees, nor should that trustee have power to remove and/or appoint trustees. (v) The trustees should be responsible for administrative matters, including investment management, tax return preparation, custody of the assets, and reporting to the beneficiaries. (vi) If the trust is an existing trust which is being moved to Alberta, and if the trust terms provide that the trust will be governed by the laws of another jurisdiction, the trust should be varied to provide that Alberta law is the governing administration. (vii) No one, such as a protector, resident outside Alberta, should have the ability to veto trustee decisions. (viii) Bank and investment accounts should be established with a financial institution in Alberta. (ix) Meetings of trustees should be held in Alberta. (x) The trust should provide for the deemed cessation of trusteeship if a trustee ceases to reside in Alberta. (xi) T3 returns should be prepared by an accountant resident in Alberta and mailed to the Canada Revenue Agency from an Alberta address. (xii) Accounts of the trustee’s administration should be passed periodically before the Court of Queen’s Bench of Alberta. 6 Craig M. Jones, ‘‘Alberta Trusts’’, in Tax & Estate Planning 2002, Prairie Province Tax Conference. See, further, Martin J. Rochwerg, ‘‘Recent Developments in Estate Planning: the Alberta Advantage When Using Trusts’’, Estates and Trusts Law Summit, Tab 3, L SUC, CLE, December 2004. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 6 Free lead: 0D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Aside from successfully establishing the trust as resident in Alberta, inter-provincial planning poses a variety of technical hurdles; looming large among these is subsection 75(2), which is discussed in some detail below.7 There are also more subjective considerations; for instance, the settlor must be comfortable with the idea that the management and control of the trust assets will be in the hands of a third party residing in a different jurisdiction and that the settlor will not be able to interfere with or direct his or her decisions. Planning Points ● The issue of residence should be addressed at the outset. Consid- eration should be given to using a clause which would discharge a trustee immediately prior to him or her becoming a non-resident. ● The relevant parties should be warned of the possible negative tax consequences which may ensue if a non-resident trustee (or other individual) assumes de facto control of the trust assets. ● Provincial tax rates vary significantly. Where the trust will hold significant assets, consideration may be given to choosing trustees resident in a low-rate province such as Alberta.

Transfer of Property to a Trust

Consequences to Settlor When property is transferred to a trust, it generally results in a disposition under the Act. Accordingly, on the transfer of property to a trust by a settlor (or anyone else) the transferor will realize a capital gain to the extent the proceeds of disposition exceed the cost of the property — unless, of course, there is no accrued gain on the property at the time of transfer. If the transfer is by way of gift, the transferor’s proceeds of disposition are deemed to be the property’s fair market value (paragraph 69(1)(b)). Other wise, if the transferor and the trust deal at arm’s length no special rules apply, and the transfer price paid by the trust is the proceeds to the transferor and the acquisition cost to the trust. However, where the transferor does not deal at arm’s length with the inter vivos trust, the provisions of subsection 69(1) will apply. If the transfer is for no proceeds or for proceeds less than the fair market value of the property, the transferor is deemed to have disposed of the property at its fair market value. The result of such deemed disposition is that the accrued capital gains or losses will be realized 7 Also to be considered is the possible application of provincial anti-avoidance provisions; see David H. Sohmer, ‘‘Fundamental Issues In Shifting Income Tax to Low-Tax Provinces’’, Estates, Trusts & Pensions Journal [Vol. 22 2003] pp. 127–139. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 7 Free lead: 110D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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with respect to the property transferred or, in the case of depreciable property, recapture of capital cost allowance or terminal losses.

Consequences to the Trust In the case of a gift to a trust, the trust is deemed to have acquired the property at its fair market value. If property is transferred by a non-arm’s length person (e.g., settlor) for proceeds less than fair market value of the property (other wise by way of gift), the trust’s acquisition cost is the purchase price, not the fair market value. However, the transferor’s proceeds, as noted above, are deemed to be the fair market value of the property. Thus, when the trust ultimately disposes of the property, there will be an element of double taxation. There is an exception for transfers to certain trusts (e.g., a spousal trust) as discussed later in this Chapter. Transfers to such trusts can take place on a tax-deferred rollover basis.

Testamentary Trusts In the case of a transfer to a testamentary trust on the death of a taxpayer, subsections 70(5) and 70(5.2) provide that the deceased taxpayer is deemed to have disposed of capital properties, at their fair market value, immediately before death. To the extent the fair market value exceeds the property’s cost to the deceased, the deceased may be subject to tax in the final taxation year. The estate acquires such properties at that same fair market value. As with inter vivos trusts, there is an exception if the testamentary trust is a qualif ying spousal trust. In such case, the transfer can take place on a tax-deferred basis. Planning Points ● The transfer of property to a trust should be supported by appropriate documentation; other wise, controversy may arise as to whether a transfer was actually effected.8 ● Loans from a spousal trust (to anyone other than the spouse) should be made on commercial terms.

Computation of Trust Income As noted above, a trust is considered an individual for income tax purposes and is generally subject to the regular income-computation rules

8 The issue has arisen in a number of recent cases; for instance, see Romkey v. The Queen, 2000 DTC 6047 (Fed. C.A.), aff ’g. 97 DTC 719 (T.C.C.). CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 8 Free lead: 105D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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applicable to other individuals. Therefore, a trust must include income from any business carried on by the trust, income from any of its properties, and capital gains on dispositions of any of its property (even though under trust law, capital gains retain their character as capital under the trust, and not income). The trust will be subject to all of the rules governing the deduct- ibility of expenses so that, for example, in computing its income from a property, expenses are not deductible if they are not incurred for the purpose of earning the income from the property. A trust cannot claim personal tax credits available to other individuals, however, a trust can claim the charitable donation credit available under section 118.1.

Election Not To Deduct Distributions Made to Trust Beneficiaries The income of a trust in a given year must be taxed in the hands of the trust or the beneficiaries. It is therefore necessary to allocate the income between them for tax purposes. With certain exceptions, pursuant to subsection 104(6), trusts may deduct an amount not exceeding the amount of income (including taxable capital gains) payable in the year to a beneficiary. An amount is payable if it is paid in the year, or if the person to whom it was payable had a right to enforce payment in the year.9 Note that a trust is not required to deduct from its income all of an amount payable to a beneficiary. It can deduct only part of the amount payable. This creates an income-splitting potential for certain testamentary trusts.10 A testamentary trust whose beneficiaries are taxed at a higher marginal rate than the trust can take advantage of the low marginal tax rates to which it is entitled by deducting from its income only part of the amounts which became payable to its beneficiaries. The trust would then designate the appropriate portion of its income actually payable to its beneficiaries as not being payable. That portion will be taxed in the trust at the trust’s lower tax rate, instead of in the hands of the beneficiaries (see paragraph 104(6)(b) and subsections 104(13.1) and 104(13.2)). Even if the terms of the trust require income to be payable to the beneficiary (as must be the case with a spousal trust), the trust may elect to have some of its income taxed in the trust even though it is payable and must be distributed to the beneficiary. However, this valuable income-splitting opportunity may be foregone where probate planning (inter vivos gifts,

9 Pursuant to subsection 104(24), the time at which the payment is actually made is not relevant.

10 Inter vivos trusts, taxed at the highest marginal rate, would have no motivation for not deducting income payable to a beneficiary. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 9 Free lead: 25D Next lead: 195D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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joint tenancy with right of survivorship, etc.) has resulted in the deceased’s assets passing outside his or her estate directly to the beneficiaries. An estate is considered a trust for tax purposes, so any estate can take advantage of this election during its first year — i.e., before it is wound up. And, if, rather than calling for the immediate distribution of the estate, the will establishes an ongoing testamentary trust, it will be possible to do this year after year. Planning Points ● A subsection 104(13.1) election could permit income to be taxed in an Alberta-resident trust but distributed to beneficiaries who are not resident in Alberta. ● A testamentary trust can serve to avoid the OAS clawback if it is possible and practical to keep the beneficiary’s taxable income below the threshold amount ($66,335 for 2009). The balance of the income can be taxed in the trust. ● Where the income-splitting election noted above was not made because the taxpayer was unaware of it, it is possible to file an amended return taking advantage of it.11

Flow-Through of Trust Income Where the trust’s income is distributed to a beneficiary or other wise included in the income of the beneficiary, some of it retains its source for the purposes of calculating the beneficiary’s tax liability. In particular, dividends received from Canadian resident corporations and capital gains realized by the estate, which are in turn included in income of the beneficiary, will, to the extent so designated in the estate’s return for the year, constitute dividends and capital gains, respectively, to the beneficiary (see subsections 104(19) through 104(21)). In such cases, for example, the individual beneficiary can enjoy the preferential tax treatment accorded to taxable dividends received from Canadian corporations (dividend tax credit available), and to taxable capital gains (only one-half included in income). By virtue of subsection 104(21.2), where the capital gain flowed through to a beneficiary would other wise qualif y for the enhanced capital gains exemption (i.e., dispositions of shares of small business corporations or qualified farm property), that exemption can be flowed through to a beneficiary. There are also provisions which flow-through pension benefits, deferred profit-sharing plan benefits, and death benefits received by the estate and passed out to its beneficiaries.

11 See Lussier v. The Queen, 2000 DTC 1677 (T.C.C.); following this case, the CRA has indicated that it will accept amended returns where the election was not made due to an honest mistake, including a lack of awareness of it. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 10 Free lead: 175D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Planning Point ● The CRA has confirmed that, as it sees it, under subsections 104(21) and 104(21.2), a personal trust could designate an amount of its net taxable capital gain in respect of each of its beneficiaries and that each of the latter could claim the capital gains exemption in respect thereto.12 It added the provision that the trust’s distributions must, of course, comply with the trust instrument and applicable law.

Losses of the Trust Deductions and losses of the trust cannot be directly flowed out to the trust’s beneficiaries. These amounts must be claimed at the trust level. However, as noted earlier, the trust can elect that any portion of income payable to its beneficiaries remain taxable to the trust rather than the beneficiary (see paragraph 104(6)(b) and subsections 104(13.1) and 104(13.2)). That income at the trust level could then be absorbed by the trust’s available deductions or losses. In effect, then, the deductions or losses of the trust can be used to benefit the beneficiaries. Assume, for example, that the trust had loss carryfor wards available in a particular year, but was required to distribute all of its income in the year to its beneficiaries. There would be no net income to which the loss carryfor- wards could be applied, because the income paid to the beneficiaries would be deductible to the trust. However, using the election described above, the trust could elect that the portion of income distributed to the beneficiaries, equal to the amount of the trust’s loss carryfor wards, remain in the trust’s income and not be included in the beneficiaries’ income. The trust could shelter the income with its loss carryfor wards, and the income would be received by the beneficiaries free of tax.

Rollover of Capital Property of a Trust One of the most important characteristics of trusts for estate planning purposes is their ability to transfer property to a beneficiary in satisfaction of the beneficiary’s capital interest in the trust on a tax-deferred basis. A capital interest is defined as a right (whether immediate or future and whether absolute or contingent) to receive all or any part of the capital of the trust. Basically, subsection 107(2) provides that trust property is passed on to the beneficiary at the trust’s cost or adjusted cost base, so that on later actual disposition by the beneficiary, any capital gains or losses, recapture,

12 See Document No. 2004-0086971C6, dated July 10, 2004. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 11 Free lead: 115D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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or terminal loss accrued while the trust owned the property, will belong to the beneficiary — who will in turn pay the appropriate tax.

Preferred Beneficiary Election Under subsection 104(14), a trust and a ‘‘preferred beneficiary’’ under the trust may elect to have a portion of the trust’s accumulating income (not exceeding the allocable amount for the preferred beneficiary) included in computing the income of the preferred beneficiary for the beneficiary’s taxation year in which the trust’s taxation year ended. Such elected amount is excluded from the income of any beneficiary under the trust (not necessarily the beneficiary making the election) for a subsequent taxation year in which it is paid. The allocable amount for a preferred beneficiary for a taxation year generally means the trust’s accumulating income for the year. A trust’s accumulating income for a taxation year generally means its income for the taxation year calculated before deducting any amount included in computing income of a preferred beneficiary because of a preferred-beneficiary election.13 Pursuant to the definition in subsection 108(1), to qualif y as a preferred beneficiary, an individual must qualif y for the disability tax credit under subsection 118.3(1). The disability tax credit is only available if the individual has a severe and prolonged mental or physical impairment. However, adults (i.e., those who are 18 years of age or older) not qualif ying for the disability tax credit, who are nevertheless dependent on another person because of mental or physical infirmity, may qualif y as preferred beneficiaries if their income (determined before allocations under the preferred beneficiary election) is below the basic personal amount ($10,320 for 2009). This dependant tax credit can generally be claimed under paragraph 118(1)(d) by the supporting person for an individual who is dependent on them because of a mental or physical infirmity. The preferred beneficiary election must generally be filed within 90 days from the end of the trust’s taxation year. Late, amended, or revoked elections can be made in limited circumstances (generally those beyond the control of the trustee and beneficiary), if the Minister so permits and a late- filing penalty is paid. Generally, all income of a trust payable in the year to a beneficiary (and amounts not so payable but on which a preferred beneficiary election has been made for the year) are included in the income of the beneficiary for that year. This will be especially significant for an inter vivos trust the income of which would other wise be taxed at the highest marginal rate. The

13 For a more detailed discussion, see Interpretation Bulletin IT-394R2, Preferred Benef iciary Election. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 12 Free lead: 15D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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election will also be beneficial for testamentary trust income, which is sufficient to put it in a higher tax bracket than the beneficiary. If an amount is payable but not paid, it is not included in the beneficiary’s income in a later year when it is paid. Once a preferred beneficiary election is made on a particular amount of income, that amount is not included in the income of any beneficiary in a later year when it is actually paid. An amount is not considered to be payable in the year unless the beneficiary was entitled to enforce payment in that year. If, without the exercise or non-exercise of a discretionary power, trust income has uncondi- tionally vested (other than survival to an age not exceeding 40 years) in a beneficiary less than 21 years of age at the end of the year, it will be considered to be payable to such a beneficiary during the year. Planning Points ● Given that the preferred beneficiary election is (since 1995) no longer generally available, as an alternative, trusts meeting the requirements of subsection 104(18) may achieve a similar effect, i.e., to shift the tax liability to a beneficiary, where such beneficiary’s right to the annual income has vested, but is not payable to him or her due to a clause in the trust agreement prohibiting such distribution while he or she is a minor. ● In making the preferred beneficiary election, be careful not to compromise the beneficiary’s entitlement to means-tested provincial assistance programs.

Upkeep, etc., of Trust Property Subsection 105(2) provides that where, on the terms of a trust, property must be maintained for the use of a life tenant or beneficiary, any income of the trust paid for upkeep, maintenance, or taxes on the property is to be included in the income of the life tenant or beneficiary. Subsection 104(6) allows a corresponding deduction to the trust. A common example would be where a man and his wife own the family home in joint tenancy and he provides in a trust will that upkeep, maintenance, and taxes on the home are to be charged to the income of his estate. It should be noted that mortgage payments would not constitute a payment for upkeep, maintenance, or taxes paid. Subsection 105(2) speaks positively of taxing the life tenant on such part of the maintenance expenses ‘‘as is reasonable’’. It would seem that the life tenant is to be taxed on the portion of expenses that can be considered reasonable in the circumstances to have been expended for his benefit, e.g., normal repairs, painting, gardening, annual real estate taxes, etc. Such CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 13 Free lead: 130D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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major and long-term expenses as landscaping or special assessments for local improvements might properly be considered an expense that the trust should bear on behalf of the remainder man and therefore could not reasonably be considered a benefit of the life tenant to be included in his income. The application of subsection 105(2) will normally be desirable in the case of an inter vivos trust: the beneficiary may be taxed at a lower rate, and have more credits and deductions available. On the other hand, this may not be the case in regard to a testamentary trust. Where it is judged advantageous to do so, the trustees can use a subsection 104(13.1) designation to have amounts to which subsection 105(2) applies taxed in the trust.

Trusts and the Principal Residence For any number of estate planning reasons, it may be desirable to have a principal residence held through a trust. This can be done without compro- mising the principal residence exemption; however, special rules have to be adhered to. The Income Tax Act allows a home owned by a ‘‘personal trust’’ to qualif y as a principal residence if the home was ordinarily inhabited in the calendar year ending in the relevant fiscal year of the trust by an individual beneficiary of the trust or a child, spouse, or former spouse of such a beneficiary. A beneficiary who satisfies this test is referred to as a ‘‘specified beneficiary’’. A personal trust is defined by subsection 248(1). Generally, a personal trust is either a testamentary trust or an inter vivos trust where all of the beneficiaries receive their interests as gifts. In order to limit the types of taxpayers who can benefit from the principal residence exemption in respect of a home held through a trust, a number of limitations are placed on the ability of a personal trust to claim the benefit of the exemption. Pursuant to paragraph (c.1) of the definition of ‘‘principal residence’’ in section 54, a taxpayer that is a personal trust may designate a property as a principal residence if: ● the designation is made in the prescribed form and manner (the prescribed form is T2091); ● each individual who, in the calendar year ending in the taxation year, is beneficially interested in the trust and ordinarily inhabits the housing unit, or has a spouse, former spouse, or child that ordinarily inhabits it, is listed in the designation; ● no corporation other than a registered charity or partnership is beneficially interested in the trust at any time in the year; CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 14 Free lead: 90D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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● no other property has been designated for the year as a principal residence by a specified beneficiary of the trust, or by the beneficiary’s spouse (other than a spouse who was, throughout the year, living apart from and was separated, pursuant to a judicial separation or written separation agreement, from the beneficiary); ● by a person who was the beneficiary’s child (other than a child who was during the year a married person or 18 years of age or over); or ● where the beneficiary was not a married person during the year or a person 18 years of age or over, by a person who was his or her mother or father, or his or her brother or sister, who was not a married person during the year or a person 18 years of age or over. The designation, which must be filed by the trust, must specif y each individual who was a specified beneficiary of the trust in the calendar year ending in a relevant fiscal year of the trust. A designation by the trust is not valid if any of the following persons have designated any other property as their principal residence: ● a specified beneficiary of the trust; ● a spouse of a specified beneficiary, unless the spouse is living apart from the specified beneficiary, pursuant to a judicial separation or a written separation agreement; ● a child of the specified beneficiary unless the child is at least 18 years old or married; ● a parent of the specified beneficiary unless the specified beneficiary is either married or at least 18 years old; or ● a sibling of the specified beneficiary unless either the sibling or the specified beneficiary is either married or at least 18 years old. A property which is validly designated as the principal residence of a trust is deemed to have been designated by each specified beneficiary of the trust as that person’s principal residence for the calendar year ending in the relevant fiscal year of the trust. This rule prevents the trust beneficiaries from designating any other property as their principal residence for the year. Subsection 107(2.01) generally allows a personal trust to claim the principal residence exemption on a transfer of a principal residence to a beneficiary of the trust in satisfaction of all or part of his or her interest in the trust. Formerly, only spousal trusts described in subsection 70(6) or 73(1) could benefit from this provision. Where the trust so elects in its return, for the year in which the transfer is made, the trust is deemed to have disposed of the property (the principal CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 15 Free lead: 5D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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residence) immediately before the transfer at fair market value and to have reacquired the property at that same fair market value. If the property qualifies as a principal residence of the trust, the trust should be able to claim the principal residence exemption on any resulting capital gain. As a result of subsections 107(2) and 107(2.01), the beneficiary will generally acquire the property (the trust’s principal residence) at fair market value, and any subsequent accretion in value can be sheltered upon a subsequent disposition by the beneficiary, assuming the property becomes the principal residence of the beneficiary. Without subsection 107(2.01), the beneficiary acquiring the property may be put in a position where he or she will be paying tax (on a subsequent disposition by the beneficiary) on the gain which accrued while the property was in the trust, for which no principal residence exemption was previously claimed. That is, the property would generally be rolled over to the beneficiary under subsection 107(2) at the historical cost of the property to the trust, and assuming the beneficiary did not ordinarily inhabit the property while it was owned by the trust, the property would not qualif y as the beneficiary’s principal residence for those years it was owned by the trust. (Subsection 40(7) provides that the beneficiary is deemed to have owned the property continuously since the trust last acquired it, but it does not provide that the beneficiary inhabited the property over that time.)

Trust Holds More than One Property14 If a trust owns multiple residences, the trust may only designate one of the residences in respect of any particular year. This is the result of paragraph (f) in the definition of ‘‘principal residence’’, which deems each property that is designated as a principal residence by the trust to be designated as a principal residence by each specified beneficiary, and subparagraph (c.1)(iv) of the same definition, which precludes the trust from designating a property if a specified beneficiary of the trust has designated any other property. Consequently, where a personal trust owns more than one home (perhaps because a parent is using a single trust to hold two homes pur- chased for two adult children), only one of the homes may be designated as a principal residence in a year. Moreover, because the property designated by the trust is deemed to be designated by each specified beneficiary, none of the specified beneficiaries will be able to designate another property for that year. As for beneficiaries of the trust who are not ordinarily inhabiting the same housing unit and who are, therefore, not specified beneficiaries, the trust would not be able to designate the second housing unit because another property has been designated in respect of another specified, beneficiary.

14 From Jack Bernstein and Elisabeth Atsaidis, ‘‘Residence Trust: Tips and Traps’’, TAX PROFILE, February 2009. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 16 Free lead: 65D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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If the homes in question were owned outright by the children, both homes would be eligible to be designated as principal residences in a year, because adult siblings do not form a family unit. Therefore, if parents wish to purchase homes in trust for children, or if they wish to use a trust to hold a cottage or a vacation home, they should use a separate trust for each property. There does not appear to be any policy reason why a trust could not own two residences, each occupied by a different adult child, and designate them as principal residences. Notwithstanding this, if parents wish to hold a different residence in trust for several children who occupy the housing units, separate trusts should be used for each residence. The trusts could be discretionary trusts, with some or all of the children being beneficiaries of each trust and with the parents not being beneficiaries of any of the trusts. In such circumstances, only the child beneficiary occupying the residence of a particular trust would qualif y as a specified beneficiary of that trust, and where the child is of majority, only that child, his or her spouse, and his or her unmarried minor children would be deemed to have designated the residence.

Cottage Properties15 Where the property in question is a cottage property, the issue becomes whether the cottage is ‘‘ordinarily inhabited’’ by the family. Arguably, every family member who is a beneficiary and has enjoyed sea- sonal use of the cottage ordinarily inhabits the cottage. Therefore, the designation of the cottage may adversely affect the principal-residence exemption of several beneficiaries. As indicated above, where a trust designates a particular property as a principal residence for a year, it will be deemed to be so designated by every ‘‘specified beneficiary’’ of the trust for the year. If every beneficiary of the trust uses the cottage — even occasion- ally — they may all be precluded from claiming another principal residence exemption if the trust so designates the cottage. A trust owning a cottage will be subject to the 21-year deemed disposition unless the assets are transferred to Canadian-resident beneficiaries before the 21st anniversary of the trust.

Planning Considerations ● Where a family owns a principal residence and is acquiring a second residential property (for example, a cottage), consideration should be given to taking title to the cottage in the name of a trust for the exclusive benefit of family children who are minors. If the trust sells

15 Ibid. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 17 Free lead: 220D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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the property, the capital gain that accrues during the period of ownership by the trust will not be attributed back to the trust settlor and instead can be paid out to the children. This will achieve an income-splitting effect. Alternatively the property can be rolled out to the children by the trust on a tax-deferred basis under subsection 107(2). The ownership of the cottage by the trust or subsequent distribution to the children will not impair the ability of the spouses to claim the principal residence exemption on the family home if no attempt is made to designate the cottage as the family’s principal residence in any year during which one of the trust beneficiaries is a minor.

● If a trust is established to hold a secondary residence exclusively for the benefit of adult children, it may be possible for the trust to claim the principal residence exemption (without impairing the principal residence exemption on the parents’ home). In this case, however, each beneficiary who ‘‘ordinarily inhabits’’ the secondary residence (or has a spouse, former spouse or child who so uses it) will be deemed to have claimed the principal residence exemption — so the beneficiary will not be able to claim a second exemption.

● Ownership of a secondary residence by a trust should prevent capital gains tax on death that would other wise occur on future apprecia- tion if it were to be held by the parents. This may be a particularly pertinent issue where the second home is a vacation property intended to be enjoyed by succeeding generations.

● Where a property that qualified as a principal residence of the taxpayer is being transferred to a spousal trust, it may be advantageous to elect out of the rollover if the property is not going to be sold by the trust or transferred to the spousal beneficiary. If the principal residence exemption is employed to shelter the gain arising on the transfer to the trust, a tax-free bump in the cost base of the property will benefit the capital beneficiary who ultimately receives the home.

● Where both spouses (or common-law partners) are potentially exposed to creditors (e.g., where they are partners in a business), it CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 18 Free lead: 0D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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may be appropriate for them to transfer the principal residence to a discretionary trust.

Testamentary Trusts

Introduction

Testamentary trusts have an obvious importance in estate planning. Subsection 108(1) of the Income Tax Act defines a testamentary trust to be, generally, a trust or estate that arose on and as a consequence of the death of an individual and that was not created by a person other than the deceased individual. A testamentary trust can lose its status as such if property is contributed to it by any other individual other than the individual upon whose death it was created. A trust that is not a testamentary trust is an inter vivos trust. Qualif ying as a testamentary trust brings some significant income tax advantages: ● Income retained in a testamentary trust (or designated to be taxed in the trust) is taxed at normal progressive tax rates rather than at the maximum personal tax rate (which is applicable to inter vivos trusts). ● The trustee can deduct from the trust’s income any amounts of income paid to a beneficiary. Where the trust is discretionary, this allows income to be channelled, without fear of the attribution rules, to family members who are low-rate taxpayers, so that the family as a whole pays less tax. ● The trustee can choose a non-calendar year end for a testamentary trust, thus allowing deferral of a beneficiary’s obligation to pay income tax on income flowed to the beneficiary out of the trust. ● The trustee is not obligated to make quarterly instalments on account of income tax owed by a testamentary trust. ● The personal representative of a deceased beneficiary can file a separate income tax return reporting income for the stub period (the period, if any, following the fiscal year end of the trust until the date of the death of the beneficiary).

Status as a Testamentary Trust For the purposes of the Income Tax Act, a trust is either an inter vivos trust (defined in subsection 108(1)) or a testamentary trust. A testamentary trust is, in general, a trust or estate which arises on the death of an individual and as a consequence of that death. It includes a trust described in CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 19 Free lead: 305D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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subsection 248(9.1), which is a trust created under the terms of a will or by an order of a court made pursuant to dependents’ relief legislation. A testamentary trust does not include a trust created by a person other than the individual who died.

The definition of ‘‘testamentary trust’’ in subsection 108(1) has important consequences to the income-splitting potential of testamentary trusts, which have arisen as a result of amendments to paragraph 104(6)(b) and the enactment of subsections 104(13.1) and 104(13.2). Previously, a trust was required to deduct from its income all of an amount payable to a beneficiary, and could not deduct only part of the amount payable. The effect of the amendment to paragraph 104(6)(b) is to permit a trust to deduct as much or as little of an amount payable to a beneficiary.

A testamentary trust whose beneficiaries are taxed at a higher marginal rate can take advantage of the low marginal rate to which the trust is entitled by using paragraph 104(6)(b) to deduct from its income only part of the amounts which became payable to its beneficiaries. The trust would then designate the appropriate portion of its income actually payable to its beneficiaries as not being payable (subsections 104(13.1) and 104(13.2)). That portion will be taxed in the trust at the trust’s lower tax rate, instead of in the hands of the beneficiaries.

In the situation where the testamentary trust is required to distribute all of its income to its beneficiaries, this income-splitting technique may not be available. If such a trust designates any part of its income which is distributed to its beneficiaries as not payable to the beneficiaries, this amount will be taxed in the hands of the trust. Because all its income will have been distributed, the trust will have to encroach on the capital of the trust to cover its tax liabilities. No problem arises if the terms of the trust are such that this would be a permitted encroachment for the benefit of the beneficiary in respect of whom a designation was made under subsection 104(13.1) or 104(13.2). Successive Trusts

The CRA is of the view that a testamentary trust does not need to be established at the time of death, providing the creation of the trust is pursuant to the terms of the deceased’s will. Consequently, where the terms of the deceased’s will provide that on the death of the first generation beneficiary (e.g., the surviving spouse), new trusts for the successive interests of second generation beneficiaries (e.g., children) would be created, the successive trusts would be testamentary trusts.16

16 See Document No. 9801035, dated September 22, 1998. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 20 Free lead: 90D Next lead: 1035D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Trust Settled With Funds from an Alter Ego or Joint Partner Trust It is the CRA’s view that the property of an alter ego trust or joint partner trust cannot be transferred to a testamentary trust after the settlor’s death or the death of the settlor and his or her spouse or common-law partner. As defined, a testamentary trust does not include a trust that is created by someone other than the deceased or a trust where any property is contributed other wise than by an individual on or after the individual’s death and as a consequence thereof. The property settled on the alter ego, joint spousal, or common-law partner trust does not belong to the settlor at the time of his or her death.17 Trust Settled with Life Insurance Funds The CRA is of the view that a trust funded from the proceeds of a life insurance policy, available on the death of an individual, will be viewed as a testamentary trust, even though its terms have been established by the individual during his lifetime and separate from his will.18 It also noted, however, that the trust would not constitute a trust created by a taxpayer’s will, within the meaning of subsection 70(6.1). Accordingly, it would not qualif y as a spousal trust for the purposes of subsection 70(6). Trust Settled with RRSP/RRIF Funds As noted above, a trust will not qualif y as a testamentary trust where property has been contributed to it ‘‘other wise than by an individual on or after the individual’s death and as a consequence thereof’’. Initially, the CRA indicated that this would apply where property held in an RRSP or RR IF that is a trust is transferred to a second trust after the beneficiary’s death.19 The CRA subsequently acknowledged that paragraph 248(8)(a) could apply where the designation of a trust as a beneficiary of a taxpayer’s RRSP after the individual’s death ‘‘amounted to a testamentary instrument under the applicable provincial legislation’’.20 Under paragraph 248(8)(a), ‘‘a transfer, distribution or acquisition of property under or as a consequence of the terms of the will or other testamentary instrument . . . shall be considered to be a transfer, distribution or acquisition of the property as a consequence of the death of the taxpayer . . .’’.21

17 This is one of the more serious limitations of these trusts; see Document No. 2001-0079285, dated November 2, 2001. 18 See Document No. 9238555, dated February 4, 1993 and Document No. 9605575, dated December 17, 1996. 19 See Document No. 2002-0143685, dated January 29, 2003. 20 See Document No. 2003-0007365, dated June 20, 2003.

21 This issue is discussed further in Chapter 9. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 21 Free lead: 10D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Planning Point ● A testamentary trust with multiple income beneficiaries can be used to ‘‘sprinkle’’ within the family unit — including children who have little or no other income and yet who are entitled to the full basic personal exemption ($10,320 for 2009). In this manner, it may be possible for significant amounts of trust income to be earned effectively tax free.

Loss of Testamentary Trust Status A testamentary trust may lose its status as such in a number of ways (typically involving a faux pas by the trustees). Thereafter, it will be taxed as an inter vivos trust. Contributions A testamentary trust will cease to be such, where property has been contributed to it ‘‘other wise than by an individual on or after the individual’s death and as a consequence thereof’’. For example, in Greenberg v. The Queen22 an estate ceased to qualif y as a testamentary trust when one of its beneficiaries contributed $230,000 to it for no consideration in order to replenish its capital fund. This payment clearly met the Court’s under- standing of a contribution to be ‘‘a voluntary payment made to increase the capital of the estate’’. Note that it is the ‘‘contribution’’, not the transfer of property, that is at issue. Accordingly, no problem should arise where the trust acquires property by paying for it at its fair market value. In other circumstances, it not always so clear as to whether a contribution has been made or not. A spousal trust may, with the consent of the spouse-beneficiary, retain income payable to that beneficiary. The CRA has recently confirmed that, as it sees things, the retention of income by the trust will not result in a contribution of property to the trust, where the trust instrument provides that, before the amount becomes payable, the spouse can elect not to receive the income for a specific year.23 The CRA also noted that: ● Notification by the spouse-beneficiary that he or she does not wish to receive the income of a trust before it becomes payable would result in a disposition of the spouse’s right to that income.24 However, this would generally not be viewed as increasing the capital of the trust or as a contribution of property to the trust. 22 97 DTC 1380 (T.C.C.). 23 See Document No. 2003-0046171E5, dated December 1, 2004.

24 See Interpretation Bulletin IT-385R2, Disposition of an income interest in a trust. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 22 Free lead: 145D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

214 The Estate Planner’s Handbook

● Where the spouse-beneficiary elects not to receive the income of the trust after the amount becomes payable, the income of the trust would be included in the income of the spouse-beneficiary unless an election under subsection 104(13.1) is made. In this case, the income of the trust is property that results in an increase in the capital of the trust. ● Where an election under subsection 104(13.1) is made, a beneficiary may agree to pay the trust’s tax liability arising from the designation. The payment of the tax is not a contribution for the purposes of the definition of ‘‘testamentary trust’’. Failure To Make Mandatory Capital Distributions The CRA indicates that a testamentary trust may become an inter vivos trust where the assets of an estate are not distributed in accordance with terms of the deceased’s will.25 Payment of Capital Expenses by Beneficiary The CRA has expressed the view that the payment of the operating expenses of the trust’s property (e.g., a cottage) by the beneficiary using that property is not a contribution to the trust. However, such a payment would be considered to be a contribution where the payment is made as a capital expenditure in respect of the trust’s property.26 Payment of Taxes The CRA considers that a payment of cash to a trust to enable it to pay its liabilities is a contribution of property to the trust for the purposes of the definition of ‘‘testamentary trust’’ in subsection 108(1).27 However, as noted above, where a beneficiary has agreed to reimburse the trust for income tax payable by the trust, by virtue of a designation to the beneficiary under subsection 104(13.1) or 104(13.2), the reimbursement will not be considered as a contribution of property to the trust.

Pending Amendment Regarding Advances Made to a Testamen- tary Trust (or Estate) Draft legislation, first announced on December 20, 2002, proposes to amend the definition of ‘‘testamentary trust’’ in subsection 108(1). This amendment is an anti-avoidance rule. As noted above, to prevent the inappropriate use of testamentary trusts for income-splitting purposes, where

25 See Document No. 2002-0172475, dated May 30, 2003. 26 See Document No. 2002-0154435, dated April 17, 2003. 27 See Document No. MR91-335, dated March 5, 1991. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 23 Free lead: 105D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 215

property is transferred to a testamentary trust, other wise than as a consequence of the death of the individual, it is deemed to be an inter vivos trust. The proposed amendment would tighten the rules by prohibiting loans as well as outright transfers of property. New paragraph (d) of the definition ‘‘testamentary trust’’ is an anti- avoidance rule. That new paragraph provides that a testamentary trust in a taxation year does not include a trust (including an estate) that incurs after December 20, 2002 and before the end of the taxation year a debt or any other obligation to pay an amount to, or guaranteed by, a beneficiary or any other person or partnership (referred to in this commentary as the ‘‘specified party’’) with whom any beneficiary of the trust does not deal at arm’s length. However, such a debt will not affect the status of the trust as a testamentary trust if it is a debt or other obligation owed to the specified party and ● it is incurred by the trust in satisfaction of the specified party’s right as a beneficiary under the trust to enforce payment of an amount of income or capital gains payable by the trust to the specified party or to other wise receive any part of the capital of the trust, ● it arose because of a service (for greater certainty, not including any transfer or loan of property) rendered by the specified party to, for, or on behalf of the trust; for example, this would include debts or other obligations arising in respect of services rendered in a person’s capacity as an executor or administrator of an estate, as a liquidator of succession, or as a trustee of a trust, or ● it arose because of a payment made by the specified party for or on behalf of (but not to) the trust; for example, a payment of funeral expenses on behalf of the deceased’s estate. However, to qualif y under this provision, additional conditions must be satisfied. In very general terms, these conditions are that the trust fully reimburse the specified party within a year of the specified party making the payment. More precisely, in exchange for the payment, the trust must transfer property (the fair market value of which is not less than the principal amount of that debt or other obligation that arose because of the payment) to the specified party within 12 months after the specified party made the payment (or, where written application has been made to the Minister by the trust within that 12 months, within any longer period that the Minister considers reasonable in the circumstances). A transfer of property, within the required period by the trust to the specified party, which does not result in the settlement or cancellation of that debt or obligation would not satisf y this requirement. It must also be reasonable to conclude that the specified party CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 24 Free lead: 490D Next lead: 555D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

216 The Estate Planner’s Handbook

would have been willing to make the payment if the specified party dealt at arm’s length with the trust. This third requirement is suspended, however, where the trust is an individual’s estate and the payment giving rise to the debt or obligation was made within the first 12 months after the individual’s death (or, where written application has been made to the Minister of National Revenue by the estate within that 12 months, within any longer period that the Minister considers reasonable in the circumstances).

These amendments apply to trust taxation years that end after December 20, 2002. However, a transfer that is required by clause (d)(iii)(B) of the definition ‘‘testamentary trust’’ in subsection 108(1) to be made within 12 months after a payment was made is deemed to have been made in a timely manner if it is made within 12 months after this amended definition receives Royal Assent. In effect, the deadline imposed by that clause for the full reimbursement of the specified party by the trust or estate is extended, without need for written application, provided that the full reimbursement is made within 12 months after Royal Assent.

In addition, for taxation years that end before Royal Assent, the exception from the arm’s length condition for obligations owed by an estate (which condition and exception are set out in clause (d)(iii)(C) of the definition) will apply so that a payment that is made by a specified party for or on behalf of the estate, and that is described in clause (d)(iii)(A), will not be subject to the arm’s length requirement where the payment is made at any time within 12 months after Royal Assent.28

Planning Point

● Estate practitioners will have to take care to advise personal representatives not to accept advances from a beneficiary (or from a person who does not deal with a beneficiary at arm’s length) unless the above conditions are scrupulously complied with.

● Where a liquidity problem is anticipated, the personal representative should be advised to write the Minister as soon as possible to request permission to accept advances beyond the 12-month period and to delay repayment beyond 12 months.

28 For these taxation years, if such a qualif ying payment is not made within 12 months after Royal Assent, then the Minister may grant a further extension of the period beyond 12 months after Royal Assent, if written application is made to the Minister by the estate within 12 months after Royal Assent. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 25 Free lead: 165D Next lead: 175D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Income-Splitting Through Multiple Testamentary Trusts Not only can a testator establish a trust that may be in a position to engage in post-mortem income splitting between itself and its beneficiaries, it is also possible to establish two or more testamentary trusts, each of which could take advantage of this opportunity. Since testamentary trusts are taxed at graduated tax rates, there will be a tax saving where, for example, the deceased’s will creates a separate trust for each of his or her children. Each trust will have a lower marginal rate than would be the case if there were only one trust accounting for all of the deceased’s property. Addition- ally, the trust income can be sprinkled amongst the various beneficiaries. The multiple testamentary trusts strategy assumes that the assets of the estate are substantial enough to make it worthwhile; the annual income generated therefrom should exceed $30,000. It is also subject to the provisions of subsection 104(2). Where several trusts have been created, substantially all the property in each of them has been received from a single person and the income from the various trusts accrues ultimately to the same beneficiary or class of beneficiaries, subsection 104(2) allows the Minister to tax the several trusts as though they were a single taxpayer. It has been held that this provision was not applicable to four trusts where the beneficiary of each trust was a different child of the settlor.29 Planning Points ● Where the testator has a number of children, the possibilities for income splitting will be increased, if the will establishes a separate trust for each. ● Each child could be the sole trustee with complete discretion regarding distributing any portion of the income or capital to the beneficiaries of the trust, including himself or herself. This would have the result that he or she would have virtually the same access to the assets of the trust than if he or she were the outright owner of the assets. ● For each trust to serve effectively as a separate taxpayer, the trustees must, of course, have the power to accumulate income.

Meaning of ‘‘Spouse’’ and ‘‘Common-Law Partner’’ The question of who qualifies under the Income Tax Act as a ‘‘spouse’’ or ‘‘common-law partner’’ of a taxpayer is important for a number of reasons, including:

29 Mitchell v. M.N.R., (T.A.B.) 56 DTC 521. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 26 Free lead: 135D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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● The attribution rules. ● The inter vivos spousal and spousal trust rollover of capital property. ● The testamentary spousal and spousal trust rollover of capital property. ● The spousal rollover of RRSPs and RR IFs. ● The rollover to a trust defined in subsection 248(1) as a ‘‘joint spousal or common-law partner trust’’ (but commonly referred to as a ‘‘joint partner trust’’). Not so long ago, the term ‘‘spouse’’ was taken to mean the person to whom one was legally married at a given point in time.30 However, beginning in 1988, common-law partners began to be treated as ‘‘spouses’’ for tax purposes. For 1993 and subsequent years up to and including 2000, paragraph 252(4)(a) provided that for the purposes of the Act, the term ‘‘spouse’’ included a common-law spouse of the opposite sex. In particular, a spouse of a taxpayer included a person of the opposite sex who cohabited with the taxpayer in a conjugal relationship, provided that they had cohabited throughout a 12-month period before that time. In addition, a spouse of a taxpayer included a person of the opposite sex who was a parent of the taxpayer’s child. The extended meaning of spouse in paragraph 252(4)(a) has been repealed and effectively replaced with the new definition of ‘‘common-law partner’’, applicable to the 2001 year and subsequent taxation years. Hence- forth, all provisions in the Act referring to spouses and marriage will refer to common-law partners and common-law partnerships. Under the definition in subsection 248(1), a ‘‘common-law partner’’ of a taxpayer at any time means a person who cohabits in a conjugal relationship with the taxpayer, provided that, either: ● they have so cohabited throughout a continuous one-year period before that time; or ● the person is a parent of the taxpayer’s child (in other words, both are parents of the same child). For these purposes, a child includes a natural or adopted child, or a person who is wholly dependent on the taxpayer for support and of whom the taxpayer has custody and control, in law or in fact (see subsection 252(1)). A parent, for these purposes, does not include a mother-in-law or a father-in-law.

30 This is the common-law definition; there is no definition of ‘‘spouse’’ in the Income Tax Act. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 27 Free lead: 55D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Once the taxpayer and the person cohabit in a conjugal relationship, they are deemed to be cohabiting in a conjugal relationship at any time after that, unless they have not cohabited for a period of at least 90 days because of a breakdown of their conjugal relationship. Therefore, once a common- law partnership exists, it is deemed to continue until there is a breakdown marked by a separation of at least 90 days.

Pending Amendment Amendments first announced on December 20, 2002 (and which still have not been passed into law) propose an amendment to the above definition that is described as clarification, but which appears to effect an important change. The proposed amendment would replace the words ‘‘throughout a continuous one-year period before that time’’ with ‘‘throughout the twelve-month period that ends at that time’’ [emphasis added]. The difference appears to be that, under the revised rule, someone who lived with you previously for a period of 12 months and, after a separation now lives with you again, does not re-establish the common-law relationship automatically until another 12 months have passed.31 For example, assume that John and Mary cohabited for 20 years and John’s will establishes a spousal trust for Mary (with the residue going to his child from a previous relationship). Eleven months prior to John’s death, the couple decide to separate, and five months later they resume cohabitation. Under the proposed amendment (effective for 2001 and subsequent taxation years), Mary would not qualif y as John’s common-law partner at his death. As the Act currently reads, she would.

Spousal Trusts

Introduction Spousal trusts, which may be inter vivos or testamentary, offer a number of tax and non-tax benefits that have resulted in their having a prominent role in estate planning. Frequently, persons involved in a second (or subsequent) marriage will establish a testamentary trust for the benefit of their spouse during the spouse’s lifetime, with the testator’s children from a previous marriage receiving the trust assets at the death of the surviving spouse. The rationale for doing so is that, if the testator left his or her assets outright to his or her spouse, that spouse might, at his or her own death, leave those assets to beneficiaries of his or her choice, which might not include the testator’s

31 Other aspects of the common-law partner rule dealing with parents and dissolution by 90-day separation are not affected by the change. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 28 Free lead: 230D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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children from a previous marriage (especially if the surviving spouse has his or her own children from a previous marriage). Or, more mundanely, a person may feel that his or her spouse lacks the energy, interest, or knowledge to take on the task of managing significant assets. Professionals fearing that they might be subject to a professional liability suit, or business persons who want to guard against creditor problems, might want to protect certain of their assets by transferring them to a trust for the benefit of their spouse.32 Assets may be transferred to an inter vivos spouse trust for probate planning purposes. Because assets transferred to an inter vivos trust do not belong to the settlor at his or her death, they are not subject to probate fees. Further, whereas probate is a public process, assets can be transferred to a trust in complete privacy. From the tax-planning perspective, the principal benefit of transferring assets to a spousal trust is that the normal deemed disposition rules do not apply. Whether it is testamentary or inter vivos, the spousal trust will receive the assets on a rollover basis, i.e., without immediate tax consequences. The assets will be deemed to be transferred to the trust at their adjusted cost base, capital cost, or cost amount to the settlor. If the assets remain in the trust, any accrued capital gains will not be taxable until the death of the spouse-beneficiary. To achieve this deferral in the realization of capital gains, a number of conditions must be met; these are outlined briefly below.

Testamentary Spousal Trusts

Subsection 70(5) provides a series of rules which apply on the death of a taxpayer to deem the taxpayer to realize all accrued gains and losses on capital properties owned by the taxpayer immediately before the taxpayer’s death. By virtue of subsection 70(6), the rules set out in subsection 70(5) do not apply to an asset transferred as a consequence of death to a spouse, common-law partner, or a qualif ying spousal or common-law partner trust. The deceased is deemed to have disposed of the asset at its cost amount, and the surviving spouse, common-law partner, or trust is deemed to have acquired it at the same cost amount. Therefore, no capital gain or recapture will be triggered upon the deemed disposition (unless the estate elects under subsection 70(6.2)) until the surviving spouse, common-law partner, or trust disposes of the asset. If the asset is not actually disposed of during the lifetime of the surviving spouse, there will be a deemed disposition upon his or her death. Several criteria must be met for this exception to apply:

32 However, any such planning must be approached with caution. See the discussion of creditor protection trusts below. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 29 Free lead: 65D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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(1) The deceased must have been resident in Canada immediately before his death. (2) Property of the deceased to which subsection 70(5) would other- wise apply must have been transferred or distributed on or after the death to one (or both) of the following: (a) the spouse or common-law partner of the deceased, who was also resident in Canada immediately prior to the death of the deceased; or (b) a trust created by the will of the deceased under the terms of which the spouse or common-law partner receives all income during life, and no other person may, during the spouse or common-law partner’s life, receive or have the use of any income or capital; such a trust is usually referred to as a ‘‘spouse trust’’; the trust must be resident in Canada immediately after the property vests indefeasibly in the trust. (3) The property in question must become vested indefeasibly in the spouse, common-law partner, or spouse trust within 36 months after the death. The vesting period can be extended where the legal representative applies in writing to the Minister within the 36-month period and the Minister considers that a longer period is reasonable in the circumstances. The result of these rules is that the deceased realizes no capital gain, capital loss, recapture, or terminal loss on death. The advantage or liability of these is passed on to the spouse, common-law partner, or spouse trust and figures in computing income on ultimate disposition of the properties. However, under subsection 70(6.2), an election may be made by the legal representatives of the deceased, such that the ‘‘rollover’’ provisions of subsection 70(6) do not apply with respect to specified property, and consequently, the rules set out in subsection 70(5) will apply. Where the circumstances are appropriate, the executor may choose to recognize accrued capital gains or losses on selected assets. Note that a taxpayer’s legal representative may designate that order of disposition of depreciable properties under subsection 70(14).

Additional Requirements for Spousal Trusts If the transferee is a trust, there are further requirements under subsection 70(6) that must be met in order for the rollover to apply. First, the provision refers to a trust ‘‘created by the taxpayer’s will’’, which often will be self-evident. However, subsection 248(9.1) provides that a trust created by a court order under provincial dependant’s relief CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 30 Free lead: 100D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

222 The Estate Planner’s Handbook

legislation will be considered to be a trust created by the taxpayer’s will for these purposes. Two significant requirements relate to the income and capital of the trust. The spouse or common-law partner beneficiary must be ‘‘entitled to receive’’ all of the income of the trust during his or her lifetime, and no other person may ‘‘receive or other wise obtain the use of’’ any income or capital of the trust during his or her lifetime. For these purposes, the trust income is that determined for trust law purposes and not tax law purposes (subsection 108(3)), so that, for example, it does not include taxable capital gains. It appears that, although the spouse must be entitled to receive the income, actual receipt is not required, for example, if the spouse directs the trustees to accumulate the income.33 Although no other person may receive or use the capital of the trust during the spouse’s lifetime, it is not necessary that the spouse receive or obtain any of the capital, including capital gains (often, the trustees will be given the discretion to either accumulate the capital or encroach upon the capital and distribute it to the spouse). If a trust created under the deceased’s will does not fulfill the foregoing income and capital requirements, but the terms of the trust are subsequently varied to ostensibly fulfill those requirements (say, under provincial variation of trusts legislation), it is not clear whether the trust can qualif y under subsection 70(6). Arguably, if the variance does not result in the formation of a new trust as a matter of trust law, then as long as the trust was created under the will, it should qualif y if the variance results in the income and capital requirements being fulfilled. Alternatively, it could be argued that the wording of subsection 70(6), which refers to ‘‘a trust, created by the taxpayer’s will . . . under which’’ the income and capital requirements are met, contemplates that such requirements be set out under the terms of the trust as created by the will (see, for example, Gilbert Estate v. MNR, 83 DTC 645). Under this latter interpretation, the variance of the trust could not qualif y the trust. Unfortunately, the CRA has issued conflicting technical interpretations on this issue.34 It is relatively clear that if the variance of the trust results in the formation of a new trust as a matter of trust law, then the new trust cannot qualif y, since variation of trusts legislation is not normally considered dependant’s relief legislation under subsection 248(9.1), and the new trust would not other wise be created under the deceased’s will. A similar issue arises where a disclaimer, surrender or renunciation by a beneficiary ostensibly results in only the beneficiary spouse being entitled

33 See CRA Document No. 2003-0014515, June 2, 2003. 34 See CRA Document No. 9731797, May 8, 1998, and CRA Document No. 9625727, December 17, 1996), and in paragraph 12 of its Interpretation Bulletin IT-305R4, it appears to take the view that a variance under variance of trusts legislation cannot qualif y a trust for the purposes of subsection 70(6). CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 31 Free lead: 60D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 223

to the income of the trust and no other beneficiary being entitled to the capital of the trust during the spouse’s lifetime. For example, consider a deceased’s will that provides that the income of a testamentary trust is to be divided evenly between the deceased’s spouse and son. The trust will not initially qualif y under subsection 70(6) because someone other than the spouse is entitled to the trust’s income during the lifetime of the spouse. If the son disclaims his interest in the trust, paragraph 248(8)(b) (discussed earlier) does not appear to remedy the problem by qualif ying the trust for the purposes of subsection 70(6). That is, paragraph 248(8)(b) does not have the effect of deeming the trust to be a trust created by the will under which only the spouse is entitled to the income of the trust; it only deems the transfer or distribution of property to the trust as a consequence of the disclaimer (if any) to be a transfer or distribution of the property as a consequence of the death. In any event, paragraph 248(8)(b) might be irrele- vant on this point, as arguably the trust could qualif y after the disclaimer since the disclaimer itself resulted in only the spouse being entitled to the income of the trust during the spouse’s lifetime, as per the subsection 70(6) requirements (see, for example, CRA Document No. 9625727, December 17, 1996). However, as discussed above, it could alternatively be argued that the wording of subsection 70(6) contemplates that the income (and capital) requirements be set out under the terms of the trust as created by the will, so that a subsequent disclaimer could not effectively change the terms of the trust for these purposes (see, for example, Gilbert Estate v. MNR, 83 DTC 645). Subsections 70(7) and 70(8) provide rules which enable certain trusts to qualify as spousal trusts notwithstanding that they provide for the payment of certain testamentary debts. That is, the payment of testamentary debts would be payments out of either the trust’s income or capital to someone other than the beneficiary spouse, and therefore would ‘‘taint’’ the trust for the purposes of subsection 70(6). Subsection 70(7) provides the ‘‘untainting’’ procedure applicable in these circumstances.

Planning Considerations ● A testamentary or inter vivos trust, stipulating that the spouse/beneficiary’s interest in it will cease upon him or her remar- rying or cohabitating with another person will not qualif y as a spousal trust. ● The terms of a trust may be established outside a taxpayer’s will and funded by insurance proceeds to be payable at his or her death. Such a trust qualifies as a testamentary trust, but not as a spousal trust.35

35 Recall, as per subsection 70(6), a spousal trust must be created by the will of the deceased. See Technical Interpretation 9625975, dated October 7, 1996. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 32 Free lead: 195D Next lead: 489D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

224 The Estate Planner’s Handbook

● It is typically considered desirable to bestow upon trustees broad administrative powers, but care must be taken in this regard not to run afoul of the above rules. For instance, it would seem that, if the trustee has the power to make loans or lend or rent property at less than commercial rates, this would disqualif y the trust from being a spousal trust.36 ● Consideration should be given to providing trustees of a spousal trust with the power to encroach on capital in favour of the spouse. Capital property can be ‘‘rolled-out’’ to the spouse-beneficiary at cost, thus allowing for capital gains splitting between the trust and the spouse with regard to properties originally settled on the trust.37 Moreover, the power to encroach on capital may prove useful if the surviving spouse meets unexpected cash needs. ● Establishing a testamentary spousal trust will serve to avoid one round of probate tax. Probate tax will be payable on the death of the testator, but on the death of the spouse-beneficiary the assets of the trust will pass directly to the residual beneficiaries and not be included in the estate of the spouse-beneficiary. ● In some circumstances (e.g., involving shares in a private corporation), it may be inadvisable for a spousal trust to terminate immediately upon the death of the surviving spouse. If the trust does not continue for a certain time, it may not be possible to use loss car- rybacks available to the terminal year of the spousal trust.38

● An RRSP or RR IF cannot be rolled over to a spousal trust. 39

36 In paragraph 16 of Interpretation Bulletin IT-305R4, the CRA states: In interpreting the requirement that no person except the spouse may, before the spouse’s death, receive or other wise obtain the use of any of the income or capital of the trust, the renting of real estate at market value or the lending of money on commercial terms (including market rates of interest, appropriate securities and a reasonable repayment schedule), does not generally mean that the person renting the real estate or borrowing the money has received or has the use of that property as the term is used in this requirement. By implication, if the loan, etc., is not on ‘‘commercial terms’’, the reverse would be true.

37 See subsection 107(2) of the Act.

38 See the discussion of post-mortem tax planning at ¶13,648 et seq. of the CANADIAN ESTATE PLANNING GUIDE. 39 However, pending amendments provide for a tax deferral for amounts transferred from a deceased taxpayer’s RRSP if the funds are used to acquire a qualif ying life annuity payable to a trust, the beneficiary under which is a mentally infirm spouse or common-law partner of the taxpayer (or a mentally infirm, financially dependent child or grandchild of the taxpayer). See the discussion of RRSPs at death in Chapter 10. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 33 Free lead: 316D Next lead: 597D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Electing Out of the Rollover

As noted above, in certain circumstances, an election may be made under subsection 70(6.2) by the legal representative of the deceased so that the ‘‘rollover’’ does not apply. For instance, the deceased may have been in a loss or loss carryfor ward position. By making this election, the legal representative may force a realization in the year of death of recapture or a capital gain to offset this available loss without incurring any tax liability for the year of death. If potential capital gains or recapture are realized in this manner, the tax arising to the spouse or common-law partner, or in the ‘‘spousal trust’’ on the death of the spouse or common-law partner, will be lessened because the spouse, common-law partner, or trust will have acquired the property for purposes at the deemed proceeds of disposition resulting from the election of the legal representative and the deemed disposition at death. Similarly, if the property is covered by an exception (e.g., the small business capital gains exemption), it is generally beneficial to crystallize it by having the deemed disposition apply.

Planning Point

● As a general rule, it is better to utilize an exemption or deduction rather than a rollover, since the latter achieves only a deferral of tax liability, while the former eliminates it.

Trust ‘‘Tainted’’ by Payment of Testamentary Debts

A testator may create a testamentary trust which other wise meets the requirements for a spouse trust except that debts of the deceased owing at death and various income and death taxes are payable from that trust. Since the payment of such debts and taxes will be a benefit to persons other than the spouse or common-law partner, the trust would not meet the strict requirements of subsection 70(6) or subsection 70(6.1) that no person other than the spouse or common-law partner may have the benefit of any trust property during the spouse or common-law partner’s lifetime.

Subsection 70(7) provides rules which enable the trust to qualif y as a spouse trust notwithstanding the fact that certain ‘‘testamentary debts’’ are payable out of it; however, the value of trust property qualif ying for the rollover treatment under subsection 70(6) and subsection 70(6.1) is reduced by the amount of ‘‘non-qualif ying debts’’. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 34 Free lead: 431D Next lead: 597D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

226 The Estate Planner’s Handbook

Caution Re Life Insurance

Not infrequently, trusts hold life insurance contracts as assets. They do so for a variety of reasons. For example, a life insurance policy may facilitate asset diversification, provide an accumulation of growth and income exempt from the interest inclusion rules, generate proceeds within the trust to fund a tax liability, and create an estate (trust) equalization vehicle for trust beneficiaries. However, this may be problematic where the trust in question is to be a spousal trust. At round table discussions the CRA was asked whether a trust that other wise met the conditions of subsection 70(6), but contained a term permitting the acquisition of a life insurance policy with a duty to pay the premiums, would continue to qualif y as a spouse trust and thus receive rollover treatment on the property transferred to it. The short answer was no. As the CRA saw it, as a result of the duty to pay life insurance premiums, persons other than the surviving spouse or common- law partner may, before the survivor’s death, obtain the use of the trust income or capital. The CRA opined as follows:

. . . the mere possibility of a person other than the survivor receiving or obtaining, before the survivor’s death, use of the trust capital or income is sufficient to disqualif y the property transfer from the rollover.

A duty to fund a life insurance policy out of trust capital or trust income would, in our view, be one under which a person may obtain the use of the trust capital or trust income. This is because the premium payment is assumed to maintain, for the period covered by the premium, the rights to receive insurance proceeds. Therefore, the existence of such a trust term would be relevant in determining whether a rollover of property can occur to the trust under paragraph 70(6)(b) of the Act.

. . . as a result of the duty to pay insurance premiums out of trust property it would appear that persons other than the survivor may, before the survivor’s death, obtain the use of the trust income or capital. There- fore, we are of the view that the trust would not satisf y the conditions of subparagraph 70(6)(b)(ii) of the Act.

In light of the above, special caution is required where a spousal trust is to hold a life insurance contract.40

40 A detailed discussion of life insurance issues is beyond its scope. The reader is referred to Robin Goodman, ‘‘Combining Trusts and Life Insurance in Estate Planning: Tricks and Traps’’ (2008), vol. 56, no. 1 Canadian Tax Journal, 188-213. and, more generally, Glenn R. Stephens, Estate Planning with Life Insurance, 2008, CCH Canadian Limited. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 35 Free lead: 185D Next lead: 312D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 227

Inter Vivos Spousal Trusts

Section 73 provides an exception to the general rule that a taxpayer who disposes of a capital property must recognize the accrued gain or loss thereon at the time of disposition. Section 73 allows a taxpayer to accom- plish an inter vivos tax-free ‘‘rollover’’ with respect to capital property, where the taxpayer transfers it to the taxpayer’s spouse or common-law partner, the taxpayer’s former spouse, or common-law partner in settlement of rights arising out of the marriage or common-law relationship, or to a trust specified in paragraph 73(1.01)(c). This type of trust provides that only the spouse or common-law partner is entitled to receive the income of the trust, and no person other than the spouse or common-law partner may receive or obtain any income or capital of the trust during the lifetime of the spouse or common-law partner. For example, this type of trust will include a trust under which the transferor’s spouse is the sole income and capital beneficiary of the trust during his or her lifetime, with the children of the transferor and the spouse becoming the beneficiaries upon the death of the spouse. Note that, for the rollover to apply, both the transferor and the transferee must be resident in Canada and the property transferred must be capital property.

If the transferor does not elect out of the rollover, it applies automatically and the realization of any accrued gain or loss in respect of the property will be postponed until the transferee disposes of the property. Note, however, that owing to the attribution rules in sections 74.1 to 74.5, the gains and losses realized by the transferee will be attributed to the settlor-spouse.

This brief discussion discloses two characteristics of inter vivos spousal trusts that (in addition, of course, to the application of the attribution rules) explains their limited use in estate planning:

(1) The requirement that the spouse-beneficiary be the only income beneficiary during his or her lifetime and that no one else can access the capital of the trust during this time applies, notwithstanding any marriage breakdown.41

(2) If the beneficiary-spouse dies before the transferor-spouse, there will be a premature realization of capital gains. (Under subsection 104(4), at the death of the spouse-beneficiary, there will be a deemed disposition of the trust property, even if the settlor is still alive.)

41 A joint partner trust can provide greater flexibility in this regard. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 36 Free lead: 59D Next lead: 436D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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On the other hand, unlike alter ego and joint partner trusts, inter vivos spousal trusts do have access to the $750,000 capital gains exemption for shares held in a qualified small business corporation or qualified farm or fishing property. Upon death, the trust is entitled to use any part of the exemption that the deceased spouse was entitled to use but did not.

Planning Points ● Although the rollover applies automatically, the fact of the transfer must be reported in the tax return of the transferor for the year of transfer. ● Generally, it is preferable not to transfer cash or near-cash assets (bonds, mortgages, insurance proceeds) to a spousal trust. There will be no deemed disposition if such assets are transferred to a trust other than a spousal trust, and no deemed disposition on the death of the spouse.

Inter Vivos Trusts for Minors Subsection 104(18) provides that certain income of the trust that is not actually distributable in the year to a minor is nevertheless deemed to be payable to him. Where the minor’s right to annual income has vested in him or her, but is not payable because, under the terms of the trust, income is not to be paid to him or her while he or she is a minor, the income is considered ‘‘payable’’ in the year. As a result, the amount thereof is deductible by the trust and included in the minor’s income. Where attribution rules apply (e.g., subsection 74.3(1)), the income will be included in the income of the transferor rather than the minor. Subsection 104(18) will be applicable where the following conditions are met: (a) the trust resides in Canada throughout the taxation year; (b) the income (including taxable capital gains) is not payable in the year; (c) the individual for which the trust holds the income is less than 21 years old at the end of the year; (d) the individual’s right to the income (including taxable capital gains) is vested by the end of the year for reasons other than the exercise or the non-exercise of a discretionary power; and CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 37 Free lead: 57D Next lead: 124D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 229

(e) the individual’s right to the income is not subject to any future condition (other than a condition that the individual survive to an age not exceeding 40 years). Where these conditions are met, subsection 104(18) overrides the general requirement in subsection 104(24) that for the income of a trust to be considered payable, it must be ‘‘paid in the year to the beneficiary or the beneficiary was entitled in the year to enforce payment of the amount’’. A trust that satisfies subsection 104(18) is sometimes referred to an ‘‘Age 40 Trust’’ because such a trust allows income and taxable capital gains earned in the trust before the beneficiary turns 21 years of age to be retained in the trust until the beneficiary’s 40th birthday. Thus, a parent, as trustee, could control a child’s entitlement to the income and gains retained in the trust until the child becomes a (presumably) mature adult. As such, the trust could protect the income and gains retained in the trust against contingencies such as financial irresponsibility of the beneficiary (albeit, a beneficiary’s vested entitlement to assets in a trust may not be safe from his or her creditors). The following chart42 illustrates how subsection 104(18) allows income to ‘‘vest’’ in the beneficiary until the age of 21 whereupon income would have to be distributed to the beneficiary, but amounts that vested up to age 21 could be withheld until the beneficiary reaches age 40.

Vested Income Distributed

Income Distributed

Age Age Age 0 21 40

Income Vests

Where subsection 104(18) is applicable, it will generally result in a reduction of the overall tax payable; this is particularly so in the case of inter vivos trusts. Pursuant to subsection 122(1), inter vivos trusts are taxed at a flat

42 From David G. Thompson, ‘‘Recent Developments Relating to Income Splitting and the Use of Trusts’’, 1999 British Columbia Tax Conference, (Vancouver: Canadian Tax Foundation, 1999), 16:1-34. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 38 Free lead: 56D Next lead: 124D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

230 The Estate Planner’s Handbook

rate of 29%. By contrast, a minor beneficiary, of course, will be taxed at the usual marginal rates. Moreover, he or she will not typically have significant income of his or her own, with the result that he or she may not have exhausted his or her basic personal exemption which will, accordingly, be available to shelter trust income. Given that they are taxed at the usual marginal rates, subsection 104(18) will be of less significance in the case of testamentary trusts. Nonetheless, where trust income is taxed to the beneficiary, it will be possible to access unused personal amounts and tax credits available to the beneficiary. Clearly, structuring a trust for a minor such that it complies with subsection 104(18) may make good tax planning sense; albeit, the loss of discretion on the trustee’s part in dealing with the trust’s income is a significant trade-off, the relative importance of which has to be weighed in the given circumstances. Where the tax rate of a beneficiary is higher than that applicable to a testamentary trust, it appears to be possible to override subsection 104(18) by designating the income as that of the trust (see paragraph 17 of Interpre- tation Bulletin IT-381R3). Planning Points ● A trust set up for one child, or a non-discretionary trust for several children where each child’s interest is vested, would cause the undistributed income to be deemed payable and thus taxable in the hands of the respective beneficiaries. ● If the trust is discretionary and it is desirable to accumulate the income, the trustees should enter into a resolution before the calendar year-end, allocating all of the income in favour of the beneficiaries. This should be evidenced in writing with a copy distributed to the beneficiaries or to their parents. Once the amount has been quantified, a demand non-interest-bearing promissory note should be issued to the beneficiary or to the parent as guardian of the beneficiary.

Distribution of Trust Property to the Beneficiaries Subsection 107(2) provides a series of rules which apply when a personal trust distributes its assets in complete or partial satisfaction of a capital beneficiary’s interest.43 The basic approach is to pass the trust

43 In addition to the following comments, see IT-381R3, Trusts — Capital Gains and Losses and the Flow-Through of Taxable Capital Gains to Benef iciaries. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 39 Free lead: 81D Next lead: 312D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 231

property on to the beneficiary at the trust’s cost or adjusted cost base so that on later actual disposition by the beneficiary, any capital gains or capital losses, recapture, or terminal loss accrued while the trust owned the property will belong to the beneficiary, who will in turn pay the appropriate tax. A ‘‘personal trust’’ is defined in subsection 248(1) as a testamentary trust, or an inter vivos trust for which no beneficial interest was acquired for consideration payable to the trust or to a transferor of property to the trust. There- fore, all testamentary trusts and most inter vivos family trusts should be personal trusts and should qualif y for the rollover. There are exceptions where the subsection 107(2) ‘‘rollover’’ does not apply. It does not apply to a distribution by a spousal trust of capital property, while the beneficiary spouse is alive, to someone other than the spouse, to a distribution by a joint spousal trust, while either spouse is alive, to someone other than either of the spouses, or to a distribution by an alter ego trust, while the settlor is alive, to someone other than the settlor (see subsection 107(4)). In addition, the rollover does not apply when a trust distributes property (with some exceptions) to a non-resident beneficiary (see subsection 107(5)). Furthermore, under certain circumstances, either the trust making the distribution of the property or a beneficiary receiving the property may elect out of the rollover under subsection 107(2.001) or 107(2.002), respectively. Also, the rules in subsection 107(2) do not apply to certain other trusts, including most deferred income trusts (see the definition of ‘‘trust’’ in subsection 108(1)). In these cases where subsection 107(2) does not apply, the rules in subsection 107(2.1) apply. Under subsection 107(2.1), the trust is deemed to have disposed of the distributed property at its fair market value. One reason for a trust to make an election under subsection 107(2.001) is in order to trigger the recognition of capital gains, which can then be offset against capital losses of the trust, or vice versa. In the case of a testamentary trust, it might also be more tax-effective to have the taxable capital gain taxed in the trust (at the graduated tax rates) rather than in the hands of the beneficiary (who may be taxed at the highest marginal rate). The primary reason for a beneficiary to make an election under subsection 107(2.002), on the other hand, would be to ensure that he or she received a stepped-up cost base for the distributed property, so as to avoid future Canadian tax on any capital gains accrued while the property was held by the non-resident trust outside Canada.44

44 The election must be filed with the tax return of the trust or the beneficiary, whichever makes the election, for the taxation year in which the distribution occurred. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 40 Free lead: 227D Next lead: 248D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Caution should be exercised when rolling out trust property to a beneficiary. Besides resulting in the attribution of income and capital gains, a rollout of trust property may be denied pursuant to subsection 107(4.1) where at any time subsection 75(2) has applied to a trust. Given that there is normally a deemed disposition of trust property on the 21st anniversary of the trust, this could obviously be a significant problem, since it is usually advisable to roll out the property to beneficiaries prior to this time. Subsection 75(2) is discussed below in some detail; very basically, it may apply in circumstances where the property may revert to the transferor, the transferor may determine who gets the property, or the transferor has a veto over the disposition of the property.

Distributions to Non-Resident Beneficiaries

Subsection 107(5) prevents certain trusts from distributing certain types of property to non-resident beneficiaries (including partnerships that are not Canadian partnerships) on a rollover basis. Where subsection 107(5) applies, the consequences of a distribution will be governed by subsection 107(2.1), and not 107(2). The purpose of subsection 107(5) is to ensure that gains accrued in Canada will be taxed in the trust. But for this provision, the trust would realize no capital gain on distribution, and when the non- resident beneficiary disposed of the property, if it were not then taxable Canadian property, he or she would not be subject to capital gains tax either.

Before October 2, 1996, the property that could not be distributed to a non-resident beneficiary on a rollover basis consisted of any property other than Canadian resource property, excluded property (defined in subsection 108(1) to be shares of a non-resident-owned investment corporation that did not own taxable Canadian property), and property that would be taxable Canadian property (as then defined in subsection 115(1)) if the trust were non-resident throughout its taxation year. Although before October 2, 1996, subsection 107(5) applied to non-resident trusts as well as Canadian resident trusts, it had no practical effect with respect to non-resident trusts, which would not normally be taxed on any capital gains accrued to the date of distribution of the property to the non-resident beneficiary. Also, before 2000, the tax consequences of the distribution were set out in subsection 107(5) and differed from those in subsection 107(2.1) in that the proceeds of disposition to the beneficiary of his or her capital interest in the trust, or part thereof, were deemed to be equal to the adjusted cost base to the taxpayer of the interest or part thereof (resulting in no tax liability to the beneficiary). Whereas under former subsection 107(2.1) they would be CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 41 Free lead: 84D Next lead: 248D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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deemed to be equal to the fair market value of the property at the time of distribution (now subject to certain deductions for pre-taxed amounts). Since October 2, 1996, the range of property that cannot be distributed to a non-resident beneficiary on a rollover basis has been extended. This is consistent with changes to the taxpayer migration rules and other provisions that ensure that Canada will allow ownership of property to pass only to a non-resident person (whether by way of an actual transfer or because the person is emigrating from Canada) without immediate tax consequences if, under subsections 2(3) and 115(1) and relevant tax treaties, it will retain the ability to tax gains thereon at a later date. The property excepted from the deemed disposition on distribution from a Canadian resident trust to a non- resident beneficiary now consists of: (i) shares of a non-resident-owned investment corporation (whether or not it owns taxable Canadian property) and property described in any of paragraph 128.1(4)(b), being real property situated in Canada, Canadian resource property, and timber resource property; (ii) capital property used in, eligible capital property in respect of, and property described in the inventory of a business carried on in Canada through a permanent establishment in Canada; and (iii) an excluded right or interest (defined in subsection 128.1(10) as certain interests in trusts and deferred income streams). Subsection 220(4.6) permits a trust to elect to defer the payment of tax owing as a result of the distribution of a taxable Canadian property to a non-resident beneficiary. The trust may elect under subsection 220(4.6) to defer the payment of the resulting tax in respect of the distribution of the property by providing adequate security with the CRA. Where a valid election is made in the prescribed manner, the payment of the tax is effectively deferred, without the imposition of interest or penalties, until the trust’s balance-due day for the year in which the property is subsequently disposed of (presumably, by the beneficiary). The election by the trust must be made, and the security provided, by the trust’s balance due date for the year in which the distribution takes place. Withholding Tax on Payments to Non-Resident Beneficiaries

Generally,45 amounts paid or credited by a trust or estate resident in Canada to a non-resident beneficiary are subject to a 25% withholding tax.

45 For further details, start with Interpretation Bulletin IT-465R, Non-Resident Benef iciaries of Trusts. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 42 Free lead: 1D Next lead: 124D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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This would be the only Canadian tax payable on this income by such beneficiaries. In some cases this tax will not apply because of the existence of an agreement between Canada and the country in which the beneficiary resides; withholding rates are set out in Information Circular 76-12R6. For example, payments made by a Canadian trust or estate out of income from sources inside Canada to a resident of the United States are subject to a 15% withholding tax. However, payments made by a Canadian trust or estate out of income from sources outside Canada are not subject to the 15% withholding tax if the beneficiary is a resident of the United States. The tax will also not apply in situations where the trust has already been taxed on the income. By virtue of sections 210–210.3, where a non-resident is a beneficiary of an inter vivos trust, the trust will be subject to a special ‘‘Part X II.2 Tax’’ of 36% on certain types of income allocations to all beneficiaries. To the extent a trust has net income from real properties situated in Canada, timber resource properties, Canadian resource properties, businesses carried on by it in Canada or net capital gains from the disposition of ‘‘taxable Canadian property’’, and has non-resident beneficiaries, it will be liable for this tax. When income net of tax is allocated to beneficiaries, resident Canadian beneficiaries will include in income their pro rata share of the tax paid, and will receive full tax credit for that tax. Non-resident beneficiaries will receive their pro rata share of the income remaining after tax, subject to 25% or less non-resident withholding tax, and will receive no credit for the tax paid in the trust (unless they are subject to ordinary Canadian income tax. This special tax system is said to be designed both to ensure that income of this kind is taxed at full personal tax rates, and to prevent Canadian resident beneficiaries from bearing an undue share of the tax. Pursuant to section 212, the dividend gross-up and credit machinery is denied to dividends received by a trust in the year if the dividends can reasonably be considered as having been included in the income of a non- resident beneficiary, applicable to trust taxation years ending after April 26, 1995.

Deemed Disposition After 21 Years Subsection 70(5) deems a deceased taxpayer to have, immediately before death, disposed of all his or her capital property at fair market value. As such, any accrued gains on such property (fair market value at death in excess of cost to the taxpayer) may be subject to tax in the terminal year. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 43 Free lead: 220D Next lead: 248D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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However, where such properties are left to the deceased’s spouse, common- law partner, or qualif ying spousal trust, the deemed dispositions can take place on a tax-deferred ‘‘rollover’’ basis.46 To prevent individuals from cir- cumventing the deemed disposition at death rules by settling their property upon trusts of prolonged duration, a trust is deemed under subsections 104(4)–(5.2) to dispose of its capital properties periodically. On the deemed disposition day, the trust is considered to have disposed of each property for proceeds of disposition equal to its fair market value and to reacquire each immediately thereafter for the same amount. It is taxed on any resulting capital gain.

Date of Deemed Realization Date

For the purposes of these deemed realization rules, trusts are divided into six basic categories: (1) Post-1971 spousal or common-law partner trusts. Such a trust is one under the terms of which: (a) the spouse or common-law partner of the taxpayer who created the trust was entitled to receive all of the income arising in the trust during the spouse’s or common-law partner’s lifetime; and (b) no person other than the spouse or common-law partner could, before that spouse’s or common-law partner’s death, receive or have the use of any income or capital of the trust; and which was created either: (c) by the will of a taxpayer who died after 1971; (d) after June 17, 1971, by a taxpayer during his or her lifetime; or (e) by the will of a taxpayer who died after 1971 to which property was transferred on a rollover basis in circumstances to which the rollover provisions on resource properties and land inventories of a deceased taxpayer or the transfer or distribution to a spouse or common-law partner or post-1971 spousal or common-law partner trust applied, provided that the beneficiary spouse died after December 20, 1991. If the beneficiary spouse or common- law partner died before that date, the deemed disposition would

46 Additionally, there is a rollover available for qualified farm property left to the deceased’s children. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 44 Free lead: 328D Next lead: 436D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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occur 21 years after the later of January 1, 1972 and the date on which the trust was created.

The time for determining whether a testamentary trust is a qualif ying post-1971 spousal or common-law partner trust is the time the trust was created. In the case of a testamentary trust to which the rollover provisions on the resource properties and land inventories of a deceased taxpayer or the transfer or distribution to a spouse or common-law partner or a post-1971 spousal or common-law partner trust applied, the relevant time is immediately after the transferred property vested indefeasibly in the trust. In the case of an inter vivos trust, it will be included in this new class of spousal or common-law partner trusts if it was a spousal or common-law partner trust at any time after 1971.

It is important to note that not all post-1971 spousal or common-law partner trusts, created for the benefit of an individual’s spouse or common- law partner, will meet the criteria of this new spousal or common-law partner trust category. For example, if the trustees have the power to encroach on capital for the benefit of the settlor’s children, the criteria will not be met. The terms of the trust must be carefully reviewed to make this determination. Such trusts not meeting the definition will have a deemed disposition on the later of January 1, 1993 and 21 years after the trust’s creation date.

(2) Alter ego trusts and joint spousal or common-law partner trusts. For 2000 and subsequent taxation years, the first deemed disposition date for:

● an alter ego trust is the day on which the settlor dies; and

● a joint spousal or common-law partner trust is the day on which the last survivor dies.

These changes parallel the existing rules for spousal trusts. A trust must satisf y the following conditions to be an alter ego trust:

(a) at the time of the trust’s creation, the taxpayer creating the trust was alive and had attained 65 years of age;

(b) the trust was created after 1999;

(c) the taxpayer was entitled to receive all of the income of the trust that arose before the taxpayer’s death; CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 45 Free lead: 212D Next lead: 248D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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(d) no person except the taxpayer could, before the taxpayer’s death, receive or other wise obtain the use of any of the income or capital of the trust; and

(e) the trust did not elect not to be treated as an alter ego trust.

In other words, an alter ego trust is a trust that one establishes for him or herself. The settlor can place all of the assets accumulated during his or her lifetime in the trust but must be the only person entitled to receive all of the income from the trust as well as the capital of the trust during his or her lifetime. He or she is permitted to transfer his or her assets to the trust on a rollover basis. The gain on these assets is deferred until the time of the person’s death.

The joint spousal or common-law partner trust is similar to both the post-1971 spousal or common-law partner trust and the alter ego trust. With a joint spousal or common-law partner trust, both the settlor and his or her spouse or common-law partner are the beneficiaries of the trust and are entitled to receive the income and the capital during their lifetimes. After death, the trust can specif y to whom the assets are to be transferred. Again, the settlor must be at least 65 years old in order to establish a joint spousal or common-law partner trust and receive the rollover treatment.

(3) Protective trusts. For 2000 and subsequent taxation years, trust property transferred on a rollover basis, without any change in beneficial ownership, and which no person other than the transferor has any right as a beneficiary, will be deemed disposed of on the date of death of the transferor and on each 21st anniversary thereafter. Prior to 2000, the Canada Customs and Revenue Agency (now replaced by the Canada Revenue Agency) took the position that a transfer of property to a protective trust would not result in a ‘‘disposition’’ for tax purposes. This meant that the property ostensibly transferred to the protective trust would be deemed disposed of on the transferor’s death. Due to the change in the definition of ‘‘disposition’’, the deemed disposition provisions apply to protective trusts in the 2000 and subsequent taxation years, and also apply where a trust elects in writing and files the election with the Minister on or before March 31, 2001 (or at any later time that is acceptable to the Min- ister).

(4) Bare trusts. A bare trust, which acts as agent for all the beneficiaries under the trust in respect of all dealings with all of the trust’s CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 46 Free lead: 80D Next lead: 124D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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property, is not considered a trust for the purposes of the deemed disposition rules nor for most other purposes of the Act. (5) Pre-1972 spousal trusts. For taxation years ending after February 11, 1991, these trusts will be deemed to dispose of their relevant properties on the later of January 1, 1993 and the day on which the beneficiary spouse dies. Additional deemed dispositions will occur every 21 years thereafter. A ‘‘pre-1972 spousal trust’’ is defined in subsection 108(1) as a trust created: (a) by the will of an individual who died before 1972; or (b) before June 18, 1971 by an individual during his or her lifetime. Such a trust will qualif y as a pre-1972 spousal trust at a particular time if, throughout the period commencing when it was created and ending at the earliest of January 1, 1993, the day of the beneficiary’s spouse’s death, and the time at which the definition is applied, the beneficiary spouse is entitled to receive all the income of the trust that arose before his or her death. A trust will be deemed not to be a pre-1972 spousal trust if a person other than the beneficiary spouse received or other wise obtained the use of any of the income or capital of the trust before the above-noted period ended. A trust may qualif y as a pre-1972 spousal trust even where there is a condition such that beneficiaries, other than the spouse, may have access to the income or capital of the trust, e.g., in the event that the beneficiary spouse remarries. In such a case, the trust would cease to be a pre-1972 spousal trust only in the event that the beneficiary spouse actually did remarry. (6) Other trusts. The deemed disposition rules will first apply to a trust not qualif ying as any of an alter ego trust, joint spousal, or common- law partner trust, a post-1971 spousal or common-law partner trust, or a pre-1972 spousal trust 21 years after the later of January 1, 1972 and the date on which the trust was created. Additional deemed dispositions will occur every 21 years thereafter. Furthermore, for deemed disposition days determined after December 17, 1999, two new sets of circumstances will cause a trust to have a deemed disposition day: (a) Property distribution f inanced by a trust liability. After December 17, 1999, a trust which distributes property that was CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 47 Free lead: 246D Next lead: 248D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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financed by a liability of the trust (e.g., a loan assumed by the trust) will have a deemed disposition day immediately after the distribution, if one of the purposes of the transaction was to avoid taxes other wise payable on an individual’s death.

(b) Property transfer in anticipation of emigration. If, after December 17, 1999, an individual transfers property to a trust on a rollover basis and the transfer was made in anticipation that the individual would subsequently cease to reside in Canada, the trust will have a deemed disposition when the individual emigrates.

Planning for the 21st Anniversary

Planning for the deemed disposition is important because many trusts have non-liquid assets and will realize accrued gains and recapture without having funds to pay the tax liability that may arise. To avoid this, pursuant to subsection 107(2), trusts can distribute the trust property (on a tax-deferred basis) to the beneficiaries before the deemed disposition date. Roll-Out of Trust Assets

The deemed disposition rules will be of no consequence to a trust that has no property, is no longer in existence after 21 years, or does not have accrued unrealized gains in excess of accrued unrealized losses, in which case, nothing need be done. However, where significant unrealized gains have accrued on the property held in the trust, effective planning is imperative. For example, where the trust is holding a cottage property, there may be significant potential tax liability that can force the selling of other non- liquid assets to generate the required funds. One possible solution is to roll out the assets in question to the beneficiaries on a tax-free basis prior to the application of the rules — providing, of course, that the trust documents permit this.

There are certain circumstances where capital distributions under subsection 107(2) may not be possible; for example:

● Subsection 107(4.1) restricts the rollover under subsection 107(2), if subsection 75(2) was applicable at any time in respect of any property of the trust. In other words, if property was contributed to the trust since the time that it was created with the proviso that such property revert to the transferor, or if property could not be distributed without the consent of the transferor, subsection 107(4.1) will deem CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 48 Free lead: 8D Next lead: 124D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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the disposition of the property distributed to the beneficiaries to take place at fair market value rather than at its adjusted cost base. ● Subsection 107(5) provides that, where beneficiaries of the trust are non-residents, most property, including now taxable Canadian property, will not roll over under subsection 107(2) but will be deemed to be disposed of at fair market value. Roll-Out of a Remainder Interest The CRA has suggested that, where a trust holds real property for the benefit of a life tenant, the impact of section 104(4) could be avoided by distributing the real property from the trust to the beneficiary or beneficiaries entitled to the remainder interest while registering the life interest against the title.47 The life interest would remain subject to the deemed disposition; however, its fair marketable value would be comparatively small. Transfers to a Holding Company There may also be circumstances where a distribution under subsection 107(2) is possible, but where it is considered to be inappropriate to distribute the assets of the trust to the beneficiaries for them to hold and control directly. In such a case, the trustees would want to ensure that they retain control of the property by first transferring it to a holding company under subsection 85(1), subscribing for voting control shares personally, and then distributing common shares or non-voting common shares to the beneficiaries under the terms of subsection 107(2). This procedure allows the trustees to control the assets through the holding company, but fixes the beneficial interest of each beneficiary, whereas the trust may have provided for discretionary distributions. If this or any similar procedure is undertaken, the trustees should ensure that there is no adverse economic impact on any of the beneficiaries such that the series of steps would constitute a breach of fiduciary duty. If the trust property is distributed prematurely to the beneficiaries of the trust in order to avoid the deemed disposition rules, the structure for the control and preservation of the property that the settlor created may be lost. A potential solution to this problem would be to have the trust property transferred to a holding corporation on a rollover basis under subsection 85(1). In consideration for the transferred property, the trust could receive participating non-voting common shares of the corporation, which would be distributed to the beneficiaries of the trust before the deemed disposition occurred. Non-participating voting preference shares could also

47 See Document No. 1999-0013475, dated February 29, 2000. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 49 Free lead: 90D Next lead: 115D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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be received by the trust on the transfer, and these shares would be retained in the trust. In order to ensure that the property stays within the family, shareholders’ agreements may be executed, restricting or prohibiting the transfer of the shares in the holding corporation. This would permit the trustees to retain control of the property.

Variation of the Trust To effect a transfer of the trust’s assets to its beneficiaries or a holding corporation, the trust instrument must provide for such; other wise, a variation of the trust will be necessary. The beneficiaries, under trust law, acting unanimously, may require that the trust’s property be distributed if all the beneficiaries of the trust are known and legally capable (i.e., age of majority and of sound mind) and there are no unborn contingent beneficiaries. If the criteria are met, the beneficiaries may agree to have the trust’s property distributed to them rather than continue to be held in the trust. This is known as the Saunders v. Vautier rule. Such a distribution would be made regardless of the terms of the trust. If the Saunders v. Vautier rule does not apply to the trust, application may be made to the courts under provincial variation of trusts legislation to obtain a variation of the terms of the trust to enable the trustees to distribute the property to the beneficiaries prior to the application of the deemed disposition rules. It should be noted that the various Variation of Trusts Acts generally permit a court to consent to a variation only if it considers the variation to benefit the beneficiaries. It is uncertain whether tax planning is a sufficient cause for a court approving a variation. Tax Consequences of Varying a Trust The CRA has expressed the view that, in general, a variance of a trust may have the effect of resettling the trust, if the variance is so significant that it causes a fundamental change in the terms of the trust.48 If this occurs, there would be an actual disposition of the trust’s property from the ‘‘old’’ trust to the ‘‘resettled’’ trust. On the other hand, a variation of a trust affecting only the administration of the trust or the investment powers of the trustees would generally not create a taxable event. This would be the case where the trust was varied to provide for replacement trustees or to extend or amend the powers of the trustees, such as to authorize the trustees to freeze some or all the assets of the trust. With respect to a variation of a trust which would add discretionary beneficiaries, the CRA noted that serious consideration would be given to

48 See Document No. 9209655, dated July 22, 1992. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 50 Free lead: 280D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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whether such variation constitutes a disposition of any interests in the trust. The decision in Murphy v. The Queen,49 implies that beneficiaries agreeing to a variation in the terms of a trust will have disposed of part or all of their interests in the trust by consenting to the variation. The CRA could not provide a general rule with respect to a variation that would prolong the distribution date of the trust’s capital. This is normally done on the basis of an advance ruling. In some cases, it will agree that this action will not result in a disposition of the trust property to a new trust; nor will it cause subsection 107(2) to apply. Generally, subsection 107(2) provides that the property of the trust is distributed to the beneficiaries on a tax-free basis and also that the beneficiaries have disposed of their capital interest in the trust.

More generally, in its technical interpretations and Advance Rulings, the CRA has taken positions largely favourable to the beneficiaries — even where there is a change in beneficial interests. One commentator has found that the CRA

has typically ruled favourably with respect to changes involving: accelera- tion of interests; deferral of vesting dates; the inclusion of encroachment powers over capital; and the creation of new trusts to hold the funds aside for minor or unascertained beneficiaries.50

Nonetheless, uncertainties remain and have been summarized as follows:51

● the possible application of the attribution rules; ● the possibility that the variation will constitute a resettlement of the trust;

● the possibility that the variation will trigger a disposition of property, either by the trust or by the beneficiaries;

● the possibility that the variation will taint the status of the trust (for example, causing a trust that formerly qualified for graduated tax rates to be taxed at the top marginal rate);

● the impact of various tax pools, including the loss carryfor wards; and

49 80 DTC 6314 (F.C.T.D.). 50 Timothy G. Youdan, ‘‘Income Tax Consequences of Trust Variation, Revocable Trusts and Powers of Appointment’’, Sixth Annual Estates and Trusts Forum, November 19, 2003, pp. 2-3.

51 William Innes and Joel T. Cuperfain, ‘‘Variation of Trusts: An Analysis of the Effects of Variations of Trusts Under the Provisions of the Income Tax Act’’, Canadian Tax Journal, 1995 Volume 43, No. 1. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 51 Free lead: 20D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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● the possible application of certain benefit conferral provisions (such as subsection 56(2) or 105(1). Planning Points ● To reduce the impact of the deemed disposition, thought may be given to changing the residence of the trust — i.e., by moving the residence of the trust from a high-tax province such as Ontario to a low-tax one such as Alberta. ● In light of the uncertainty as to the consequences of varying a trust, consider obtaining an advance ruling from the CRA. ● When establishing a new trust, the trust document should be drafted so that it provides the trustees with broad powers to accelerate the distribution date of the trust assets to the capital beneficiaries in partial or total satisfaction of their capital interests. This would enable the trust to avoid the deemed disposition rules. In addition, the trustees could be given a power of variation to allow amendments of the trust (as may be required) to be made without a court order and/or consent of all the adult beneficiaries of the trust. ● life insurance is not ‘‘capital property’’; therefore, it can be used as an asset within the trust, which will grow without being subject to taxation on the 21st anniversary of the trust and thereafter. This is particularly useful where the trust acquires the policy early on and does so with 21-year planning in mind.52

Attribution Rules Because the Income Tax Act taxes each individual separately, imposes a higher marginal rate of tax as an individual’s taxable income increases, and permits each individual to take certain specified deductions from income, it is generally beneficial for an individual with a large amount of taxable income to transfer or loan property that will produce income and capital gains to an individual with less taxable income, who will not be subject to as great a tax on the income and capital gains. This form of tax planning, commonly referred to as ‘‘income splitting’’, reduces the total amount of tax payable by the family on its collective income and capital gains.

52 See further Robin Goodman, ‘‘Combining Trusts and Life Insurance in Estate Planning: Tricks and Traps’’ in ‘‘Personal Tax Planning’’, (2008), vol. 56, no. 1 Canadian Tax Journal, 188-213, who notes that ‘‘ where insurance planning was not originally contemplated, insurance can be used as an asset to replace the value of assets rolled out of the trust.’’ Life insurance essentially protects the value of the trust beneficiary’s interests, when the trustees have to ‘‘arbitrarily’’ roll out trust capital to one or more capital beneficiaries in order to avoid the tax liability other wise arising on the 21st anniversary deemed disposition. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 52 Free lead: 0D Next lead: 175D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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The ‘‘attribution rules’’ set out in sections 74.1 to 74.5 are intended to eliminate the tax benefit of certain transfers and loans of property by requiring the taxpayer, who transferred or loaned the property, to include the income and losses generated from such property and substituted property. As a result, the taxpayer will be subject to tax on such income, which is attributed to the taxpayer. These provisions generally apply to a transfer or loan of property by a taxpayer to his spouse or common-law partner, to a person who becomes his spouse or common-law partner, to a person under 18 years of age with whom the taxpayer does not deal at arm’s length, to the taxpayer’s nephews and nieces under 18 years of age, and to trusts and certain corporations in which the spouse, common-law partner, or such minor has an interest. There is, however, generally no ‘‘double tax’’. When there is attribution, the transferee or the person who borrowed the property is not subject to tax on the attributed income. On the other hand, if the transferee or borrower is a minor child and the income from the property is subject to the tax on split income under section 120.4, the attribution rule of subsection 74.1(2) does not apply. In this case, the income is subject to tax in the hands of the minor child at the highest marginal rate. Trusts Section 74.3 provides a mechanism for determining the amount to be attributed where an individual has loaned or transferred property to a trust in which a ‘‘designated person’’ is beneficially interested at any time. A ‘‘designated person’’ is defined as: (a) the individual’s spouse or common-law partner; (b) a person under 18 years of age who does not deal at arm’s length with the individual; or (c) a person under 18 years of age who is the niece or nephew of the individual. Basically, any income from the property, to the extent that it is included in the designated person’s income, is attributed back and included in the transferor’s income. Likewise, any capital gain from the property included in the spouse beneficiary’s income is attributed back and included in the transferor’s income. Income and capital gains that are accumulated and taxed in the trust are not subject to attribution. Revocable Trusts The attribution rules also apply to revocable trusts. Under subsection 75(2), property income and losses, and capital gains or losses from trust property will be deemed to be that of the settlor if, under the terms of a trust, the property: CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 53 Free lead: 440D Next lead: 455D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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(a) may revert to the transferor; (b) may pass to persons to be determined by the transferor at a time subsequent to the creation of the trust; or (c) will not be disposed of during the lifetime of the transferor without his or her consent or discretion.

Exceptions to the Attribution Rules

While the attribution rules constitute a barrier to certain avenues of income-splitting, there remain some notable exceptions. The following are among those most relevant to the settlement of a trust. Adult Children

Generally, the attribution rules do not apply to adult children. One can transfer property to one’s adult children and the income earned thereon is not attributed back to oneself (e.g., shares, bonds, earning dividend and interest income). However, attribution may apply to a loan, or indebtedness incurred on a transfer of property, if one of the main reasons for the loan or indebtedness was to reduce one’s tax and to benefit an adult child. This is not a concern where interest is charged at the prescribed rate under the Act and is actually paid each year. Further, recall that, when property other than money is disposed of by way of a gift, the property is deemed disposed of at fair market value and any capital gain inherent in the property will be taxable to the donor. Minor Children

The attribution rules do apply to income, but not to capital gains, realized by minor children. Non-Residents

The attribution rules do apply to non-residents. Therefore, for instance, non-resident parents or grandparents could transfer funds to a trust for Canadian-resident children or grandchildren without attribution of income or capital gains. Loans at the Prescribed Rate of Interest

There is no attribution where money or other property is loaned to a spouse or minor child and interest is charged at the prescribed rate at the time of the loan. The interest must be paid for every year during which the loan is outstanding, by January 30 of the following year. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 54 Free lead: 35D Next lead: 290D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Sales for Fair Market Value Consideration The attribution rules do not generally apply where property is transferred to a spouse or minor child for fair market consideration. Where the consideration includes indebtedness, interest must be charged at the prescribed rate and paid every year by January 30 of the following year. Planning Points ● Investments with low current yield but high capital gain potential may be suitable for transferring to a trust for one’s children (including minor children). Even though the income may be attributed to the transferor, the capital gain will be taxed to the children and subject to their tax rates and, for qualified property, capital gain exemptions. ● The attribution rules do not apply to testamentary trusts.

Tax on Split Income (the ‘‘Kiddie Tax’’) The tax on ‘‘split income’’ was in response to tax-planning techniques that avoided the existing attribution rules. For example, family- run corporations could be structured so that minor children received dividend income on shares in the corporation, either directly or through a trust or partnership, without attracting attribution. If the child had no other income, up to about $23,000 of dividends (depending on the province of residence) could be received tax-free each year. Another structure that effectively avoided the application of the attribution rules was the management services partnership or trust that provided its services to a professional practice or other business in which a parent of the children was involved. The children would be passive members of the partnership, or beneficiaries of the trust. The business income earned by the partnership or trust could be flowed out to the children, who were taxed at their lower marginal rates. In response to the success of such techniques, the government introduced the tax on ‘‘split income’’, applicable to 2000 and subsequent taxation years. Under section 120.4, the tax on split income is imposed at the rate of 29%, the highest marginal rate of tax, and it applies only to children under the age of 18 at the end of the relevant taxation year. Split income includes taxable dividends received on shares of corporations, other than shares that are listed on a prescribed stock exchange or those of mutual fund corporations. The dividends remain eligible for the dividend tax credit. Split income includes shareholder benefits or shareholder loans included in the child’s income, other than in respect of shares of a corporation listed on a prescribed stock exchange. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 55 Free lead: 515D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Split income also includes a child’s income, from a trust or partnership, that is derived from the provision of property or services to a business carried on by a person related to the child, a corporation in which a person related to the child is a specified shareholder, or a professional corporation in which a person related to the child is a shareholder. Except for the dividend tax credit and the foreign tax credits, no deductions or credits are allowed in computing the minor’s split income or the tax thereon. A child’s split income is deducted in computing the child’s income from a business or property that would other wise be subject to Part 1 tax at graduated rates of tax, in order to prevent double taxation of the same amount.

Excluded Amounts

An ‘‘excluded amount’’ in respect of a taxation year is not included in split income. An excluded amount means an amount that is income from a property acquired by or for the benefit of a minor as a consequence of the death of the minor’s parent. Thus, income from property inherited from the child’s parent will always be exempt from the split-income tax. An excluded amount also includes income from property in a particular year, when the property was inherited from someone else, if the specified individual is eligible for the disability tax credit in the year or is enrolled as a full-time student at a post-secondary educational institution during the year. The latter exception will obviously be of limited use, as most individuals enrolled in post-secondary education in any particular year are 18 years of age or over by the end of the year.

Split income does not include:

● dividends received on shares of corporations listed on prescribed stock exchanges, mutual fund corporations, and dividends received through mutual fund trusts. Split income does not include interest. However, such amounts may be subject to other attribution rules (e.g., subsection 74.1(2)), where shares or debt instruments were transferred or loaned from a parent to a minor child for inadequate consideration, so that care must be exercised in order to ensure that those rules do not apply;

● income from employment or personal services carried on by the minor; or

● capital gains realized by minor children, which are not split income (and are not subject to any attribution rules). CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 56 Free lead: 990D Next lead: 230D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Planning Points

● Split income is restricted to taxable dividends, shareholder benefits, and related business income. The tax does not apply to interest, rent, royalties or capital gains or to salaries.

● If a minor earns income by working at his or her parent’s business, the income will not be split income.53

● It is still possible to have portfolio investments owned by (or held in a trust for) children in order to ‘‘split capital gains’’. A minor child or a trust for a minor child may benefit from the $750,000 capital gains exemption on a sale of shares of a qualified small business corporation or a qualified farm corporation. There is also the limited exemption for unincorporated business income derived from providing goods or services to an unrelated business. Ownership by a minor child or a trust for a minor child of a partnership interest or of shares of a private corporation also has the advantages of asset protection and estate planning. Assets owned by minors would not be exposed to creditors of the parents, nor would they be subject to deemed disposition or to probate fees on the death of the parents.

● Consideration may be given to expanding the conventional income splitting network; possible candidates include elderly parents or grandparents who are in low tax brackets (and to whom the attribution rules do not apply).

The Reversionary Trust Rules — Attribution Under Subsec- tion 75(2)

Very basically, subsection 75(2) of the Income Tax Act provides for the attribution of income and capital gains derived from trust property where the property was received by the trust from the person and can revert to that person (or pass to other persons determined by that person).

53 And remember that the basic personal exemption (for 2009) shelters the first $10,320 in income, so even a small salary will still result in material tax advantages. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 57 Free lead: 315D Next lead: 440D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Subsection 75(2) may apply to any inter vivos trust that does not fall within the statutory exceptions set out in subsection 75(3).54

In certain circumstances, the application of subsection 75(2) may be inconsequential or even desired. The danger lies in inadvertently falling within the purview of subsection 75(2); in which case, the tax consequences can be quite severe. Aside from attribution under subsection 75(2) itself, subsection 107(4.1) precludes a rollout to beneficiaries of capital property of a trust to which subsection 75(2) applies (or has applied). A notable aspect of subsection 75(2) is that, in contrast to many of the other attribution rules, which explicitly or implicitly incorporate an intention on the part of the taxpayer to reduce or avoid tax and/or benefit a non-arm’s length person, subsection 75(2) may apply even where the trust was established for strictly non-tax planning purposes. And the fact that subsection 75(2) may apply where tax planning is not the order of the day probably increases the risk of inadvertently falling within its provisions. Therefore, it is imperative that subsection 75(2) be considered in planning and implementing an inter vivos trust. More particularly, the provisions of subsection 75(2) should be considered in determining:

● the identity of the settlor;

● the identity of the trustee(s);

● the identity of the income and capital beneficiaries;

● the manner in which trustees are to reach decisions; or

● what (if any) power should be retained by the settlor (or any other contributor to the trust).

The following provides an overview of some of the issues to be considered in making such decisions.55

54 The trusts exempted by subsection 75(3) include: trusts governed by registered pension plans; employee profit sharing plans; registered supplementary unemployment benefit plans; RRSPs; deferred profit sharing plans; registered education savings plans; registered retirement income funds; employee benefit plans; retirement compensation arrangements; and related employee segregated fund trusts. Paragraph 75(3)(d) refers to prescribed trusts, although currently there are no trusts prescribed in the Regulations for this provision. Pending amendments propose to add new paragraph 75(3)(c.2), which is intended to ensure that subsection 75(2) does not apply to property held by a ‘‘60-month immigration trust’’, viz., a trust in respect of which all of the contributors are recent immigrants to Canada (i.e., none of the contributors to the trust has been resident in Canada for more than 60 months). 55 For a more detailed discussion, see Brenda L. Crockett, ‘‘Subsection 75(2): The Spoiler’’, Canadian Tax Journal (2005) Vol. 53, No. 3, pp. 806–830. See also M. Elena Hoffstein, ‘‘Tips & Traps: Issues in Estate Planning’’, Estates and Trusts Forum 2001, pp. 1–40. Reference may also be made to Interpretation Bulletin IT-369R, ‘‘Attribution of Trust Income to Settlor’’. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 58 Free lead: 0D Next lead: 270D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

250 The Estate Planner’s Handbook

The Trap — Key Words Subsection 75(2) reads as follows: Where, by a trust created in any manner whatever since 1934, property is held on condition (a) that it or property substituted therefor may (i) revert to the person from whom the property or property for which it was substituted was directly or indirectly received (in this subsection referred to as the person), or (ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust, or (b) that, during the existence of the person, the property shall not be disposed of except with the person’s consent or in accordance with the person’s direction, any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of property substituted for the property, shall, during the existence of the person while the person is resident in Canada, be deemed to be income or a loss, as the case may be, or a taxable capital gain or allowable capital loss, as the case may be, of the person. Italics have been added above to highlight aspects of subsection 75(2) that make it a particularly expansive provision and thereby increase the scope for taxpayers to inadvertently fall within its purview. ‘‘Or property substituted therefor’’ The property to which subsection 75(2) applies includes ‘‘substituted property’’, as defined by subsection 248(5). Subsection 248(5) provides that where one property is disposed of or exchanged and a second property is acquired in substitution for the original property and that second property is disposed of or exchanged and a third property is acquired in substitution for the second property, the third property is deemed to have been substituted for the original property. This deeming rule will apply to a fourth property acquired in substitution for the third property and so on, such that no matter how many substitutions are made, the property owned at any particular time is deemed to have been substituted for the original property. ‘‘May’’ Subsection 75(2) will apply whenever, under the terms of a trust, there is the possibility that trust property could revert to the person who contributed it, even if the possibility of reversion is remote. It may apply, for example, where the contributor has no more than a contingent capital interest under a ‘‘disaster’’ clause. The CRA has made the following comment on the word ‘‘may’’: CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 59 Free lead: 425D Next lead: 455D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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The word ‘‘may’’ implies that the subsection applies even though there is only a possibility that the property reverts to the transferor. We would like to stress that the condition found in subparagraph 75(2)(a)(i) of the Act does not refer to the notion of control or certainty in order to be met.56

Accordingly, the CRA concluded that subsection 75(2) would apply where a taxpayer transferred property to a trust, under the terms of which the taxpayer’s spouse was given a power of appointment exercisable through the spouse’s will. Accordingly, the spouse would determine the beneficiaries who would share in the assets of the trust at the spouse’s death. The assets of the trust would not become the assets of the spouse’s estate. Rather, the assets of the trust would be distributed to the persons chosen by the spouse through the exercise of the power of appointment given to the spouse in the trust indenture. Since the contributor could be so chosen, subsection 75(2) applied. (The CRA went on to state that, where the terms of the power prevented the donee of the power from appointing the transferor, subsection 75(2) would not apply because the property could not return to the contributor through the operation of the trust.)

‘‘Directly or indirectly’’

Not only will subsection 75(2) apply where the meeting of its conditions is only a hypothetical possibility, the contribution triggering it may be direct or indirect. Therefore, it would apply where property is transferred to a taxpayer who thereafter (perhaps years later) establishes a trust naming the transferor as a beneficiary (and perhaps only a contingent beneficiary at that). It is not hard to imagine how such a circumstance might arise. Say, for instance, Parent gives Child a property which, a number of years later, Child transfers to an inter vivos family trust, the primary beneficiaries of which are Child’s spouse and children, but the terms of which name Parent as a contingent residual beneficiary. In such circumstances, subsection 75(2) applies to attribute any income, loss, etc., from the property to Parent.

‘‘Received’’

Unlike most of the attribution rules, subsection 75(2) can apply even where the property was transferred to the trust for fair market value consideration (or where the property can pass back to the transferor for fair market value consideration).57 The word ‘‘received’’ is very broad and subsection 75(2) does not qualif y it by reference to ‘‘for inadequate consideration’’ or any other such phrase.

56 Document No. 2002-0162855, April 25, 2003. 57 Document No. 2004-0086941C6, October 8, 2004. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 60 Free lead: 44D Next lead: 123D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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‘‘The person’’ Generally, it is the settlor who transfers property to a trust to which subsection 75(2) may apply. However, subsection 75(2) is worded such that it may apply to any person from whom property is received by the trust and not just the settlor. By virtue of the definition of ‘‘person’’ in subsection 248(1), this may include a corporation or another trust. ‘‘Consent’’, ‘‘direction’’ Typically, the settlor of an irrevocable trust will retain some control over the assets of the trust by being one of its trustees. The CRA is of the view that subsection 75(2) may apply where: ● the transferor has the ability to select beneficiaries, including the beneficiaries among a predetermined class, to whom property will pass; and ● the transferor has retained the right to veto distributions of trust property to beneficiaries. To avoid the application of subsection 75(2), the settlor should not be the sole trustee. Where, as is common, three trustees are appointed, the settlor should not have a veto. The trust indenture should specif y that decisions are to be made by a majority vote. In the absence of such a clause, trust law requires decisions to be unanimous, which would mean the trust property could not be dealt with without the consent of the settlor-trustee. Although two relatively recent CRA technical interpretations (see the discussion of ‘‘Co-Trustees’’ below) have cast some doubt on the issue, it has generally been understood that the presence of such a veto would cause subsection 75(2) to apply. Notwithstanding the leniency expressed in these documents, it should be borne in mind that: these documents are not binding on the CRA; the latter frequently revises its position and the precise interpretation to be given these two particular technical interpretations is subject to question. Accordingly, it remains prudent for the settlor not to be the sole trustee, for him or her not to have a veto, and for decisions to be made by a majority of at least three trustees. Even where it is provided that decisions are to be made by a majority of three trustees and the settlor does not have a veto, a de facto veto may arise in certain circumstances such as when a non-contributing trustee resigns before he or she can be replaced. This would leave the settlor-trustee with a veto until a replacement trustee was appointed and, even though the situation could be quickly corrected, the temporary nature of the veto would not stop subsection 75(2) from applying. (The significance of even the temporary application of subsection 75(2) will become clear when subsection 107(4.1) is considered.) To preclude such an eventuality, the trust indenture CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 61 Free lead: 47D Next lead: 123D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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could stipulate that, while the settlor-trustee is one of fewer than three trustees, all discretionary distributions and dispositions are to be suspended until a third trustee is appointed.

Restrictions on the Application of Subsection 75(2) It will be apparent from the above that subsection 75(2) is broadly worded and may apply in many seemingly innocent situations. However, the terms of this provision and the CRA’s administrative position in regard thereto indicate some significant restrictions on its scope and impact. Loans In Interpretation Bulletin IT-369R (paragraph 1), the CRA states that: ‘‘A genuine loan to a trust would not by itself be considered to result in property being ‘held’ by the trust under one or more of these conditions (i.e., would not by itself result in the application of subsection 75(2)), if the loan is outside and independent of the terms of the trust.’’ Therefore, based on the CRA’s administrative discretion, a loan to a trust will not attract the application of subsection 75(2), although a sale or gift to a trust would. Of course, the loan must be ‘‘genuine’’ and its terms not so generous as to constitute a disguised gift. Also not to be overlooked is the requirement that ‘‘the loan is outside and independent of the terms of the trust’’, which is to say, at least, the making of the loan should not be reflected in the drafting of the trust. The issue of whether subsection 75(2) applies in regard to loans to a trust was considered in the recent case of Howson v. The Queen, 2007 DTC 141, in which the Tax Court of Canada stated plainly enough (at paragraph 15): ‘‘It stands to reason that a bona f ide loan is, on its face, not subject to reversion by the terms of the Trust. It returns to the lender by operation of the loan itself and the law of creditor rights.’’ The CRA did not contest this position; rather, it simply argued that no ‘‘genuine’’ loan had been made. The Tax Court of Canada, however, held that the existence of a loan does not necessarily require a contemporaneous written agreement, interest payments, or security given by the borrower. On the basis of the taxpayer’s evidence, the Trust accounts, and a written agreement made three years after the loan, the Tax Court held that the preponderance of evidence indicated that a bona f ide loan had been made. Second Generation Income As is generally the case with other attribution rules, subsection 75(2) does not apply to second-generation income. Therefore, for example, as the CRA puts it in Interpretation Bulletin IT-369R (paragraph 6), ‘‘if the CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 62 Free lead: 10D Next lead: 123D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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property received from a person is money which is deposited by the trust into a bank account, the interest on the initial deposit will attribute to that person but interest on the interest left to accumulate in the bank account will not attribute.’’ As noted above, subsection 75(2) applies to ‘‘substituted property’’. Thus, while subsection 75(2) does not apply to attribute second- generation income, it does apply to second- (and subsequent) generation capital gains. Income Beneficiaries If the settlor/contributor is an income beneficiary under the trust, subsection 75(2) will not normally apply unless, for example, there is a power to encroach upon the trust capital for the benefit of the income beneficiary. The terms of any trust can deny the settlor access to the capital of the trust. It s interesting to note, however, that doing so becomes problematic in the case of an alter ego trust. The rub is that a trust will not qualif y as an alter ego trust if anyone other than the settlor has access to the capital (or income) of the trust during the lifetime of the settlor. Therefore, for an alter ego trust to avoid subsection 75(2), the entire capital of the trust will have to be completely inaccessible during the lifetime of the settlor. Reversion by ‘‘Operation of Law’’ The CRA has consistently held that the reversion of property contemplated by paragraph 75(2)(a) would not include the situation ‘‘where the property may revert to the person by operation of law only, e.g., a total failure of the trust for lack of beneficiaries, and not pursuant to any condition under the trust indenture’’.58 This creates the possibility of planning for reversion by the operation of law. Contributor Inherits Property from Spouse’s Estate As noted above, it is the CRA’s view that subsection 75(2) could apply where an individual transferred property to a trust for the benefit of the individual’s spouse where the disposition of the trust’s assets would be determined by the spouse through his or her will. As the settlor could reacquire the property under the terms of the spouse’s will, it was the CRA’s view that subsection 75(2) could apply. Nonetheless, the CRA has said that, as it sees it, subsection 75(2) would not apply where the spouse’s estate acquires the property and the spouse could potentially — through his or her will — leave that property to the settlor of the trust.59 In brief, then, if the trust indenture grants a power of appointment to be exercised via the will of

58 Document No. 2002-0116535, February 19, 2002.

59 Document No. 2002-0139205, July 22, 2002. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 63 Free lead: 11D Next lead: 123D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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the beneficiary, subsection 75(2) applies (unless the power of appointment is suitably limited); but, if the property becomes part of the beneficiary’s estate (again to be distributed pursuant to his or her will), it will not. Transfer of Property from Reversionary Trust to New Trust The CRA has expressed the view that, where property of a trust to which subsection 75(2) applied is transferred to a new trust, the terms of which would avoid the provision, subsection 75(2) would not apply to the new trust solely because the provision applied to the first trust.60 Business Income Subsection 75(2) does not apply to business income or losses of a trust (see Interpretation Bulletin IT-369R (paragraph 5)). However, capital gains or losses arising in regard to business property are attributed to the contributor. ‘‘In Existence’’ and ‘‘Resident in Canada’’ Subsection 75(2) applies ‘‘during the existence of the person while the person is resident in Canada’’. It, therefore, will not apply on the death or emigration of a contributor. However, note that, although any income, gain and loss in respect of property received from a person is attributed by subsection 75(2) to that person only during a period when that person is resident in Canada, its application does not depend upon the person having been resident in Canada at the time the property was received by the trust. Given the requirement that the person be in ‘‘existence’’ for it to apply, subsection 75(2) will not apply to a deceased testator. And, given that a testamentary trust is defined in subsection 108(1) in such a manner that it ceases to be such if anyone other than the deceased contributes to it, subsection 75(2) can have no application to testamentary trusts. Applies on a Property-by-Property Basis Where subsection 75(2) applies, ‘‘any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of property substituted for the property’’ is attributed to the person who contributed it. What is attributed then is only the income, loss, etc. of the specific property

60 Document No. 2001-0067955, January 3, 2002. The CRA noted in the same document that, in its view, where subsection 75(2) applied to the first trust, the rollover under subsection 107(2) would not apply to the transfer of property to the new trust unless one of the conditions in paragraphs 107(4.1)(c) and (d) is not met. Other wise, subsection 107(4.1) applies to deny the rollover under subsection 107(2), and subsection 107(2.1) would apply to the disposition of property by the first trust. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 64 Free lead: 20D Next lead: 187D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

256 The Estate Planner’s Handbook

(i.e., the property contributed by a person to whom it may revert) and not that of the assets of the trust as a whole. Accordingly, in and of itself, the attribution of income under subsection 75(2) may not be of great importance. Determination of the Quantum of Capital Distributions The CRA has indicated that subsection 75(2) may not apply where the person from whom the property was received by the trust cannot determine the identity of the beneficiaries but can only determine the quantum of the trust property to be distributed to the beneficiaries which have already been identified by the trust.61 However, it added that, if the power to determine the quantum of the trust property is such that it results in the power to determine the beneficiaries to whom the property will pass, subsection 75(2) would apply. (For example, this situation may occur, if the settlor retains the possibility to identif y which property can be distributed to a beneficiary or if he or she retains the possibility to fix the quantum (for example, in allocating nothing to a beneficiary) so that he has retained the possibility to identif y the beneficiary. Co-Trustees As noted above, in recent years the CRA has moved away from the position that subsection 75(2) will necessarily apply where the settlor (or other contributor) has what amounts to a veto. Most recently, the CRA has stated:62 Generally speaking, when no specific provision is made in a trust indenture as to the way in which the trust’s property must be administered, the administration of this property is subject to the standard terms in the trust indenture. In this case, the fact that an individual from whom the trust received property is a co-trustee of the trust with one or more individuals and the trustees, decisions must be made by a majority or unanimously does not in and of itself mean that paragraph 75(2)(b) I.T.A. applies. Also in 2004, the CRA commented as follows:63 When the settlor is one of two or more co-trustees acting in a fiduciary capacity in administering the trust property and there are no specific terms outlining how the trust property is to be dealt with, but rather the property is subject to standard terms ordinarily found in trust indentures, we accept that paragraph 75(2)(b) will generally not be applicable.

61 Document No. 9213965, August 11, 1992.

62 Document No. 2004-0086921C6, October 8, 2004.

63 Document No. 2003-0050671E5, April 5, 2004. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 65 Free lead: 96D Next lead: 123D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

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Similarly, in an earlier document,64 the CRA opined that: Our current position is that where a person contributes property to a trust and is one of two or more co-trustees acting in a fiduciary capacity in administering the trust property and there are no specific terms outlining how the trust property is to be dealt with, but rather the property is subject to the standard terms of the trust, paragraph 75(2)(b) may not be considered applicable. The CRA’s current position appears to be that a trust will not necessarily be subject to subsection 75(2) where a contributor is a trustee and decisions are to be made unanimously, so long as the trustees are required to deal with the property pursuant to ‘‘standard terms ordinarily found in trust indentures’’ or their fiduciary duties. Yet, this attitude toward co- trustees is hard to square with the CRA’s longstanding position that subsection 75(2) necessarily applies to a sole trustee who has contributed property to the trust.65 While practitioners no doubt welcome an accommodating approach from the CRA, they may have misgivings about relying too heavily on its current administrative largesse. As one commentator has put it:66

The CRA’s recent reassurances in respect of co-trustees aside, if a contributor of property is also a trustee it seems prudent to continue the practice of using a minimum of three trustees with decisions to be made by a simple majority vote, except where doing so would be entirely impractical and where all possible negative consequences have been fully analyzed.

Denial of Tax-Deferred Roll Out Where Subsection 75(2) Applies The application of subsection 75(2) may be temporary and pertain to only a relatively minor contribution; however, even in such circumstances, due to its interaction with subsection 107(4.1), the application of subsection 75(2) can have momentous tax consequences. One of the most valuable features of a personal trust67 is its ability to transfer property to its capital beneficiaries on a tax deferred ‘‘roll out’’ basis. Pursuant to subsection 107(2), a distribution in satisfaction of a

64 Document No. 2000-0042505, April 30, 2001. In the same document, the CRA made a corresponding statement re paragraph 75(2)(a).

65 See for instance, Document No. 2001-0110425, June 20, 2002.

66 Brenda L. Crockett, supra, note 2, at p. 812.

67 As defined in subsection 248(1), a personal trust is essentially either a testamentary or inter vivos trust, all the beneficiaries of which received their interests as gifts. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 66 Free lead: 92D Next lead: 123D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

258 The Estate Planner’s Handbook

beneficiary’s capital interest will generally occur without triggering adverse tax consequences. Therefore, for instance, to avoid the deemed disposition that normally takes place on the 21st anniversary of a trust, it is usually advisable to roll out the capital property to the beneficiaries sometime prior to this date. The interaction of subsection 75(2) and subsection 107(4.1) puts an end to this happy arrangement. In brief, where subsection 75(2) applies to a trust, or has ever applied to it, the subsection 107(2) rollout will not be available. Subsection 107(4.1) is intended to remove the tax advantage in creating a trust under which the settlor holds capital property which will appreciate in value for a period during which such property could revert to the settlor or pass to people to be determined by the settlor in the future. As a result of subsection 107(4.1), the settlor cannot cause the trust property to be distributed on a tax-free basis to persons chosen by him or her subsequent to the creation of the trust. Subsection 107(4.1) reads in part as follows:

Subsection (2.1) applies (and subsection (2) does not apply) in respect of a distribution of any property of a particular personal trust or prescribed trust by the particular trust to a taxpayer who was a beneficiary under the particular trust where

(a) the distribution was in satisfaction of all or any part of the taxpayer’s capital interest in the particular trust;

(b) subsection 75(2) was applicable at a particular time in respect of any property of

(i) the particular trust, The words that make this provision particularly expansive have been itali- cized. Two aspects of this provision are particularly noteworthy: ● The denial of the 107(2) rollout applies to all the property of the trust and not just the property subject to subsection 75(2). ● For subsection 107(4.1) to apply, it is enough for subsection 75(2) to have ever applied to the trust. It does not matter, if at the time of the distribution, 75(2) no longer applies to any property then held by the trust. Therefore, whereas a subsection 75(2) problem can be rectified more or less simply, a subsection 107(4.1) problem is permanent. Prior to a 2001 amendment, paragraph (b) of subsection 107(4.1) read ‘‘subsection 75(2) was applicable at any time in respect of any property of the trust,’’; as quoted above, it now reads ‘‘subsection 75(2) was applicable at a particular time in respect of any property of’’. This would appear to be the CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 67 Free lead: 688D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

Ch. 8/Taxation of Basic Trusts Used in Estate Planning 259

case of a distinction without a difference. The fact remains that, where subsection 75(2) has ever applied to any of the property of the trust none of the property of the trust may be rolled out under subsection 107(2). It is interesting to note that when subsection 107(4.1) was introduced in 1988, there were no grandfathering provisions, with the result that trusts that were in existence at that time could be subject to it due to the application of subsection 75(2) at some earlier time in the life of the trust. This retroactive aspect of subsection 107(4.1) can be very problematic since, before 1988, some trusts (established, for example, in the course of an estate freeze) may have been purposely formulated with the knowledge that subsection 75(2) would apply, i.e., because the settlor wanted a high degree of control of the trust assets and because there was little downside prior to subsection 107(4.1). The effect of subsection 107(4.1) is that, where it applies to exclude subsection 107(2),68 subsection 107(2.1) applies instead, with the result that: ● The trust is deemed to have disposed of the property distributed to the beneficiary for proceeds equal to its fair market value at the time of distribution. As a result, the trust will realize a capital gain or loss at the moment of distribution. In addition, the trust may realize profits or losses in respect of inventory, and recapture or terminal losses in respect of depreciable property. ● The beneficiary is deemed to have acquired the trust property at a cost equal to its fair market value. In this light, not only should subsection 75(2) be considered in establishing a trust (choosing the trustees, etc., as noted above); given its interaction with subsection 107(4.1), anytime an in specie distribution of assets to a beneficiary in satisfaction of his or her capital interest in the trust is considered, it will be necessary to review the history of the trust to determine if subsection 75(2) ever applied to it.

68 The rules in subsection 107(2.1) will not apply to a disposition of property by a reversionary trust which takes place after the death of a settlor. Nor do they apply where the trust property was transferred to a spouse or common-law partner of the settlor on a rollover basis under subsection 73(2). In these two circumstances, the rollover provisions of subsection 107(2) remain available. CCH CANADIAN LIMITED ♦ NT PAGER Username: jdsouza Date: 18-AUG-09 Time: 10:43 Filename: D:\books\b170\chap08.dat Style: D:\books\b170\fmt\book.bst Format: $BOOKS/b170/fmt/book.bft (binary) N Seq: 68 Free lead: 212D Next lead: 0D Comment: ***** TAX BOOKS * DTD: (taxlib.dtd) *****

260 The Estate Planner’s Handbook avoiding probate. Tax Treatment . gains attributed to settlor; no deemed disposition at death of settlor. marginal rates, post-mortemincome-splitting. on death of life beneficiary. inter vivos may be used in creditorprotection. top marginal rate; no deemed investment; avoids probate. funding; income and capital disposition at death of settlor. planning. second spouse. Basic Types of Trusts, Their Benefits and Tax Treatment forever. investment; avoids probate;during lifetime of testator. funding; taxed separately at investment.control; trustee mere agent.no contingent beneficiaries;trustee not mere agent. contingent event (such as of testator; taxed at regular attribution; disposition on settlor can receive income deteriorating health).or capital; contingent of testator. Can avoid tax provincial tax planning and beneficiaries allowed. to both spouses. death of settlor. planning for incapacity. income and capital during his or her lifetime. application re family law disposition only at death of may be effective in Trust Type Characteristics Non-Tax Benefits Income Probate APPENDIX: TYPES OF TRUSTS (1) Irrevocable Living Settlor gives up property(2) Revocable Living Supervised control and Settlor can revoke. Deemed disposition on initial Avoided. (3) Testamentary Supervised control and Created by will; revocable(4) Bare Deemed disposition on initial Supervised control and Avoided. (5) Protective Deemed disposition on death Can be included in estate (6) Alter Ego Settlor retains complete Settlor is sole beneficiary, Often negligible.(7) Joint Spousal Used to guard against Settlor at least 65; only No ‘‘disposition’’ on creation;(8) Spousal Same as (6), except applies Varied, including inter- Same as (6); possible Same as (4). Taxable to settlor. Same as (5). Same as (5), but deemed Only spouse entitled to In limited circumstances Avoided. Varied. Avoided. Rollover, possible attribution if Avoided. The Estate Planner’s Handbook, 3rd Edition

This book provides a concise yet comprehensive overview of many of the most important issues in the estate planning process. It is particularly recommended for lawyers, accountants and other professional advisors who are new to this growing field or who have more experience but seek a handy guide to issues outside their particular area of expertise. Topics covered include: tax planning the will; pros and cons of will substitutes; pros and cons of alter ego and joint partner trusts; life insurance trusts; and creditor protection for registered plans.

New with this edition is a chapter on estate planning for the disabled that, among other things, addresses the use of planning vehicles provided by the Income Tax Act (such as a Lifetime Benefit Trusts and Registered Disability Savings Plans) and Henson trusts designed to safeguard access to provincial income support programs.

Other issues addressed in this edition include: • Wills • Multiple Wills • Will Substitutes • Continuing Powers of Attorney • Health and Personal Care by Proxy • Some Basic Trust Law Concepts & Principles • Taxation of Basic Trusts Used in Estate Planning • Certain Other Trusts Used In Estate Planning • Charitable Donations • Taxation at Death • United States Estate & Gift Tax • Probate • Dependants’ Relief • Spousal Property Rights in Ontario

Robert Spenceley, M.A., LL.B., was called to the Ontario Bar in 1989. As a member of the tax group at CCH Canadian Limited, he is: the author of Estate Administration in Ontario, a member of the editorial board of the Canadian Estate Planning Guide, and contributor to CCH newsletters The Estate Planner, Tax Notes and Tax Topics®.

Book No. B170 ISBN 978-1-55496-063-7

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