Balancing the needs of income and capital beneficiaries

Some clients believe they’ll earn lower investment returns if they use trusts in their estate planning, because trustees have restricted investment decision-making powers under trust law.

This is often a concern where a trust has an income beneficiary who receives income from the trust assets, usually during his or her lifetime (e.g., a surviving spouse). On the income beneficiary’s death, capital is paid to one or more capital beneficiaries. Historically, most Canadian trust legislation has placed inflexible restrictions on a trustee’s choice of investments, limiting them mainly to conservative, income-oriented investments—otherwise known as the “legal list.” Many jurisdictions, including Ontario in 1999, have adopted the prudent investor rule, which allows trustees to invest in any investment a prudent investor would. Moreover, under this revised legislation (including Ontario’s Trustee Act), trustees are to now focus on the total return of a trust’s invest-ment portfolio.

If there is an income beneficiary followed by a capital beneficiary, though, trustees may have trouble achieving a fair balance between the two. Often, a trust will require the trustee to equally balance each beneficiary’s interests—referred to as the “even hand rule.” In other words, the trustee must generate income for the income beneficiary who is entitled to the trust’s income, including interest and dividends, while ensuring that the trust fund’s real capital value (adjusted for inflation) is at least preserved for its ultimate distribution to the capital beneficiary.

In our low-interest rate, almost deflationary times, it’s difficult for trustees to generate an appropriate income level for an income beneficiary if a will or trust agreement does not provide enough flexibility. Too much emphasis is sometimes put on generating interest and dividends at the expense of a total-return approach, which would allow trustees to shift asset allocations nimbly, based on changing market conditions, to achieve better overall returns.

How to ensure flexibility

Trust terms can include flexible capital encroachment powers or the ability, where appropriate, for trustees to pay (or an income beneficiary to withdraw) from the trust each year a fixed percentage of capital or an amount equivalent to the total return of the trust on an inflation-adjusted basis. Letters of wishes setting out helpful guidelines can also be helpful, but are usually not legally binding. These options can free the trustee from the traditional approach of looking only at whether the receipt is income or capital. They also allow trustees to separate investment decisions from distribution or allocation decisions. In future, there will be more need for, and use of, trusts where the interests of an income beneficiary are followed by those of capital beneficiaries. The reasons clients may want to use more trusts in their planning include:

• to avoid the costs of an increasingly onerous probate system, including legal expenses, valuations, fees and taxes paid to probate a will;
• to provide for capital succession to children and further descendants, in particular for blended families and high value estates;
• to minimize and defer tax; and
• to protect wealth in general, including from creditors and matrimonial claims.

It will be increasingly important to adopt creative but careful approaches when using a trust in a client’s planning in order to optimize financial returns.

In the U.S., percentage trusts—also known as “unitrusts”—are often used, which allow by statute a fixed percentage of the trust fund (such as 3.5% or 4%) to be paid to the income beneficiary each year. Discretionary allocation trusts, which allow trustees to adjust receipts between income and capital as part of modern portfolio theory and total return investing, are also used. Many U.S. states have legislation and very developed practices for using these trusts.

Canada, on the other hand, is far behind. The Uniform Law Conference of Canada’s 2012 Uniform Trust Act facilitates a total return policy by including rules to allow for discretionary allocation trusts and percentage trusts. This model legislation can be adopted by any Canadian jurisdiction, but none have done so to date.

While existing Canadian income tax legislation can make it difficult to fully embrace a total return approach for spousal trusts, which are designed to get a tax-free rollover and require all trust income be paid to a spouse, thoughtful trust design can go a long way to protecting the interests of both the income beneficiary and capital beneficiaries while optimizing returns.

Margaret O’Sullivan

Tax & Estate

Margaret O’Sullivan is founder of O’Sullivan Estate Lawyers LLP.