The benefits of tax-informed trusts

The trust has been around for centuries as a device for the planning, protection and transition of property. Once perceived as the preserve of the affluent, trusts can now be woven into solutions – simple to sophisticated – across the spectrum of wealth holdings.

Investors have the potential to strategically manage who’s liable for income tax, and how and when such taxes are paid. And for financial advisors, a trust can be a tax-friendly platform to house clients’ current and estate investments, with minimal or no downside.

Settling a trust

A trust is the description of a property relationship, whereby an original property owner separates ownership interests into legal authority and beneficial entitlement. The original owner (person or corporation) is the settlor, the new legal owner is the trustee and the new beneficial owner is the beneficiary.

Interestingly, a trust is not a legal entity but it is a taxable entity. The trustee is required to file tax returns for the trust, generally in that trustee’s resident jurisdiction.

Inter vivos v. testamentary

There are little or no tax benefits available through the use of inter vivos trusts, those settled during lifetime. They are taxed at top marginal rates, cannot claim most personal tax credits (those intended for natural persons, such as the basic personal amount), and must report income on a calendar year basis.

On the other hand, a testamentary trust settled using a will could be used very effectively as a long-term tax management vehicle. While it similarly cannot claim those personal credits, it is entitled to apply graduated tax rates up through the combined federal-provincial marginal brackets. The year-end of a testamentary trust may be elected as any day in the full year following the relevant death.

Tax-informed trusts

Apart from the graduated tax treatment of testamentary trusts, there are other trust tax attributes that may be accessed, depending on circumstances. In fact, a given trust may fall under more than one of these following characterizations (among other possibilities).

Qualifying spousal trust

Property may be rolled at cost base into a QST, either while living or at death. The spouse is entitled to all income for life, and nobody else may receive any capital before that spouse’s death. This could be used to ensure that a spouse has reasonable access to a residence and/or investments for life, while preserving and protecting the ultimate distribution to the couple’s mutual children (as opposed to a later spouse and/or subsequent children).

Alter ego and joint partner trusts

These trusts, available after 1999 for those aged 65 and above, allow an individual or couple to effectively retain indistinguishable use of selected property for life, with distribution on death to contingent beneficiaries. Mainly, it enables probate tax avoidance, but there can be unexpected income tax complications if it isn’t carefully managed. For example, capital losses in a trust cannot offset personal capital gains (or vice versa), which could be particularly costly on death, or last death of spouses.

Life insurance proceeds

CRA allows plan proceeds to be directed to a testamentary trust outside of an estate, possibly effected as simply as naming a trustee for a beneficiary on insurer forms.

However, under such a bare designation, the trustee may merely be a conduit for delivery of those funds to the beneficiary at the age of majority. If ongoing management is intended, the trustee’s powers should be more explicitly defined in a formal trust indenture.

RRSP/RRIF receipts

Again, CRA allows the direction of plan receipts to a testamentary trust outside of an estate. The additional hook here is that whereas life insurance proceeds are tax-free, RRSP/RRIF receipts give rise to a tax liability to the deceased. Accordingly, it is prudent to have trust terms that explicitly state whether and how the tax will be apportioned between the estate and the RRSP/RRIF trust.

Charitable remainder trusts

A charitable remainder trust allows a settlor to make a lifetime donation of the remainder interest of property, but retain a life interest personally. The donor can then claim the net present value of the capital interest for the associated charitable tax credit currently, rather than leaving the tax benefit of the donation to his or her estate.

Non-resident trusts

As a trust is taxed where the trustee is resident, in theory it may be possible to arbitrage tax rates where the trustee is in a lower bracket jurisdiction as compared to the beneficiary’s location. That said, non-resident trust tax rules generally cause trust income to be recorded in the hands of a Canadian resident beneficiary, whether that trust income is realized or not. On a province-to-province basis, provincial general anti-avoidance rules – or a specific rule for the province of Quebec – may be used to combat such inter-provincial tax avoidance.

Immigration trust

An exception to the general rules of non-resident trusts is made for trusts established by non-residents prior to immigrating to Canada. Originally enacted to allow for simplified tax rules applying to business people temporarily relocated to Canada, these trusts can be effectively used to transition an immigrant’s wealth into the domestic tax system, allowing up to a 60-month tax holiday until the trust is subject to tax in Canada.