Trusts are a versatile tool used in tax and estate planning. They can hold property that’s managed by a trustee on behalf of beneficiaries. The income earned in a trust can be shared by the beneficiaries — a useful tax strategy. They also allow for assets to flow outside of one’s estate, providing some valuable estate planning benefits. These benefits and more drive potential clients’ interests in trusts. However, there’s a lot to learn about trusts, including how they work and the different types. This article covers several topics related to trusts, such as:
Consult with legal counsel
This article is intended to give a basic understanding of the most common types of trusts used in Canada. It focuses on trusts with Canadian resident trustees only. We recommend that you consult with legal counsel for advice concerning tax and legal matters involving the constitution, management, and reporting for trusts. Note that, due to the different legal structure in Quebec, the comments contained in this article don’t apply to trusts in Quebec.
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 or beneficiaries) while imposing certain restrictions and conditions over the property. The property is held and administered by the trustee.
A trust isn’t a legal entity. Rather, it’s 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) 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 — e.g., a person’s children).
If any one of these criteria is missing, there’s 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 can’t revert to the settlor, unless the trust document specifically indicates it’s revocable. Later in this article, we’ll discuss why revocable trusts are not desirable from a tax perspective.
A trust is a taxable entity under the Income Tax Act (ITA). There are two different types of trusts: inter vivos and testamentary. Inter vivos trusts are set up during an individual’s lifetime. Their main purpose is to transfer the benefit of owning assets to others (i.e., the trust’s beneficiaries) while the trust’s terms impose restrictions over those assets. Testamentary trusts are created as a consequence of the death of an individual: the settlor. The trustee(s) will manage the assets of the testamentary trust in accordance with the particular trust provisions. Testamentary and inter vivos trusts are taxed on any income retained in them at the top personal marginal rate, exceeding 50% in some provinces. In contrast, graduated rate estates (GREs) and qualified disability trusts (QDTs) are taxed at graduated rates.¹ 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 received. 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.
Key trust terms
A trust is a method for one person to convey property to another person for the benefit of a third person. It’s not a legal entity itself. However, under the Income Tax Act (Canada), a trust is treated as an individual and thus can be taxed as one.
Settlor (also known as donor or transferor)
This individual creates the trust by contributing property to it and by establishing terms of the trust.
This is the legal owner of the property, who’s responsible for administering the property in accordance with the terms of the trust agreement and applicable trust laws. Pursuant to trust law, the trustee and the settlor can be the same person; however, for tax reasons, the trustee should be different from the settlor.
This is the person(s) for whose benefit the trust was established — the ultimate owner of the property and income from that property.
Inter vivos trust
This is a trust that isn’t a testamentary trust. Property is settled on the trust while the settlor is still alive.
This type of trust is generally created by a will that takes effect on the death of the settlor.
A formal trust is established by a written trust agreement that outlines terms and conditions and clearly identifies the persons and property involved.
An informal trust doesn’t involve a written trust agreement. As such, there may be confusion over the terms and conditions and difficulty in proving their existence.
The property gifted to the trust can revert to the settlor at the settlor's will. From a tax perspective, this type of trust is undesirable.
Distribution of trust property
Trust property may be distributed to the beneficiary at its cost base. Therefore, the trust doesn’t realize any capital gains on the transfer and realization of the capital gains will be deferred until the beneficiary disposes of the property. If the trust document doesn’t provide for distributions in kind, or the property can’t be distributed in this manner, the property may first have to be sold, thereby triggering any unrealized gains on the property.²
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 establish limitations and restrictions over the property (either by being a trustee or by choosing the trustee and dictating the terms of the trust). If the settlor doesn’t want the beneficiary to own the property until a future date, the settlor can, through the trust agreement, set out how the trust property is to be invested and when the property will be distributed to the trust’s beneficiary.
Trusts are also often used to hold assets on behalf of minors. Since minor children don’t have the legal capacity to enter a binding 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 or older.
Trusts are also used for tax-motivated reasons. Properly structured, trusts allow for the deferral of accrued capital gains and some income splitting.
Types of trusts
A formal trust agreement or deed is typically drafted by a lawyer and identifies the settlor, the trust property, the trustees, 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 investment of trust assets. It may allow investing the funds to be at the trustees’ discretion, or it may list permitted investments. It’s 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 allows a trustee to invest in any type of property provided it’s one that a prudent investor would invest in
- the length of time the trust is to be in force and the date and mechanism for the final distribution of trust property
- the purpose of the trust (e.g., to provide money to the trust beneficiary for educational pursuits)
- successor trustees, or it may outline how a new trustee may be appointed in the event a trustee passes away, or is unwilling or unable to act
- other powers of the trustees.
Formal trusts are helpful because they clarify who can deal with the funds and there’s little ambiguity in how the trust is to be administered. However, when dealing with smaller sums of money, most people don’t want to go to the expense of setting up a formal trust and instead attempt to show the existence of a trust in the setup of the contract.
As discussed above, trusts don’t necessarily have to be in writing unless they contain land or real property. However, to verify that there’s 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’s often not enough information, informal trusts can lead to difficulties for both the trustee and trust beneficiary if there’s ever any dispute involving the administration or distribution of the trust assets or income. For example, take 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’ll squander the funds, and decides, as trustee, not to distribute the funds. Since there’s no trust document to indicate otherwise, the child, on attaining the age of majority, would be entitled to apply to the Court for an order that the funds be paid to him.
Planning with specific trusts
Under the right circumstances, trusts can be effective estate and tax planning tools. Here are some examples of trusts that can be used for such purposes:
- alter ego or joint partner trust – inter vivos trust created by a settlor who’s 65 years old or older. There’s no taxable disposition of assets transferred into an alter ego or joint partner trust. Only the settlor (or settlor and their spouse or common-law partner for joint partner trusts) can benefit from the income and capital while alive. On the last survivor’s death, the trust will have a deemed year end and the assets can be passed to other beneficiaries outside the deceased’s estate, avoiding probate fees and estate administration.
- family trust – can be inter vivos or testamentary trust, often used to split income with family members along with other tax planning strategies (i.e., income splitting using prescribed rate loans or estate freezes), or used for spendthrift or minor beneficiaries. As a result, family trusts are more commonly inter vivos trusts.
- Henson trust – can be inter vivos or testamentary trust used in estate planning for disabled individuals. Typically, a family member of a disabled beneficiary settles a Henson trust with funds that are needed to provide support for that beneficiary while maintaining their provincial disability benefits.
- qualified disability trusts (QDT) – a testamentary trust with a qualified disabled beneficiary. The trust and beneficiary can make an annual joint election to have the trust taxed as a separate taxpayer at marginal tax rates (instead of the top rate). Testamentary Henson trusts can be QDTs if they meet requirements set out under the ITA, but not all will. Further, QDTs may also preserve provincial disability benefits for the beneficiary.
- testamentary spousal trusts³ – allows property to be transferred to a surviving spouse (including a common-law partner) when an individual dies. Assets can be transferred to the trust on a tax deferred basis. Such trusts may be used to protect the trust’s assets for other beneficiaries (i.e., children of the deceased spouse) and may also allow a third-party trustee to manage them where the surviving spouse may be unable to (i.e., incapacity or disability). This allows the deceased spouse to maintain some control over these assets on their death. One important limitation with a spousal trust is that no person other than the surviving spouse (during their lifetime) may be entitled to or receive income from that trust.
The Income Tax Act (Canada) contains complex income attribution rules that are designed to attack income splitting situations that may be abusing the tax advantages of setting up a trust. Generally, the rules apply when a person transfers or lends property, directly or indirectly, to a spouse (including a common-law partner), or non-arm’s length person (including the individual’s minor children), or niece or nephew who’s 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 Canada Revenue Agency (CRA) may find such situations abusive is because, generally, this type of scenario will be used when the transferee is in a much lower tax bracket than the transferor. When a trust is involved, the settlor would be the transferor and the beneficiaries of the trust would be the transferees.
It’s 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 minor child, grandchild, great-grandchild, a spouse's child, a child's spouse, a sibling, or brother/sister-in-law.
If the above criteria are met, income on the transferred property will be attributed back to the transferor. This means that the income must be included on the transferor’s tax return, instead of the transferee’s.
However, there are a few exceptions to the attribution rules:
- Capital gains on property transferred to a minor child aren’t 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’s no attribution back to the transferor.
- If income from the investment is reinvested, earnings on that income (i.e., second-generation income) aren’t 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, or funds received from an arm’s-length individual.
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 doesn’t include business income). In addition, the property can’t be distributed to the trust’s beneficiaries (unless it’s distributed back to the settlor or the settlor’s spouse, and that individual is also a beneficiary of the trust) during the settlor’s lifetime without adverse tax consequences.² Attribution ceases if the settlor becomes a non-resident or when the settlor ceases dies.
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’re 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’s important to make sure that there are at least two other trustees and that the transferor can’t be allowed to compel or overrule any majority decisions. With the creation of a trust, it may be easier just to make sure the settlor and trustee aren’t the same person.
The attribution rules can be very complex. However, the rules should be kept in mind whenever a person 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
A 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 use their personal exemption limit and to enjoy income up to that amount tax-free. This can also be useful in preventing a disabled individual from losing government disability benefits.
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’s 18 years old and is dependent 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.
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’s recommended that the opinion of legal 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 interests of the beneficiaries. They must avoid and disclose 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 prudent persons would conduct their own business. This includes investment of the trust property in the manner of a prudent investor, which can include the requirement of diversification.
- duty to act personally – They must not delegate their powers to others except with regards to administrative matters that a prudent businessperson would delegate.
- duty to act with an even hand – They cannot favour one beneficiary over others.
The settlor of the trust can provide in the trust deed how trustee compensation is calculated. This might include a stated hourly amount (based on the time the trustee spends on their duties), a percentage amount (on the gross value of the trust’s assets, or on flows in and out of the trust, or a combination), a flat dollar amount, etc. If the settlor feels strongly that compensation shouldn’t be awarded to the trustees, then they must explicitly state this in the trust deed; otherwise, the beneficiaries or the court can award compensation.
We recommend that the trust deed address trustee compensation; otherwise, the trustees can still obtain compensation, but that matter would be determined by the beneficiaries or the court through costly litigation. If the trust deed doesn’t address compensation, most common law provinces’ trustee legislation provides that trustee compensation must be fair and reasonable, which often leaves it to the court to determine what compensation is appropriate for the trustees. Courts often look at a number of factors when determining appropriate compensation, which can include the expertise of the trustee, the value added by the trustee (i.e., did they grow the trust assets and manage them well), time and effort expended, size of the trust, complexity involved in administering the trust, etc. If all trustee beneficiaries are of the age of majority and are of sound mind (sui juris), then the beneficiaries and the trustees could reach a mutual agreement on trustee compensation; if not, then the court will decide, and this can be part of the trustees’ application for passing of accounts.
Trustee compensation is fully taxable as income to the trustee. Attempts to recharacterize compensation as a gift are often reviewed by the CRA. As an example, a specific bequest made to a trustee in the settlor’s will could face scrutiny and may be reassessed as trustee compensation disguised as a gift.
21-year deemed disposition
Under the ITA, 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. To avoid tax payable on the unrealized gain, the trust assets may be distributed to the beneficiaries of the trust on a tax-free basis.² For this reason, many formal trusts restrict their existence to 21 years from their creation. 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. Where the trust deed doesn’t provide the trustee with discretion for these distributions or where it fails to address the 21-year disposition, then the trustee will need court approval to wind up the trust to potentially avoid adverse tax consequences. The court must be satisfied that it’s in all beneficiaries’ best interests to wind up the trust, which can be a hard burden to satisfy.
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’ve carried out their duties properly. We recommend 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, which can also help protect the trustees from claims by the beneficiaries.
New 2021 tax compliance for trusts
For trusts with tax years ending on or after December 31, 2021, there are increased tax-reporting and disclosure requirements associated with many types of trusts, which are intended to provide greater transparency to the CRA at the expense of greater privacy previously afforded to trustees and beneficiaries.
Prior to the implementation of these new rules, an inactive trust (such as a trust that hasn’t disposed of capital property during the year), a trust with no income, or a trust with no tax payable was generally not required to file a T3 return. Once these new rules come into effect though, most express trusts (not including resulting or constructive trusts) will now be required to file T3 returns even if there’s no tax payable or income to report. Trusts that are required to file returns under these new rules will also be required to provide new information regarding:
- the name
- date of birth
- tax identification number (SIN, business number, etc.)
- jurisdiction of residence
of each of these individuals:
- the settlor
- each trustee
- each beneficiary, which includes contingent beneficiaries
- any person who can control or override certain trustee decisions, such as a protector of the trust.
There are very few exceptions or types of trusts that aren’t subject to these new rules. Some of these exceptions include graduated rate estates, qualified disability trusts, registered plans (e.g., registered retirement savings plan, registered retirement income fund, tax-free savings account, registered education savings plan, etc.), mutual fund trusts, segregated funds, and trusts that hold less than $50,000 in assets throughout their taxation year (and these assets are comprised of cash or portfolio type investments — i.e., they aren’t private corporation shares).
Ultimately, this means that more trusts must file T3 returns, and these returns must provide additional disclosure of personal information. This increases the burden placed on trustees, which requires trustees to be even more meticulous with their record keeping and forces them to obtain very personal information from individuals, like the settlor and beneficiaries, that they wouldn’t otherwise need for the administration of the trust — information that the trustees may have difficulty obtaining.
Moreover, there are new significant punitive penalties for non-compliance with these new rules, which can include a five percent penalty of the maximum fair market value of the trust’s property during the given year if that failure to comply was made knowingly or due to gross negligence.
Trusts can be used to achieve a number of different estate planning and wealth succession objectives. The most notable tax benefit is for the trust’s income to be taxed in its beneficiary’s hands. Understanding what trusts are, how they work, and why they’re popular can help determine if they fit within your tax and estate plan. Working directly with a trust and estate lawyer can help determine the right trust for your situation.
1 When an estate qualifies as and elects to be a graduated rate estate for income tax purposes, it’ll be taxed at graduated rates for 36 months after the individual’s death. Testamentary trusts that benefit disabled individuals who are eligible for the disability tax credit will continue to be taxed at graduated rates. Such trusts are known as qualified disability trusts. 2 Normally, a trust can distribute capital assets to Canadian resident capital beneficiaries at the trust’s cost base, resulting in no tax for the trust or the beneficiary. However, when a trust is revocable, is otherwise subject to subsection 75(2) of the ITA, or the recipient capital beneficiaries are non-residents of Canada, distributions must be done at the asset’s fair market value. 3 While it’s possible to have inter vivos spousal trusts, most are testamentary.
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.