We have received numerous inquiries regarding policies to be owned in trust. In particular, we have received inquiries regarding Manulife's requirements when accepting applications for these policies.
This document is intended to clarify certain issues regarding trusts and policies that are to be owned in trust and should be used as a guide by producers who sell these plans. The document will discuss such items as:
- the basic concept of a trust
- definitions of relevant terminology
- the types of trusts
- formal and informal trusts
- the need for proper documentation on an informal trust
- the concept of attribution
- the preferred beneficiary election
- instructions on how to complete an application for a contract held in trust
We have also included as appendices two sample declarations of trust, a sample trust agreement, and a summary of case law and the Canada Revenue Agency’s (CRA) views on trust accounts.
Consult with counsel
This article is intended to give a basic understanding of the most common types of trusts used in our industry. Note that, due to the different legal structure in Quebec, the comments contained in these articles do not apply to trusts in Quebec. However, the article will give you a general guideline of the tax issues involved in trusts. Manulife and its representatives make no representation as to the validity and completeness of this document and to the tax and legal consequences of the attached specimen trust agreement and declarations. We recommend that you and/or your client consult with counsel for advice concerning tax and legal matters.
Basic concepts of a Trust
Understanding trusts and contracts held in trust
What is a trust
A trust provides a mechanism for a person (the “settlor”) to provide property to another person (the “trustee”) for the benefit of a third person (the “beneficiary”) while still maintaining some form of control over the property. The property is held and administered by the trustee.
A trust is not a legal entity in itself. Rather, it is a method of settling property and involves a relationship between the trustee and the beneficiary. However, a trust is treated as an individual for income tax purposes.
A trust must have three characteristics (or "certainties") in order to be valid:
- certainty of intention: the settlor must disclose an intention to create a trust
- certainty of subject matter: there must be property vested in the trustee
- certainty of objects: it must be possible to ascertain the beneficial owners of the trust (either specifically named or by class - i.e. a person’s children)
If any one of these criteria is missing, there is no trust. Therefore, any document (whether a formal trust document or a declaration of trust) must indicate these essential parts: settlor, property, trustee and beneficiary.
Trusts are irrevocable, which means that the property cannot revert to the settlor at his or her command, unless the trust document specifically indicates it is revocable. Later in the article we will discuss why revocable trusts are not desirable from a tax perspective.
Why are trusts so popular?
Trusts are often used as a mechanism by settlors to transfer property to family members (or others) while still allowing the settlor to retain some control over the property (either by being a trustee or by choosing the trustee and by dictating the terms of the trust). If the settlor does not wish the beneficiary to own the property until a future date, the settlor is able, through the trust agreement, to set out how the trust property is to be invested and when the property will be distributed to the trust beneficiary.
Trusts are also often used to hold assets on behalf of minors. Since minor children do not have the legal capacity to enter into a binding contract or the authority to deal with a contract, even if ownership is transferred to them, trusts are used as a mechanism to hold the assets until the child reaches the age of majority.
Trusts are also used for tax-motivated reasons. Properly structured, trusts allow for the deferral of accrued capital gains and some income splitting¹.
Settlor (donor, transferor):
The person who contributes the original monies or property to the trust and who creates the trust by establishing the terms of the trust, appointing trustees and designating beneficiaries. Note that a loan by the settlor is not sufficient to create the trust. Generally, when the settlor contributes or transfers assets other than cash to a trust, he or she is considered to have disposed of the assets at their fair market value at the transaction date. Therefore, the settlor may realize a capital gain on the transfer to the trust. It is also important to note that, where the trust is irrevocable, the settlor is not entitled to take back the donated property. Once property has been settled in the trust, it belongs to the trust and must be used for the benefit of the trust beneficiary. This is not the case in a revocable trust.
The legal owner of the trust property and the person in charge of administering the trust for the benefit of the trust beneficiary in accordance with the trust agreement, applicable trust legislation and the law relating to fiduciary obligations. The trustee may be the settlor or someone else (however, as discussed later, if the settlor is the trustee, adverse tax consequences may occur). Any number of trustees can be selected by the settlor and they must act unanimously unless the trust agreement specifies otherwise. However, to ensure there is no attribution of income to the settlor, there should be one independent trustee, for example, a friend or business advisor. In accordance with Regulatory and Compliance rules, advisors should not allow themselves to be put in a real or perceived conflict of interest position and this includes not accepting an appointment as trustee for a client, other than in accordance with the policies of the company.
The person(s) for whose benefit the trust is established and to whom the trust income and/or assets ultimately belong. Beneficiaries under a trust may be either “income beneficiaries” where they are entitled to only the income of the trust, or “capital beneficiaries” where they would be eligible to receive the capital from the trust, or both.
Income tax rules that deem income to be taxed in the hands of one individual even if it was received by another individual. Attribution rules are designed to attack income splitting situations which have been determined by the legislators to be abusive.
Types of trusts
There are two types of trusts: inter vivos and testamentary. Testamentary trusts arise on the death of an individual and can be established under a will. Inter vivos trusts are established while the settlor is alive. These trusts are commonly divided into two categories: formal and informal. Formal trusts are established by a written trust agreement while informal trusts do not involve a written trust agreement.
A formal trust agreement or deed is typically drafted by a lawyer and identifies the settlor, the trust property, the trustee(s) and the beneficiaries.
A formal trust agreement typically sets out:
- The effective date of the trust
- How the trust is to be administered
- Authorized investments or guidelines for investments for the trust assets. It may allow the trustee to use his or her sole discretion when investing the funds or it may list permitted investments. It is important to note that where the trust is silent, the investment authority defaults to the applicable provincial trustee legislation that currently incorporates a version of the “Prudent Investor Rule” which enables a trustee to invest in any type of property, provided it is one that a “prudent investor” would invest in.
- The length of time the trust is to be in force and the final distribution of trust property
- The purpose of the trust (e.g. to provide money to the trust beneficiary for educational purposes)
- Successor trustees, or it may outline how a new trustee may be appointed in the event a trustee passes away, is unwilling or unable to act
- The powers of the trustee(s)
Formal trusts are beneficial because they clarify who can deal with the funds and there is little ambiguity in how the trust is to be administered. However, when dealing with smaller sums of money, most people do not want to go to the expense of setting up a formal trust and instead attempt to show the existence of a trust in the policy or contract application.
As discussed above, trusts do not necessarily have to be in writing. However, in order to verify that there is a trust, the three certainties must be identified somehow.
To demonstrate the existence of an informal trust, the trustee, the settlor, and the trust beneficiary must be clearly identified on the application. The trust property will already be identified on the application.
Because there is often not enough information, informal trusts can lead to difficulties for both the trustee and trust beneficiary if there is ever any dispute involving the administration or distribution of the trust assets or income. Take, for example, a parent who sets up an informal trust for her minor child. When the child turns 18, he wants to receive the funds personally to spend as he wishes. The parent disagrees, thinking that he will squander the funds, and decides as trustee not to distribute the funds. Since there is no trust document to indicate otherwise, the child, upon attaining the age of majority, would be entitled to apply to the Court for an order that the funds be paid to him or her.
The need for a trust agreement or a declaration:
A written copy of the formal trust agreement, or in the case of an informal trust, a document describing the terms of the trust (commonly referred to as a declaration of trust), is required by Manulife when setting up policies owned in trust.
The reasons for this are:
- A trust cannot exist in perpetuity. Therefore, we must know at what point the distribution of trust assets to the trust beneficiary can occur. This helps to determine whose life the contract should be based on (who the most suitable annuitant would be).
- When a trust beneficiary dies, the assets to which he/she was entitled to under the trust document must be distributed somehow. Therefore, the trust document should identify who should receive the trust assets upon the death of the trust beneficiary. Under our policy application, the named beneficiary is normally the trust. Upon the death of the annuitant (usually the trust beneficiary), the death benefit is paid back to the trust so it can be distributed according to the terms of the trust.
- Manulife needs to know who has the authority to enter into the contract with us under the terms of the trust. Therefore, the trust document should identify the trustee(s) and their powers.
- Certain products may not be appropriate for the trust, depending on the terms of the trust. The trust document will help to confirm that the appropriate product is selected so that the trust monies are not locked into an investment beyond the time for distribution outlined in the trust.
- If the trustee dies, the trust does not terminate. Instead, a successor trustee must be selected. Different provinces have different provisions on how the successor trustee is determined. In order to ensure continued administration of the trust, the trust document should state that the settlor has the power to appoint a successor trustee on death, resignation or removal of the incumbent. This means the settlor does not actually have to name the successor trustee at the establishment of the trust but can determine the individual(s) when needed. However, in the case of a testamentary trust, such as one created in a will or life insurance declaration, the alternate trustee should be named at the outset as the settlor will not be available to name a successor if the need arises.
It is important to note that the declaration of trust does NOT create the trust. The intent of the declaration is to provide us with information regarding the details of the trust.
The ITA contains complex income attribution rules which are designed to attack income splitting situations which are considered to be abusive. Generally, the rules apply where an individual transfers or lends property, directly or indirectly, to a spouse, or non-arm’s length person (including the individual’s minor children), or niece or nephew who is under the age of 18 and the intended result is that income on the property is taxed in the transferee’s hands. The reason the CRA may find such situations abusive is that, generally, this type of scenario will be used when the transferee is at a much lower tax bracket than the transferor.
It is important to note that the phrase "directly or indirectly" includes a wide range of transfers, including those made to trusts. Individuals not dealing at arm's length generally include a child, grandchild, great-grandchild, his/her spouse's child, his/her child's spouse, a sibling, or brother/sister in law.
If the criteria above are met, income on the transferred property will be attributed back to the transferor. This means that the transferor must include the income on his or her tax return, instead of the transferee. However, there are a few exceptions to the attribution rules:
- Capital gains on property transferred to a minor child are not attributed back to the transferor. This includes capital gains realized when the investment is sold and capital gains distributed or allocated on the investment (as in a mutual fund or segregated fund contract).
- If the transferred property is used to generate business income, there is no attribution back to the transferor
- If income from the investment is reinvested, earnings on that income (i.e. second generation income) are not attributed back
Generally, no attribution will occur on "in-trust-for" accounts for a child if the funds are from a child’s inheritance, child tax benefits, non-resident donor and funds received from an arm’s length individual.
Note that CRA has made an administrative concession with respect to child tax benefit monies. If these funds, received by a parent, are deposited into an account that is to be held in trust for the child, attribution will not occur on these funds. For this reason, it is advisable to keep these funds separate from other funds (on which attribution may apply).
When the minor child attains the age of 18, all attribution ceases (unless the donor still has control or direction over funds in the account). Also, attribution ceases if the settlor dies or becomes non-resident.
As discussed previously, a revocable trust can cause adverse tax consequences. If the property in a trust can revert, at the transferor’s will, back to the transferor or to individuals determined by the transferor after the trust was created, income from property and capital gains is attributed back to the transferor (however, this does not include business income). In addition, the property cannot be distributed to the child beneficiaries during the settlor’s lifetime without adverse tax consequences. Note that even an irrevocable trust may be considered revocable if the transferor and sole trustee are the same person. The reason for this is that, as sole trustee, the transferor may have the ability to control the trust assets and to determine how they are distributed, depending on the terms of the trust. This rule may also apply if one spouse is the settlor and the other spouse is the trustee. This is because it could be argued that the spouses are acting together. Therefore, to avoid application of this attribution rule, if the transferor is also a trustee, it is important to ensure that there are at least two other trustees and that the transferor cannot be allowed to compel or overrule any majority decisions. With the creation of a trust, it may be easier just to make sure the donor and trustee are not the same person.
In summary, the attribution rules can be very complex and we will not attempt to deal with them all in this article. However, the rules should be kept in mind whenever an individual transfers or loans funds, either directly or indirectly, on behalf of specified individuals. In this type of scenario, the client should seek the advice of a qualified tax advisor.
The preferred beneficiary election
As mentioned previously, a trust is treated as an individual for income tax purposes. The trust is considered to receive the income earned from the investments and any income retained in a trust (testamentary or inter vivos) is taxed at the top marginal rate (a Graduated Rate Estate (GRE) and Qualified Disability Trust (QDT) are taxed at graduated rates)¹.
Preferred beneficiary elections can be filed for both testamentary and inter vivos trusts. To do this, a joint election is filed that permits the income to be retained by the trust but to be taxed on the beneficiary’s tax return. The elected amount is deducted in computing the trust’s taxable income.
A “preferred beneficiary” includes an individual who has attained the age of 18 years old and is dependant as a result of being mentally or physically infirmed. The beneficiary can be a spouse, common-law partner, child, grandchild or great grandchild of the settlor.
The preferred beneficiary election allows the income that would otherwise be distributed to the beneficiary to accumulate in the trust. It also allows the preferred beneficiary to effectively utilize their personal exemption limit and to enjoy income up to that amount tax-free. This can also be beneficial in preventing the disabled individual from losing government disability benefits.
Other points regarding trusts:
Duties of Trustees: Under common law and provincial legislation, trustees are given certain powers with respect to the administration of a trust. If it is unclear whether the trustees have the power to do a certain act, and it is not specifically documented in the trust agreement, it is recommended that the opinion of counsel be sought.
In addition to their basic duty to comply with the terms of the trust, trustees have the following fundamental duties:
- Duty of loyalty to the beneficiaries - they must act solely for the benefit and best interest of the beneficiaries; they must avoid any conflict of interest between their personal interests and the beneficiaries and they must not personally benefit or profit from the trust except as the trust permits
- Duty of reasonable care - they must conduct the business of the trust as a prudent person would conduct his or her own business. This includes investment of the trust property in the manner of a prudent investor.
- Duty to act personally - they must not delegate their powers to others except with regards to administrative matters which a prudent businessperson would delegate.
- Duty to act with an even hand - they cannot favour one beneficiary over the other
21-year deemed disposition: Under tax law, a trust is generally deemed to dispose of its assets after 21 years from the creation of the trust. This has the effect of taxing any unrealized gains in the trust. In order to avoid the tax payable on the unrealized gain, the trust assets may be distributed on a tax-free basis to the beneficiaries of the trust. For this reason, many formal trusts restrict their existence to 21 years from the creation of the trust. When the assets are ultimately disposed of by the beneficiary, the beneficiary may realize a capital gain and be liable for tax on that gain.
Trust Records: There are no specific legal requirements as to the particular records to be kept by the trust. Nevertheless, the trustees should keep accurate records to document that they have carried out their duties properly. It is recommended that these books include records of all discretionary decisions. The appropriate accounting records for the trust should be kept in the usual manner and in accordance with the requirements of the ITA.
Tax Reporting for Trusts: The trust is considered to be a taxable entity under the ITA. Testamentary and inter vivos trusts are taxed on any income retained in them at the top personal marginal rate1 exceeding 50% in some provinces. Generally, trusts report any income earned but are entitled to an offsetting deduction for amounts paid or made payable to the trust beneficiary in that year. The beneficiary would then report the income distributed to him or her. Since the beneficiary is usually at a lower tax bracket than the trust, the total tax burden is reduced by paying out funds to the beneficiaries.
Completing the policy application:
Completing the owner, annuitant and beneficiary sections of the application correctly will help to make sure it is issued in a timely manner.
It is important that the owner of the policy is named accurately on the application.
In the case of a formal trust, where the trust has been named (e.g. The Smith Family Trust), the trust name should be entered into the "Owner" section of the application.
A testamentary trust is generally established under a will, which sets out the terms of the trust and the trustee's authority. This is separate and apart from the estate itself which is also a testamentary trust. If the estate or testamentary trust were to purchase the policy, the estate or testamentary trust would be the owner of the policy.
In the following situations it is appropriate to identify the owner as the trustee in trust for the beneficiary (e.g. Judy Smith in trust for Susie Smith):
- If the formal trust does not establish the name of the trust.
- If the will (in the case of a testamentary trust) authorizes payment to the trustee rather than the executor, and they are not the same person.
- An informal trust.
Please note in the case of a formal trust or an informal trust, other than a trust for child tax benefit funds, we should not obtain a social insurance number (SIN) for the trust beneficiary, since all tax reporting should be in the name of the trust. In the case of an informal trust for child tax benefit funds, the SIN of the trust beneficiary should be obtained and reported.
The annuitant must be correctly established because our segregated fund contracts are considered life insurance policies and terminate on the annuitant’s death. Given this, it is important to set up the application to correspond, if possible, with the distribution under the trust. In most cases, the annuitant under the contract would be the trust beneficiary.
The beneficiary under our contract should not be confused with the trust beneficiary. The beneficiary under our contract would typically be the trust, so that upon the death of the annuitant the funds would be paid back to the trust and would be distributed according to the terms of the trust. Where a formal trust specifies who should receive the funds from the trust upon death, that person can be named as a beneficiary under the policy.
Summary: informal trusts
Where no formal trust exists, Manulife requires a declaration of trust describing the terms under which the trustee holds the funds.
Some things to keep in mind regarding trusts:
- The terms of an informal trust can be set out in a declaration of trust
- The declaration of trust does not create a trust. The three certainties must still exist in order for the trust to be valid
- The trustee retains control of the funds for the child until the child reaches the age specified in the declaration of trust (if no age is specified, it is the age of majority). In fact, the child may have the legal right to the trust assets at the age of majority, unless the declaration of trust indicates a later age and makes alternate provisions in the event that the child doesn’t live to the specified age. Manulife’s Declaration of Trust does not have these alternate provisions in the event of death
- The settlor cannot remove trust property from the trust (unless it is a revocable trust with the associated tax consequences)
- The trustee will exercise rights of ownership exclusively for the benefit of the trust beneficiary
- Attribution can be a concern where an individual transfers property directly or indirectly by means of a trust to a related minor (including the individual’s descendants, spouse’s child, child’s spouse, brother, sister, brother in-law, sister in-law as well as a niece or nephew)
- The settlor and the trustee are often not the same person. In fact, to avoid the attribution of capital gains, they should not be.
- Second generation income is not subject to attribution
- Funds with capital growth as the primary objective are ideally suited to contracts held in trust for a related minor since any capital gains will not be attributed back to the settlor
- At the age of majority, attribution ceases (unless the donor has continuing control or direction over the funds)
- Upon the death of the settlor, attribution ceases
- Upon the settlor becoming non-resident, attribution ceases
- When the beneficiary takes control of the assets at the age of majority (or other age), there are no capital gains consequences. The assets are rolled over to the beneficiary at cost.
Sample trust agreement and declarations
Appendix III is a specimen trust agreement. This document is only a draft intended to be a sample for the use and guidance of a lawyer when writing a trust agreement.
Appendix I and Appendix II are trust declarations. We will accept these with an application when the policy is being purchased "in trust".
The intent of the declaration is to show the existence of the trust and to provide some details, not to establish it. The declaration is simply to describe the general terms of the trust. These are examples and should be modified by the client where necessary to reflect the actual terms of the trust.
- The first declaration can be used for Child Tax Benefit monies. Other monies should not be intermingled.
- The second declaration is to be used for any monies transferred by way of a gift or a loan to a trust for the benefit of a trust beneficiary.
This form should be used when the funds are originating from Child Tax Benefit monies:
This form should be used when the funds are not from Child Tax Benefit monies:
Summary of Case Law and the CRA's Views
Two cases have examined the issues surrounding "In Trust For" accounts.
The case of Koons v. Quibell, a Saskatchewan lower court decision dated February 10, 1998, examined whether an "In Trust For" account was an irrevocable trust. In that case, the deceased named his second wife, Mrs. Quibell, sole beneficiary of his estate and named her as co-executor with his cousin. He made no provision for his grandchildren, which angered his only daughter. The Defendant widow opened two credit union accounts, one for the Plaintiff granddaughter and one for her brother and transferred money to each account from the estate account. She advised the children’s parents that she had set up trust funds for the children which they would receive upon attaining the age of 18. The account documentation for the Plaintiff granddaughter read, "Koons, Julianna Dorothy c/o Cheryl Larson (Mrs. Quibell) Trustee, Vincent Hawkes Trustee". On the advice of her lawyer, Mrs. Quibell forwarded the annual T-5 forms showing interest earned on the accounts, to the children’s parents.
The Plaintiff’s brother received the funds from the account in his name upon attaining age 18. The Plaintiff discovered at the age of 17, however, that Mrs. Quibell had withdrawn the funds from the account in her name three years earlier. The Plaintiff sued.
The Court held that a valid trust had been created and ordered payment by the Defendant to the Plaintiff of the funds that had been withdrawn, plus interest.
The second case, Blum v. the Queen, decided in September 1998, by the Tax Court of Canada, turned on whether gains and income on shares purchased by a grandfather in trust for his grandchildren should be attributed to him. Mr. Blum sold some corporate shares in 1987 and 1988. Although the shares were issued in his name "in trust for" his grandchildren, the CRA included the capital gains and interest in Mr. Blum’s income for the two years in question. Mr. Blum appealed to the Tax Court of Canada arguing that although there was no formal trust documentation, the funds had not been used by him personally, but rather, he had held the shares and the subsequent sale proceeds in trust for the grandchildren. The Court ruled that this was a validly created trust and that, therefore, the gains and interest were not attributable to Mr. Blum.
Although each of these cases upheld informal "in trust for" accounts, they emphasize the necessity of formal trust documentation, and illustrate how difficult it is to prove a clear intention to create a trust without a formal arrangement.
The CRA’s View
There has also been some communication from the CRA on this subject. The question posed was whether tax returns are required for in-trust accounts where s. 75(2) of the Income Tax Act does not apply (i.e. in the case of an irrevocable trust), and further, whether it is necessary to do so where there is only one beneficiary. In Document Number 9833995, the CRA made it clear that where there is a trust, even in the case of an informal "In Trust For" account, a T-3 return is generally required to be filed for the trust, whether or not s. 75(2) applies. In particular, the Trustee would be required to file a T-3 return in any year where the trust has disposed of capital property. This is true regardless of the number of beneficiaries of the trust.
The CRA also examined the issue of taxation of "in trust for" accounts in Document Number 9829145. The Department reviewed the three certainties (intention, subject matter and beneficiaries) which must be present for a finding of the existence of a trust and went on to say:
Where an "in trust" account is opened by a parent for his or her children, in absence of a formal trust document, the certainty of intention to set up a trust would be a difficult one to prove. As the children involved are most likely minors, often the arrangement is designed to accommodate the fact that minors do not have the legal capacity to enter into legally binding contracts and hence purchase financial instruments in their own name.
The point to be taken from the above statement is that it is not clear in such a situation that there is a certainty of intention to create a trust. The Department also indicated that, given the requirement of the three certainties, "a written trust document would serve as the best evidence of their existence and would resolve any ambiguities that may otherwise arise".
Additionally, in Document Number 9830997, the Department has stated that the existence of an "in trust for" account does not, in and of itself, result in the existence of an actual trust. The three certainties must still be present.
1 When an estate qualifies as and elects to be a Graduated Rate Estate (GRE) for income tax purposes, it will be taxed at graduated rates for 36 months after the individual’s death. Testamentary trusts that benefit disabled individuals eligible for the disability tax credit will continue to be taxed at graduated rates. Such trusts are known as Qualified Disability Trusts (QDT).