A trust is a relationship under which a person, called a settlor, contributes cash or other property in trust for the benefit of others, called the beneficiaries. The trust is not a legal person or entity for most purposes, but it is considered a “person” and a “taxpayer” for income tax purposes. The person or persons in charge of administering the trust affairs is called the trustee (or trustees). (The trust has its origins in common law, although the Quebec Civil Code now has a similar concept.)
Trusts are set up for various purposes. For example, you may want to set up a trust with investments for the benefit of your minor children who are not capable of managing the investments themselves. Another example is where a beneficiary is mentally infirm or disabled and unable to manage the investments. But there are a multitude of reasons for setting up trusts, and most are perfectly legal and legitimate.
More generally, a trust allows the settlor and/ or trustee to maintain at least some control over the property. If the property were instead transferred directly to a beneficiary without a trust, that element of control would normally be lost.
In general terms, for income tax purposes, the income of the trust is taxed either to the trust or to the beneficiaries. If the income for a year is retained in the trust, it is normally taxed to the trust. To the extent it is distributed to the beneficiaries, it is normally taxed to the beneficiaries.
So, for example, if the beneficiaries are in a lower tax bracket than the settlor, there could be obvious tax savings.
This all sounds good. But there are many complexities and “traps” that you need to be aware of when setting up a trust. One in particular is this: If you are the settlor of the trust, you could be subject to a rule in Income Tax Act (subsection 75(2)). It is sometimes called the reversionary trust or revocable trust rule. It is essentially an income attribution rule that will attribute trust income to the settlor.
The rule normally applies after the settlor contributes property to the trust, if the conditions set out below are met. If the rule applies, any income or loss from the property, and any taxable capital gains or allowable capital losses on the disposition of the property, will be deemed to be that of the settlor. This rule can obviously defeat some of the tax planning reasons for using a trust.
When does the rule apply?
First, subsection 75(2) applies if the property contributed by the settlor to the trust, either directly or indirectly, is held on condition that the property may:
a) “revert” (go back) to the settlor,
b) pass to persons to be determined by the settlor after the creation of the trust.
The above rule also applies to “substituted property”. For example, it can apply if the original property contributed by the settlor is sold by the trust and the proceeds are used to acquire another property that falls under the above conditions.
Second, the subsection 75(2) rule can apply if the property cannot be disposed of except with the settlor’s consent or in accordance with their direction.
Scenarios where the rule could apply
This is where it gets tricky.
The rule is quite broad. It can apply in the following circumstances if you are the settlor of the trust:
- You are a capital beneficiary of the trust, meaning that the property may eventually go to you as beneficiary. This does not mean that you cannot be a beneficiary. You just have to make sure that the trust terms cannot result in you getting the property. You can receive only income from the trust.
- After the trust is created, you have the authority to determine who gets the property.
- You are the sole trustee of the trust, since in this case you may be able to determine who gets the property or the property might not be disposed of without your consent or direction.
- For similar reasons as above, there are multiple trustees including you, but you have veto power over trustee decisions.
- There are multiple trustees including you, but the majority of trustee decisions must include you as part of that majority.
Exceptions to the rule
Obviously, the rule does not apply if the subsection 75(2) conditions described above are not met.
In addition, the rule does not apply in any of the following situations:
- To loan cash or other property that you lend to the trust, as long as it is a “bona fide” loan.
- If you cease to be a resident in Canada.
- After your death.
- To most deferred income plans that are trusts, such as registered retirement savings plans, tax-free savings accounts, and registered education savings plans, among others.
- If you are only an income beneficiary and therefore cannot receive the property / capital from the trust.
- If you are a trustee, but there are multiple trustees and you do not have ultimate control or veto power as discussed above. For this reason, personal or family trusts usually have two or more trustees, unless the sole trustee is someone other than the settlor.
- If you could receive the property from the trust only if it ceases to be a valid trust in law and therefore must be terminated.
Another problem: Potential Tax on Distribution of Property
In most cases, when trust property is distributed to a capital beneficiary, this occurs on a tax-free “rollover” basis. That is, the trust is deemed to dispose of the property at its tax cost, and the beneficiary picks up the same tax cost of the property.
Unfortunately, this rule does not always apply. It may not apply if the subsection 75(2) rule discussed above ever applied to property of the trust.
In such case, if trust property is distributed to a beneficiary other than the settlor or their spouse or common-law partner while the settlor is alive, the rollover will not apply and the trust will have a deemed disposition for fair market value proceeds. This may generate ordinary income or capital gains (or losses). However, if the settlor has died, the rollover can apply for distributions to other beneficiaries.
This non-rollover treatment is quite harsh, as it can apply if any property is distributed to a beneficiary of the trust, even if it is not the property that the settlor contributed to the trust. In other words, if subsection 75(2) ever applied to the trust, any property distributed to a beneficiary will be at fair market value proceeds, unless one of the exceptions noted above applies.