3 tricky trust rules

Trusts have been a staple of estate planning for generations. Their importance will continue despite changes to the taxation of testamentary trusts proposed in this year’s federal budget. In fact, trusts may become more popular, given Canada’s aging demographic.

This article discusses three laws governing trusts. They determine:

• when capital gains/losses generated by trust property must be recognized;
• how long income may be accumulated in a trust; and
• how long a trust may last (“rule against perpetuities”).

The first, known as the 21-year deemed disposition rule, is federal law and therefore applies to all trusts resident in Canada. The rules against accumulations and perpetuities originated in common law and apply differently across the country. While some provinces have codified these rules, others have modified or abolished one or both. (Note: the following discussion deals with personal trusts only; charitable and other non-personal trusts are subject to different regimes.)

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21-year rule

The 21-year rule was introduced in 1972, along with the capital gains tax. The objective was to curtail a person’s ability to transfer property tax-free from generation to generation.

The rule applies to certain types of property held by a trust, and not to trusts generally. It’s also important to note the deemed disposition does not necessarily occur at 21-year intervals and, depending on the circumstances, other deemed disposition and reacquisition rules may apply.

Although commonly referred to as the 21-year rule, there are actually several deemed disposition rules set forth in subsections 104(4) through 104(5.2) of the Income Tax Act. Pursuant to these rules, both inter vivos and testamentary trusts are generally deemed to dispose of , at periodic times, certain types of property for proceeds equal to fair market value (FMV), and to immediately thereafter reacquire the properties at a cost equal to that value. This means trusts may be required to realize and pay tax on capital gains without actually receiving the proceeds of disposition.

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Here’s how the rules apply to common types of trusts:

• Most non-spousal personal trusts are subject to a deemed disposition every 21 years. The clock starts running when an inter vivos trust is established or, in the case of testamentary trusts, on the testator’s death.
• Qualifying spousal trusts are subject to a deemed disposition on the death of the spouse (or common-law partner) and every 21 years thereafter.
• Alter-ego trusts are subject to a deemed disposition on the death of the settlor and, should the trust continue beyond this date, every 21 years thereafter.

Joint spousal trusts are subject to a deemed disposition on the death of the surviving spouse (or common-law partner) and, should the trust continue beyond this date, every 21 years thereafter.

With careful planning, application of the 21-year rule can generally be avoided. This is normally done by ensuring the terms of the trust allow trust property to be distributed to a Canadian- resident capital beneficiary before the deadline. Most well-drafted trust documents contain the relevant encroachment provisions.

Estate and tax planners typically view these rules as a means of deferring capital gains for a significant time period, rather than as an impediment to establishing a trust.

Rule against accumulations

This common-law rule prohibits adding income or interest earned by a trust back into the capital of the trust fund beyond a certain time period. After codifying the rule in legislation, many provinces have since abolished it.

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But the rule remains in force in Ontario and Newfoundland and Labrador. Ontario’s Accumulations Act establishes six maximum accumulation periods. You need to determine which type of trust and/or beneficiaries you’re dealing with, and select the corresponding period. The most common is 21 years from the death of the settlor or testator.

Here’s an example of how the rule works. Jane’s will creates trusts for her grandchildren with instructions to hold the funds so no payments are made until a grandchild is age 25. Granddaughter Lisa is 2 years old at the time of Jane’s death, so her share will be held in trust for 23 years. Pursuant to Ontario’s Accumulations Act, the income generated by the trust property can be added back to the trust for 21 years only. Beginning in year 22, the trustee may no longer accumulate this income, but must instead pay it to Lisa, notwithstanding the trust’s terms.

Rule against perpetuities

The rule against perpetuities is one of the most technical and misunderstood doctrines of common law. The rule dates back to late 17th-century England and was designed to prevent testators from tying up property for long periods.

The rule states that an interest in a trust must vest within a particular period. This means the beneficiary must become entitled to the property within that timeframe. The time period specified was “no later than 21 years after the death of a ‘life in being’ [the remaining duration of the life of a person alive at the time the trust deed or will takes effect]” when the interest was created. Common law says the interest is void if there was any chance it might vest outside this period.

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Many jurisdictions agreed with the rule’s rationale that property should be in circulation, not tied up for undue lengths of time. The problem was with its arcane and sometimes bewildering application. The concept of a life in being can be confusing, as can the concept of vesting. It’s easy for a drafting lawyer to inadvertently breach the rule and for a trustee to misinterpret the rule. As a result, the rule has been abolished in a few provinces, including Saskatchewan, Manitoba and Nova Scotia. Others have simplified it and introduced a different time period for vesting (80 years in B.C., 60 in P.E.I.). This common-law concept doesn’t exist in Quebec; however, the Civil Code does have certain restrictions related to time and rank of beneficiary. The resulting rule is that no person may be a beneficiary for a period of more than 100 years.

Ontario’s Perpetuities Act retains the 21-year measure, but establishes a wait-and-see approach. Instead of deeming an interest void if it might possibly vest outside this period, interests are presumed valid until actual events establish the interest cannot vest within the perpetuity period.

Importance of sound planning

Failure to address the deemed disposition rule may result in adverse tax consequences, while failure to address either or both of the rules against perpetuities and accumulations may result in a plan that fails to deliver on the testator’s intentions. Costly legal opinions and court applications may also result.

When discussing estate planning with clients, the best advice you can give is to work with specialists. This will help ensure they get a plan that addresses their goals, delivering peace of mind.

Elaine Blades is director, Fiduciary Services, at Scotia Private Client Group.