As we near the end of the calendar year, trustees of inter vivos trusts (created during a person’s lifetime) such as family trusts or testamentary trusts (created by will) should pass resolutions or meet with co-trustees to ensure that all trust tax matters are in order by December 31. Although other times of the year can also be important and trustee meetings can take place at various times throughout the year for decision-making, for most trusts, December 31 is the trust year-end and there can be essential steps for the trustees to take on or before that date. The trustees’ minutes or resolutions are primary sources used to prepare the trust’s T3 Trust Information and Tax Return due 90 days after the trust year-end. That there have been proper steps taken by the trustees by December 31 appears to be a matter of increasing interest for Canada Revenue Agency.
For most Canadian trusts (exceptions include Qualified Disability Trusts and where the preferred beneficiary election is available), net income of the trust for the year is taxed in the trust itself at the highest personal tax rate applicable for the trust’s provincial tax residence. In Alberta, for example, this rate is currently 48% on ordinary income, like interest.
A deduction by the trust from the net income which would otherwise be taxed in the trust is usually available to the extent that net income has actually been paid to one or more beneficiaries of the trust in the year or has been made payable in the year to one or more beneficiaries, such that the beneficiary has a legally enforceable right to payment in the year. To the extent that this has been done on or before December 31 of the year, then generally the net income which would otherwise be taxed in the trust’s hands can be taxed in the hands of the recipient beneficiaries, often at much lower tax rates or even with no tax having to be paid.
The tax rate at which the recipient beneficiaries can have this allocated net income taxed in their hands is, however, subject to the application of the recent “tax on split income” or “TOSI” rules expanding upon the previous “kiddie tax” rules. For more information on these rules, please see the four-part series by Colleen Ma and William J. Fowlis in Tax Notes “A New Era of Private Corporation Tax Rules – Parts I – IV” February 5, 2018, February 23, 2018, April 30, 2018 and July 26, 2018, available on the Miller Thomson website.
Previously, for testamentary trusts, net income could be taxed in the trust at the graduated tax rate of the trust. This option is no longer available for most testamentary trusts so the need to determine if net income should be “flushed” out of the trust by year-end is important for testamentary trusts as well as inter vivos trusts.
If the net income has not actually been paid to one or more beneficiaries in the year, then the trustees (unless prepared to have the net income of the trust taxed in the trust itself) will need to take the necessary steps to allocate the net income and ensure that the beneficiary has a legally enforceable right to the net income within the year. This may be done in a few different ways such as by irrevocable resolution of the trustees, notice to the beneficiary and issuance of a promissory note for the amount in question. The document by which the trust was established may contain relevant provisions on how legally enforceable rights can be created. Where there is any doubt on how to establish a legally enforceable right, a Miller Thomson private client lawyer can assist.
It is important to recognize that there can be a difference between income for “trust” purposes and income for “tax” purposes. The document which established the trust may address how “income” is to be calculated. Where it does not, the default is generally income for “trust” purposes. The distinction often relates to the treatment of net taxable capital gains which are not usually included in income for “trust” purposes. Special consideration is required where there are net taxable capital gains earned by the trust in the year. In order for them to be taxed in the hands of a beneficiary, rather than the trust, it may be necessary for the trustees of the trust to encroach on the capital of the trust for the benefit of that beneficiary.
The document which established the trust should be consulted to ensure that the actions which the trustees propose to take are authorized. In addition, it is important that the trustees consider all the factors appropriate in exercising their discretion, where they have discretion. Sometimes they do not have discretion such as, for example, where they are obliged to pay all net income for the year to an individual under the trust terms. They will need to be sure in exercising any discretion they have that they do not blindly let the “tax tail wag the dog”.
Of course, things can often be more complicated. Particularly with inter vivos trusts (ones created during a person’s lifetime), specific rules under the Income Tax Act (Canada), known as the “attribution rules”, can really play havoc with the plan to allocate income to beneficiaries in a lower tax bracket than the trust. The rules which come into play can include where the person who established the trust (the “settlor”) has a potential ability to receive back capital he/she contributed to the trust. This can cause the income or capital gains of the trust to be attributed back to the settlor and taxed in his/her hands even if the amounts are paid out to a beneficiary. Other special rules are involved where spouses/common law partners or minors are beneficiaries and in certain situations where there are transfers or loans to a corporation which could benefit “designated persons”.
To overcome these rules, in some cases, funds are loaned to the trustees of the trust rather than gifted. Where the loans have been made at the “prescribed rate” under the Income Tax Act (Canada) or otherwise on arms-length terms, then the attribution rules may not apply. It is important for this purpose, however, that the annual interest on the loan be paid within 30 days of the following year (by January 30) for every year the loan is outstanding. The trustees can use the meeting on or before December 31 to ensure that steps are in place to have this interest paid by the trust in time.
The annual trustee meeting is also an appropriate time to consider planning for the deemed disposition date which occurs on the 21st anniversary of the date the trust was established and every 21 years thereafter. Although there are exceptions to this rule, such as for spousal trusts, alter ego trusts and joint spousal/partner trusts, for most trusts, the trustees need to be aware of when that anniversary date will arise. On the applicable anniversary dates, the trust can be deemed to have disposed of its capital property at fair market value as if it had sold the property in question. This can result in significant tax on the capital gain. There are often ways to avoid this result but it can take a few years beforehand to put the mechanism in place. It is normally prudent for the trustees to take legal advice on the matter well in advance.
In conclusion, the annual minutes/resolutions of trustees on or before December 31 are critical for the tax efficient operation of trusts and prudent trustees will ensure that they are a standard annual procedure.