INCOME TAX PLANNING

Chapter 17
Trusts

Definition of a Trust
 The Income Tax Act does not define “trust,” it merely outlines the tax treatment of
income generated by one
 A broad, generally accepted definition is that a trust, under common law, is “a legal
arrangement whereby a person (the “settlor”) transfers property to another person (“the
trustee”) to hold for the benefit of one or more persons (“the beneficiaries”)
 The trust does not have the status of a legal person like a corporation
 Rather its format is closer to a partnership in that its existence is created by the writing of
a trust document or deed spelling out the obligations of the trust
 A trust constitutes a relationship between the settlor who places property under the
management of a trustee for the enjoyment of designated beneficiaries
 Beneficiaries may be entitled to enjoy the income or the capital of the trust, or both
 Trusts have certain unique features
o The most important relates to income
o Income earned by a trust can be taxed in the trust itself as a separate taxpayer or
all or some of its income can be allocated to beneficiaries and taxed as part of
their income
o Any income allocated to beneficiaries is deducted from the trust's income and
therefore trust income is only taxed once—either as trust income or as beneficiary
income
o In some circumstances the trust document specifically states what income is to be
allocated; in other circumstances it is left to the discretion of the trustee to
determine if, when, and what amount is to be allocated
o After income is taxed in the trust it forms part of the trust's capital and is not
subject to further tax when it is eventually distributed
o So, a trust is like a partnership in the sense that income can be allocated to
participants and taxed only once
o However, in a partnership the allocation is mandatory and all income must be
allocated, whereas in a trust the allocation is discretionary
o It is important to note that the use of trusts and partnerships result in only one
level of tax on income, unlike a corporation whose income is subject to tax at the
corporate level and at the shareholder level
 Other unique features of trusts vary depending on the type of trust created
 The various types of trusts are described on the next page

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Types of Trusts (two primary types)
 Inter vivos trust
o Is one that is created by the settlor during his or her lifetime
o For example, while alive, an individual may establish a trust to hold certain
investment properties for the benefit of children or other family members
 Testamentary trust
o Is established upon the death of an individual as dictated by her/his last will and
testament
o For example, an individual's will may direct an executor to establish a trust or trusts
for surviving children that holds and invests certain property until they reach a
desired age
 When inter vivos or testamentary trusts are created for the benefit of a spouse they are
categorized as spousal trusts
 The above trust characterizations can be further divided into two broader categories—
Personal trusts and Commercial trusts
 Personal Trust
o A personal trust includes inter vivos and testamentary trusts whose beneficiaries did
not purchase their trust interests
o Effectively, they receive their trust interest from the goodwill of others who are
typically a parent or a spouse
o Generally, personal trusts are used for estate and tax planning purposes
 Commercial Trust
o A commercial trust generally refers to trusts whose beneficiaries purchase their trust
interests or units
o Examples of commercial trusts include mutual funds, real estate investment trusts
(REITs), business or investment income trusts, and royalty trusts
o Typically, commercial trusts are traded on stock exchanges and, except for mutual
fund and real estate investment trusts, have limited appeal as an alternative to the
historical use of corporations as a primary business structure

Tax Treatment of Trusts

 For tax purposes a trust is considered to be an individual
 Therefore, the trust, whether inter vivos or testamentary, represents a separate entity as if
it were a separate individual taxpayer
 A trust is taxable in Canada if it is resident in Canada at any time during the year
 For tax purposes the trust is represented by the trustee(s) who manages and controls the
trust property
 The residence of a trust is determined by the jurisdiction where the central management
and control of the trust resides, regardless of the residence of the trustees
 In most cases all of the trustees are Canadian residents, so the question of where the
central control and management resides is not an issue
 Where some or all of the trustees reside in a foreign country, the central control and
management determination is important
 This test is similar to the test for determining the residency of a corporation
 Even when all the trustees reside in Canada it may be necessary to apply the central
management and control test to establish which provincial jurisdiction is relevant.
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Determination of Taxable Income and Tax
 Net income for tax purposes of a trust is determined using the net income formula established
in Chapter 3 and again in Chapter 9
 Net income for tax purposes is then converted to taxable income by applying the rules
established in Chapter 10 of which the non-capital loss and net capital loss carry-overs are
most important
 There are several major exceptions that apply to determining trust income
 They involve amounts allocated to beneficiaries
 The exceptions are reviewed below
o When arriving at net income for tax purposes, an inter vivos trust and a testamentary
trust deduct from its income any income that is payable to a beneficiary
o Income is considered payable if it was paid in the year or the beneficiary was entitled
to enforce payment in the year
o Any amount that is not allocated is subject to tax in the trust, at which point it
becomes part of the trust's residual capital and can subsequently be distributed tax-
free
o A trust can choose to designate an amount that is actually payable to a beneficiary,
not to have been payable, but only where the taxable income of the trust is nil and
remains so after the designation
o Therefore, unless the trust has losses available from other years, the designation will
not be permitted
o It should be pointed out that if losses of a trust exceed income during a year, they
remain with the trust as either non-capital losses or capital losses and may be carried
back or forward in accordance with the normal loss carry-over rules
o This treatment of losses is different than the treatment by partnerships. Recall that
losses incurred by a partnership are automatically allocated to the partners at year end
o In some circumstances a trust may allocate income and deduct that amount from its
income for tax purposes even though it is not payable to the beneficiary
o This may occur when trusts are created for minor children and income is accumulated
on their behalf until they are 21 years of age or older
o This option permits income splitting by allocating trust income to minor children who
may not be taxable because of low amounts of income

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Determination of Taxable Income and Tax (continued)
 Taxation Year of a Trust
o As a trust is considered to be an individual, its taxation year is automatically the
calendar year (December 31)
o Prior to 2015, a testamentary trust was allowed to choose a taxation year other than
the calendar
o However, as of 2015, all trusts (testamentary and inter vivos), with one exception,
must use the calendar year
o Trusts that previously had a non-calendar taxation year are deemed to have a year-end
on December 31, 2015 and must continue on a calendar basis thereafter
o A testamentary trust that is designated a “Graduated Rate Estate” is permitted to
retain a non-calendar taxation year where the deceased died less than 36 months prior
to December 31, 2015
o Thereafter, a graduated rate estate may choose a non-calendar taxation year for as
long it qualifies as a graduated rate estate
o A Graduated Rate Estate of an individual is an estate testamentary trust that arises on
death and continues for no longer than 36 months
o Presumably, 36 months is the reasonable time to collect a deceased's properties, pay
bills, file necessary returns and make distributions to beneficiaries or to trusts for
beneficiaries
o Inter vivos trusts and testamentary trusts, with two exceptions discussed below, must
apply the highest federal tax rate (29%) to all income plus the highest applicable
provincial or territory rates
o Using the marginal tax rates for a certain province developed in Chapter 10 (Exhibit
10-7), the tax rates for inter vivos and testamentary trusts are as follows:

 The fact that testamentary and inter vivos trusts are taxed at the highest personal rates forces
most trusts to allocate income to beneficiaries to be taxed at their personal graduated rates
 Two types of trusts are permitted to apply the graduated tax rates to income
o A trust that is designated as a graduated rate estate (defined above) and a qualified
disability trust is permitted to use the graduated tax rates applicable to individuals
o A qualified disability trust is a testamentary trust with a beneficiary who qualifies for
the disability tax credit
o Therefore, all of the tax rates and brackets developed in Chapter 10 (Exhibit 10-7)
apply to trusts that are graduated rate estates and qualified disability trusts. These
rates are as follows:

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This graduated rate scale provides a separate tax base for all or a part of a trust's income. For
example, a trust having two equal income beneficiaries with nominal other income may divide
its $60,000 of trust income through appropriate allocations as follows:

 As three separate taxpayers, each having access to a separate tax base, the entire $60,000 is
taxed at the lowest possible rates
 Therefore, the testamentary trust allows for valuable income splitting
 When calculating tax for inter vivos and testamentary trusts the federal tax can be reduced by
the dividend tax credit, donations and gifts tax credits, foreign tax credit, political
contribution tax credit, and various investment tax credits
 Neither type of trust can deduct any of the personal tax credits
 Other tax issues for testamentary and inter vivos trusts are as follows:
o Testamentary and inter vivos trusts are subject to the alternative minimum tax rules
but cannot claim the minimum tax exemption of $40,000 (effective 2016)
o A testamentary trust designated as a graduated rate estate may claim the $40,000
exemption
o Testamentary and inter vivos trusts must remit quarterly tax instalments (effective
2016)
o A testamentary trust designated as a graduated rate estate is not required to make tax
instalments

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Income Allocations and Beneficiaries
 Trusts earn a variety of types of income of which some, such as capital gains and Canadian
dividends, have preferential tax treatment
 As indicated earlier, the trust can allocate income to beneficiaries, thereby reducing the trust
income
 In making the allocation, the trust may designate the source and characteristic of certain
types of income as being transferred to the beneficiary
 The most important of these pertain to capital gains and taxable Canadian dividends
 For capital transactions, the trust may designate its net taxable capital gains for allocation to
the beneficiaries
 The allocation can include capital gains eligible for the capital gain deduction
 Net taxable capital gains refer to taxable capital gains minus the allowable capital losses to
the extent the amount is positive
 As indicated previously, net capital losses are retained by the trust for deduction against
capital gains of other years
 As a result, beneficiaries' are taxed on only one-half of the net capital gains
 Taxable Canadian dividends allocated to beneficiaries will be classified as eligible or non-
eligible, and grossed up for the beneficiaries' tax purposes to 138% or 118% (in 2015, and
117% in 2016) of the actual dividend with appropriate dividend tax credits available
 The trustee may decide to allocate income types to beneficiaries in different proportions
provided that each of the beneficiaries receives the desired benefit and is treated equitably
 For example, the trustee may allocate more capital gains to a beneficiary who has unused loss
carry-overs from past years
 Other beneficiaries may then receive a greater proportion of other types of income provided
that they are not economically disadvantaged
 A trust may also designate other types of income to be allocated such as tax-free capital
dividends, foreign business and non-business income (including foreign tax credits), certain
pension incomes, and others

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The 21-Year Rule
 Although a trust is considered to be an individual it may have an unlimited lifespan
 Individuals, on the other hand, have a limited life and upon death have a deemed disposition
of certain property at market values
 So, in order to prevent a trust from escaping tax on property that it holds for an extended time
period, inter vivos and testamentary trusts are deemed to have sold certain properties at
market value on its 21st anniversary date and every 21 years thereafter
 The properties include
o capital properties (non-depreciable);
o depreciable properties;
o land that is inventory; and
o resource property
 In many cases the trust can successfully avoid the deemed disposition at fair market by
transferring the particular properties to the beneficiary prior to the 21-year anniversary date
 Such transfers are normally deemed to be a disposition at the property's cost amount
 Therefore, the beneficiary simply takes over the tax position of the property received from
the trust
 Once the property is in the hands of the beneficiary, it will be taxed when sold by the
beneficiary or upon his/her death
 When a trust holds property beyond 21 years and triggers a deemed disposition, for tax
purposes it will recognize the related gains or losses on the relevant properties as if they were
sold
 The trust then is deemed to reacquire the properties at fair market value, which becomes the
new cost amount of the property for the trust. Consider the following properties:

d
On the day of the trust's 21-year anniversary, the properties are deemed sold at market value,
resulting in the following gains:

d
After recognizing a capital gain of $15,000 and recapture of CCA of $55,000, the trust cost
amounts for the land and Building #1 are $70,000 and $210,000 respectively. However, for
Building #2 the market value ($95,000) was lower than the original cost ($100,000) of the
building, and so the trust is deemed to have acquired Building #2 for a cost of $100,000 (equal to
original cost) but has a deemed undepreciated capital cost of $95,000. Future CCA is based on

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$95,000. However, if in the future Building #2 is sold for more than the $95,000 current value, a
recapture of CCA may occur up to $100,000 and a capital gain realized for proceeds over
$100,000.

Transactions with Settlors and Beneficiaries

 This segment reviews the tax implications of the transfer of property from a settlor to the
trust and the transfer of trust property to beneficiaries
 The comments in this segment apply to personal trusts (inter vivos and testamentary), but
exclude those classified as spousal trusts
 As previously noted, a trust is a separate taxpayer and when property is transferred to the
trust (usually by the settlor) a disposition of property occurs (subject to minor exceptions)
 This disposition normally occurs at market value. Consequently the market value of the asset
transferred becomes its cost base in the trust
 From time to time, and certainly at the time a trust is terminated, property of the trust is
transferred to beneficiaries
 The tax treatment on the transfer depends on the type of beneficiary receiving the property—
they may be an income beneficiary, a capital beneficiary, or both
 A beneficiary who is entitled to receive income from the trust is considered to have an
“income interest” in the trust, and is an income beneficiary
 If the beneficiary is entitled to receive capital, they have a “capital interest.”
 In many cases, a beneficiary has both a capital and an income interest
 When trust property is transferred to a beneficiary who has only an income interest, the trust
is deemed to have disposed of the property at market value that may realize taxable income
 The opposite occurs when trust property is transferred to a capital beneficiary or a person
who is both a capital and income beneficiary
 Here the disposition is deemed to be at the property's cost amount
 It is less common for a trust to distribute property to a beneficiary who is only an income
beneficiary
 So, as a general rule one can say that property transferred from a trust to a beneficiary is
deemed to be sold by the trust at its cost amount and the beneficiaries assume the tax position
formerly held by the trust
 The cost amount of property refers to:
o Capital property—ACB
o Depreciable property—UCC
o Cumulative eligible capital—4/3 of the CEC
 When depreciable property is transferred, the beneficiary assumes the capital cost of the
property and its undepreciated capital cost. Therefore, on a subsequent sale a potential
recapture of CCA can occur.

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Spousal Trusts
 Special rules apply for personal trusts that qualify as a spousal trust
 In general terms, a trust is a spousal trust if the spouse of the settlor is entitled to receive all
of the income of the trust and no person other than that spouse can use or receive the capital
of the trust before the death of the spouse
 The most common use of a spousal trust is one that holds assets of a deceased person under
terms that allow the income generated from the assets to be distributed to the spouse but
preserves the assets for future distribution to children
 The distribution to children occurs on the death of the spouse
 In this way, capital is preserved for the next generation but can be used by the surviving
spouse to generate income during his/her lifetime
 There are three unique features of a spousal trust. These are:
1. When property is transferred into the trust, the settlor is deemed to have sold the property
at its cost amount. Therefore, the tax status of the property prior to its transfer is assumed
by the trust.
2. The 21-year deemed disposition requirement is waived for the first 21-year anniversary.
Therefore, in most situations, the property remains without tax until the death of the
beneficiary spouse.
3. Upon the death of the spouse who is the beneficiary, the spousal trust property is deemed
to be sold at market value. In addition, the trust is deemed to have a taxation year that
ends on the day that the deemed disposition occurs. Any taxable income created from the
deemed disposition is deemed payable to the deceased individual in the year of his or her
death. Therefore, the gain is taxable in the deceased's final tax return using the graduated
tax rate scale of an individual.
 The above features are the opposite of the tax treatment for non-spousal personal trusts.

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Estates
 Following the death of an individual, an executor or administrator takes control of property
owned by the deceased
 The executor discharges all debts and obligations and distributes property to beneficiaries.
So, an estate is actually an administrative period that exists until debts are settled and assets
distributed to beneficiaries. Beneficiaries of an estate can be:
 individuals, or
 testamentary trusts, such as spousal trusts or trusts for children until they reach a certain
age or satisfy other conditions.
Therefore, an estate life is limited and lasts until the executor's duties are completed.

 For tax purposes the estate period is considered to be a separate trust

 When assets are transferred to testamentary trusts, new trusts begin as separate taxpayers
from the estate
 Income earned during the estate period is taxed in the estate trust and may include property
income, capital gains, and other sources of income resulting from the disposition of certain
assets
 Remember, that upon death, an individual is deemed to have sold assets at fair market value
unless they are bequeathed to a spouse or spouse trust
 So, except for assets going to a spouse or spouse trust, the estate assumes the assets at a cost
equal to the market value of the asset at the time of death
 If the estate subsequently sells such an asset, any gain or loss is calculated by comparing the
selling price to the asset's market value at the time of death
 As indicated earlier in this chapter, the estate is considered to be a graduated rate estate for
its first 36 months
 During that time any income earned by the estate and not payable to beneficiaries is taxed at
the graduated individual tax rates
 If the estate trust continues beyond 36 months its future income is taxed at the top individual
tax rates
 Also, the estate is not required to use the calendar year as its taxation year for the first 36
months
 On the day that is 36 months after the individual's death, a deemed taxation year occurs
 Thereafter, the estate must use the calendar year as its taxation year
 The estate trust is automatically terminated when all assets are transferred to the
beneficiaries.

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Other Trusts
 There are certain other types of trusts that are widely used and deserve brief mention
 These include tax deferred income plan trusts, unit investment trusts, and bare trusts
 Deferred Income Plan Trusts
o Trusts governed by deferred income plans include Registered Pension Plans (RPP),
Registered Retirement Savings Plans (RRSP), Deferred Profit Sharing Plans (DPSP),
Registered Retirement Income Funds (RRIF), and Registered Educations Savings
Plans (RESP)
o These plans are not taxable and hold income for distribution to beneficiaries at a later
time
o Therefore, tax is deferred on income until distributions are made from the trusts, at
which time the beneficiary is subject to tax
 Bare trusts
o Are entities whose sole purpose is to hold property on behalf of others. It is a
structure used for convenience
o For example, a corporation may act as the trustee to hold a real estate investment on
behalf of a number of individual owners
o This permits the real estate to be registered to one party rather than to many separate
investor owners
o As a bare trust it is not taxable in any form
 Unit Investment Trust
o Has wide application in the Canadian securities and investment community. This
category includes mutual funds, real estate investment trusts (REIT), income trusts,
and royalty trusts
o All of these vehicles have one important tax status in common—income earned can
be allocated to unit holders and taxed in their hands
o This avoids the double taxation impact that may occur when a corporate structure is
used
o Ownership of these trusts is widely distributed through units and these are typically
traded on stock exchanges
o In addition, most unit trusts qualify for ownership in retirement vehicles such as
RRSPs, RPPs, and so on.

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The Use of Personal Trusts
 Personal trusts have a number of non-tax as well as tax uses
 Remember, personal trusts include both inter vivos and testamentary trusts
 The Estate Freeze
o Typically, the estate freeze involves a family business or an investment corporation
whose shares are growing in value and are subject to capital gains tax on the death of
the owner
o The estate freeze is designed to reduce the impact of this tax and often involves the
parent exchanging common shares in the company for non-participating fixed value
preferred shares
o At that point, new common shares, which continue to grow in value, are issued to
family members who are typically children
o The parent now owns only fixed value preferred shares and the potential capital gain
will not increase
o An inter vivos trust can be used to hold the growth shares on behalf of children,
especially if they are minors
o In this way, increases in share values accrue to the children and avoid the related tax
on the death of the parent
 Income Splitting
o There are significant anti-avoidance rules that prevent the splitting of income
amongst family, especially for inter vivos trusts
o There are, however, some income splitting opportunities that remain with the use of
inter vivos trusts
o In particular, capital gains on property previously transferred by a parent or
grandparent to minor children are not attributable to the transferor. Where possible,
parents or grandparents can transfer capital growth properties to inter vivos trusts
with children as beneficiaries
o Future capital gains can then flow through the trust and be taxed as part of the
children's income presumably at a lower rate
o This allocation is very useful where a beneficiary is entitled to claim the capital gain
deduction on eligible capital gains (for example, a gain on shares of a small business
corporation)
o Testamentary trusts can also achieve some income splitting benefits. After death,
there is no attribution, and therefore testamentary trusts can be used for surviving
minor children to take advantage of lower tax rates or allocate income to be taxed as
part of the children's income
o Also, income earned as a result of reinvesting past income is not subject to the normal
attribution rules
o For example, if a parent transfers property to a trust for minor children and the
property earns interest and dividends from public corporations, that income is
normally attributed to the parent for tax purposes
o However, when that income is reinvested, the returns on the reinvestment belong to
the trust

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 o As an inter vivos trust, the tax to the trust would be at the top personal rate. It would
therefore be desirable and possible to allocate this income to the beneficiaries to be
taxed as part of their income.

Administrative Benefits
 While tax advantages are often associated with the use of trusts, their fundamental benefits
are from non-tax related estate planning. Some of these are summarized below:39
 A trust may provide a vehicle to manage property for persons who cannot manage their
own affairs.
 A trust may provide direction on how to use property after a person's death and may span
several generations.
 A trust may be used to preserve property and reduce the risk of wasting an asset. For
example, parents may settle property for their children to be used for specific needs of
those children, such as education.
 A trust may be used to hold property for persons not yet born, such as future
grandchildren.
The trust is a unique and flexible structure that has a broad range of uses in family estate
planning.

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