Build family trusts properly

A trust’s tax benefits should be secondary to its planning benefits. But some people put things in trust with the express goal of reducing or deferring the taxes they will pay.

To deter such behaviour, CRA has created attribution rules, and Section 75(2) of the Tax Act is one of them. When the section’s invoked, all income and capital gains from trust property are attributed back to the person who contributed that property, rather than the trust itself.

Section 75(2)’s been in the news lately—well, at least that’s what tax practitioners say—because some family trusts have been using it to create tax-free intercorporate dividends. Unfortunately for those trust holders, CRA has invalidated the strategy (see “Evil trusts won’t work,” below).

But even if you’re not trying to pull one over on CRA, you’ll need to understand the implications of 75(2), also known as the reversionary trust rule, if any of your clients have family trusts. A client could think she’s doing everything properly, but still accidentally trigger 75(2) and, with it, unexpected tax consequences.

Read: The importance of post-mortem planning

Here’s how to make sure family trusts operate as intended.

Keep a safe distance

Trusts are meant to hold property for the benefit of someone other than the person who put that property in the trust (the settlor). So once a person transfers something into (or settles) the trust, it’s not supposed to be hers any longer.

“If the settlor has some ability to get the property back as a beneficiary, or to control the property as a sole trustee, then Section 75(2) kicks in,” says Robert Kepes, partner at Morris Kepes Winters LLP in Toronto. In those circumstances, 75(2) will attribute any income, gains or losses back to the settlor.

That can have nasty consequences. “From a tax perspective, it’s as if you never transferred the property at all,” says Blair Botsford of BotsfordLAW in Kitchener, Ont.

Section 75(2) can be invoked at any point during a trust’s lifetime, although it’s usually invoked on setup. Worse, once it is, the trust loses its ability to roll out assets at cost.

“Say an asset went into the trust at $50,000, and now it’s worth $100,000,” says Botsford. “When it comes out and you’d previously invoked 75(2), the trust has to report the $50,000 and pay tax on it, and the beneficiary acquires the asset at the bumped-up value, $100,000.” And, since the trust attributes gains back to the settlor, the settlor actually pays the tax.

On the other hand, if 75(2) isn’t invoked, the trust “can transfer the asset out at the $50,000 cost base. The beneficiary gets the asset and doesn’t pay tax.” If he sells it five years later, when it’s worth $150,000, he pays the tax at that time—the trust doesn’t, and neither does the settlor.

Read: Alternatives to testamentary trusts

If a client accidentally triggers 75(2), it’s possible to undo the income attribution damage. Depending on how she invoked the section, “she could remove herself as a beneficiary of the trust, or add more trustees,” says Botsford. But, neither move restores the trust’s roll-out provision.

Karen Slezak, a partner with Crowe Soberman’s tax group in Toronto, says people may sell shares to family members to hold directly and avoid family trusts altogether.

This works best when all family members are adult children, and the owner is fairly certain about who’s going to own what proportion of the company.

Avoid triggering 75(2)

The best defence against 75(2) is for your client to settle a trust and then have no further involvement with the asset she contributed. But that distance may not always be obvious to CRA, so here are ways to demonstrate her intentions.

Multiple trustees

Your client cannot both settle and be the sole trustee of a trust without invoking 75(2). If she wants to play both roles, make sure she appoints at least two other trustees, says Botsford. That way, the client doesn’t have a controlling interest, but she’d “have some say in how the asset’s managed.”

When a trust has two trustees, Slezak says, and one of them is the settlor, “CRA has flip-flopped on deciding whether 75(2) applies or not.” She says trusts have to make decisions unanimously, “unless you put in a clause saying that the majority rules. And how can you have a majority rule when there are two trustees?”

When there are more than two trustees, the documents should include a majority rule clause to ensure the settlor-trustee cannot overrule the other two trustees.

Read: 3 tricky trust rules

Martin Rochwerg, partner in Miller Thomson’s tax and private client services practice in Toronto, says if a co-trustee dies, resigns or becomes incapacitated, “it’s best that the trust documents state there’s someone else appointed to automatically replace” that co-trustee. Then, that would ensure the settlor is never the sole trustee.

Loan the property at prescribed interest

If a trust beneficiary wants to contribute property to it, “[he] can loan property at fair market value or get a bank loan, so that nobody has contributed the funds that bought the property,” says Slezak.

For instance, say a company’s owner wants to put nominal-value assets like 100 new common shares (e.g., those costing $1 per share) in a trust. In that case, Slezak suggests the trust open an empty bank account with overdraft protection, “because for $100 you don’t want to arrange a whole loan.” Then, a trustee would write a cheque for $100 to the operating company to acquire the common shares, “so it’s effectively borrowed $100 from the bank” by invoking the overdraft.

Then, “when the trust gets a dividend from the operating company, it goes to pay off the overdraft or bank loan.”

Sell the property to the trust at fair market value

Section 75(2) can be avoided if a settlor sells property to the trust. But, it’s important to make sure the sale doesn’t look like a gift, because that would invoke 75(2). The sale must be at fair market value, says Botsford, so “going through a valuation process is usually safest.” If CRA determines the amount unreasonable, she adds, the agency could argue the settlor invoked 75(2).

Don’t contribute later

Beneficiaries may inadvertently contribute to a trust years after it was created, says Rochwerg, so it’s important for them to remain vigilant. “Say a mother sets up a trust for her children and, 10 years later, all the children happen to add property to the trust.” Those children would be treated as if they were settlors for tax purposes, triggering 75(2).

Read: Client collapses trust to fund daughter’s education

Add a safety clause

“It’s common to have language in a trust that says something [like] ‘Anything in here that would offend 75(2) is not to be recognized,’ ” says Rochwerg. “There are different views as to whether a court would recognize that language, but it’s used a fair bit.”

Tricky trust questions

Q. If Section 75(2) is triggered, and gains or income are attributed back to the settlor, will the trust also be taxed?

A. Unlikely. Tax lawyer Robert Kepes says CRA has argued it could theoretically tax the trust, “but nobody thinks that argument has any weight. CRA may make that argument to see if it’ll stick, but there’s little chance that income or gains could be double-taxed like that.”

Q. If my client settles a trust, and her spouse is its trustee, would that trigger 75(2)?

A. No, as long as her spouse fulfills his trustee duties, says accountant Karen Slezak. She tells trustees who are the settlor’s spouses to get legal advice outlining their duties and how to fulfill them. These may include meeting with other trustees at least once a year (or, if the spouse is the sole trustee, documenting his decisions), reviewing the trust’s investments, signing tax returns, and keeping financial records. “It helps them understand they’re not just going to sign anything that their spouse puts under their nose to sign.”

Q. 75(2) comes into play if the settlor is a Canadian resident and alive. What if the settlor is dead or living elsewhere?

A. If the settlor’s dead, 75(2) no longer applies. Slezak worked with a sole trustee who died in the 21st year of the trust (the year the trust’s assets would be deemed disposed). “That’s a harsh way to get out of your tax problem,” she says, “but it did work, because then other trustees could step in,” and the settlor and trustee were no longer the same people. But, if the trustee or beneficiary moves out of Canada, that creates a different problem: there may be departure tax, says Kepes.

Evil trusts won’t work

Imagine using CRA’s own rules against it. That’s what several family trusts have tried over the last few years, by creating what are known as evil trusts.

How did they do this? Robert Kepes, partner at Morris Kepes Winters LLP, explains. OpCo, an active business, created HoldCo. OpCo converted its common shares into preferred shares. Then, HoldCo subscribed for new common shares at a nominal cost (say, $10) and transferred those shares into a trust—of which it was a beneficiary.

That transaction made HoldCo one of the trust’s settlors, deliberately causing 75(2) to apply (since the settlor and beneficiary were the same, and the settlor can get its shares back).

Then, OpCo declared a dividend on its common shares, and paid that dividend in cash to the trust, which owned the shares. Normally, the trust would be responsible for taxes on that dividend. But, since 75(2) applied, the income was attributed back to the settlor: HoldCo.

And HoldCo didn’t have to pay tax, because corporations are not taxed on dividends from active businesses. So, the dividend was paid to the trust without anyone paying taxes on it, and the trust could distribute the cash freely (e.g., to OpCo’s owner if she was also a beneficiary).

“It was converting 75(2) from a shield into a sword,” says Martin Rochwerg, a partner with Miller Thomson.

CRA took one trust that tried the strategy, the Brent Kern Family Trust, to court. CRA argued successfully that 75(2) didn’t apply, since the family trust bought those shares for fair market value from HoldCo. That meant the trust owed the dividend tax and not HoldCo, as Brent Kern had intended.

Brent Kern appealed that decision to the Federal Court of Appeal, but lost. Kepes expects the trust to apply for leave to appeal to the Supreme Court of Canada, so he counsels people to suspend undertaking these transactions until a potential appeal is heard.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.