Multiplying the capital gains exemption: WAIT – THEY GET THE MONEY??

1 mars 2022 | Raymond G. Adlington

( Disponible en anglais seulement )

You’re ready to sell your business. Excellent – congratulations on building something worth buying. You’ve had one of those family trust things around for several years. Thanks for following sound tax planning advice. You’re hearing now about multiplying the lifetime capital gains exemptions to pay less tax on the sale proceeds. Multiplication is good, especially multiplication of tax exemptions. Use the children (or grandchildren) who are beneficiaries of the trust to multiply. Fine – we may tell them about it someday. Pay the amount allocated to them when they reach age 18. Got it. WAIT – THEY GET THE MONEY?

Absent additional planning, the answer is probably yes unless you manage to spend it all on their behalf before they hit that magical birthday. One of the requirements to multiply the capital gains exemption by utilizing the exemption room of minor beneficiaries of a family trust is for the family trust to “pay or make payable” the amount of the gain to the child or grandchild so the exemption can be claimed by them. This is because only a natural person is able to claim the exemption, and not a trust except in very limited circumstances. For the minor child or grandchild to utilize their exemption, the amount must have been paid to them in the year, or the trustees must cause the amount to become “payable” to them in the year. This means they must take all necessary steps to ensure that the minor beneficiary has a legal entitlement during the year to enforce payment of the amount with no conditions attached. Money or property cannot be paid directly to a minor child, but once that child attains the age of majority they have the right to enforce payment. In Ontario, the age of majority is 18, and is either 18 or 19 in all other provinces and territories.

Please indulge this short digression to be clear about how much money we are talking about here. The lifetime capital gains exemption in 2022 is $913,630, and is indexed annually for inflation. The inclusion rate for capital gains is currently 50%, meaning the “taxable portion” of an “exempt” gain is $456,815. This is the amount that we are talking about if the gains exemption of the child or grandchild is maximized (less that pesky alternative minimum tax they may have to pay). At a Canada Revenue Agency (“CRA”) Roundtable hosted by the Society of Trust and Estate Practitioners in 2020, the CRA agreed that a family trust need not pay or make payable the non-taxable portion of a capital gain realized by a trust to the child or grandchild for their full exemption to be utilized.[1] Implied in this response is that the non-taxable portion of $456,815 may be capitalized by the trust and paid to any of the capital beneficiaries free of tax at a later time.

Let’s get to the point. How can you multiply those capital gains exemptions and keep control over the money past the 18th or 19th birthday of your minor child or grandchild? Two possible solutions to consider are (a) creating an “age 40 trust”, or (b) causing the trust to pay the taxable portion of the gain allocated to the minor beneficiary in an illiquid form. One example of this second strategy is to distribute to the beneficiary non-voting, cumulative dividend preferred shares in a family-owned investment corporation. The terms of the trust agreement and the exercise of trustee discretion acting in the best interests of the relevant beneficiary should dictate to the optimal approach.

Age 40 trust

An “age 40 trust” is a solution to retain control over the money where your family trust agreement (a) allows the trustees to allocate and pay income to a second trust for the benefit of one or more of the beneficiaries, and (b) contains a provision directing that payments to minor beneficiaries can be made to such a trust. Trust income such as the “taxable portion” of the gain sought to be made exempt is deemed payable to a child or grandchild where:

  • the individual is less than 21 years of age at the end of the year;
  • the individual’s right to the income is vested by the end of the year;
  • the individual’s right to that income did not become vested because of the exercise or the non-exercise of a discretionary power; and
  • the individual’s right is not subject to any future condition (other than a condition that the individual survive to an age not exceeding 40 years).

Deeming an amount to be payable is the legislative solution to allowing the deduction by the trust to move the “taxable portion” sought to be exempted to the income of the beneficiary who may then claim the exemption even where the amount is not actually made payable. The requirement of the right to the income to be vested means that no one else can ever be entitled to that amount while the individual is alive. The last requirement of this list is where the “age 40” trust draws its name.

A new trust (or a sub-trust if preferred) is created for the sole benefit of the beneficiary who is under 21 years of age at the end of the relevant calendar year. The terms of this new trust provide that the beneficiary is to be paid the capital of the trust at some future time on or prior to their 40th birthday. Of course, the terms of the trust may also allow for the distribution of income and capital prior to that time at the discretion of the trustees.

The establishment of the “age 40” trust allows the multiplication of the capital gains exemption while also keeping control over the spending of the amount allocated for an extended period of time prior to its ultimate payment to the beneficiary.

Cumulative dividend preferred shares

An amount made payable to a beneficiary of a family trust can be satisfied by the trustees distributing an asset other than cash, provided that the fair market value of the asset is equal to the amount payable. This strategy involves distributing an illiquid asset (in this example non-voting, cumulative dividend preferred shares of a private corporation) owned by the family trust to satisfy the amount of the taxable capital gain made payable to that child or grandchild. Utilizing this strategy is most cost-effective where the family already has, or will be retaining as part of a pre-closing safe income strip, a family controlled investment corporation (“Investco”).

After the share sale has been completed and the family trust has received its proceeds, the trust would use the amount desired to be allocated to selected beneficiaries for the purposes of multiplying the exemptions to subscribe for non-voting preferred shares of Investco. These preferred shares would carry a cumulative dividend entitlement, be redeemable at the option of Investco for a redemption price equal to the original subscription price plus any accumulated unpaid dividends, and be entitled to receive this same amount as a preferred distribution should Investco be wound-up. The cumulative dividend rate is set with regard to the definitions of “safe harbour capital return” and “reasonable return” (depending upon the age of the beneficiary) to ensure that no future dividend paid on the shares will be considered “split income” for the purposes of the rules that impose the highest possible rate of tax to such income (affectionately referred to as “TOSI” as the acronym for tax on split income).

These preferred shares owned by the trust can then be transferred by the trust to the child or grandchild as satisfaction of the amount made payable to them by the trustees to multiply the capital gains exemption. The investment and distribution of the money are then controlled by the directors of Investco. The omission of a retraction feature, effectively a forced redemption at the option of the holder of the shares, from the preferred share terms means that a distribution of cash can’t be forced by a beneficiary when they reach the age of majority. The CRA accepts that a cumulative dividend entitlement with a reasonable rate of return supports that the fair market value of the preferred shares will equal the redemption price of the shares. When distributions to the child or grandchild are desired, the directors of Investco may simply pay out accumulated dividends or redeem the desired number of the preferred shares.

Conclusion

Yes, your child or grandchild gets the money when you want to utilize their room to multiply the capital gains exemption. Let’s face it – they’re probably getting it eventually anyway. Using an age 40 trust or cumulative dividend preferred shares allows you to smooth or delay the distribution of the money to your child or grandchild. One final non-startling revelation – we all want control over the money.

The author would like to thank Stephen Sweeney for his contributions to this article. 


[1] Canada Revenue Agency Technical Interpretation 2020-0839881C6 (November 26, 2020)

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