On the twenty-first anniversary of a trust’s settlement, trustees run into a major roadblock. Canada’s Income Tax Act deems the capital property held by the trust to have been disposed for tax purposes, giving rise, potentially, to a capital gain. Depending on the tax qualities of the trust property, the inclusion of the taxable portion of the capital gain in the trust’s income tax obligations for the year could be expensive, and difficult where the trust does not have liquid assets to pay.
One of the ways drafters of discretionary family trusts may plan for the 21-year deemed disposition rule is to include in their deeds a trustee power to irrevocably allocate an absolute interest in the whole trust to one or more beneficiaries prior to the twenty-first anniversary. The effect of such an allocation should be to indefeasibly vest the beneficiaries’ interests in the trust in the proportions determined by the trustee.
When done properly to all interests in a trust, this style of allocation (granting the beneficiaries a fixed, absolute interest in the trust) exempts the trust from the application of the 21-year rule, while still permitting the trustees to nominally retain the property in trust. Depending on the circumstances, this could be a welcome option to the trustees, and language specifically authorizing it ought to be considered for inclusion in the deed at the time the trust is settled.
To vest indefeasibly, the person entitled to the interest must be alive and ascertainable, the interest must not be subject to a subsequent condition, and the grant of the interest must not be determinable. In other words, the interest must be held by an identifiable person, and there can be no “strings attached” to the interest—i.e., circumstances that would terminate or reduce the interest (such as the person’s death). In practice, this could be accomplished by naming the individuals outright in a trustee resolution, clearly identifying the scope of the interest being distributed and being careful to make the allocation unconditional.
When contemplating an allocation of an indefeasible interest, several additional factors should be considered:
- The specific requirements of s.108(1)(g) of the Income Tax Act. This subsection sets out the rules regarding the exception, including exceptions to the exception. For instance, Canadian-resident trusts with non-resident beneficiaries whose interests exceed 20 per cent of the trust property’s fair market value are not eligible for this treatment. The exceptions must be reviewed to ensure that this planning is available to the trust at issue.
- The fiduciary obligations of trustees. Trustees are required to exercise a high degree of care in administering the trust. The specific provisions of the trust deed and the general law applicable to trustees should be considered to ensure the distribution will not be contrary to a trustee’s fiduciary obligation.
- The possibility that the beneficiaries will apply for the trust to be wound up. Since the trust interests granted to the beneficiaries are absolute, if all the beneficiaries are of the age of majority and are capable, they may be able to apply to a court to have the trust wound up and their interests paid to them outright.
- The exposure of the trust interest to creditors, family law claims, taxation on death of the beneficiary. Vesting the interest indefeasibly means what it says. Without conditions encumbering the interest (such as trustee discretion,) the interest is the absolute property of the beneficiary and, consequently, is available for seizure by the beneficiary’s creditors and family law claimants. Upon the beneficiary’s death, the interest, with any latent capital gains from when it was first settled in trust, will now be deemed disposed in the hands of the beneficiary. Tax planning should be prepared to address this eventuality prior to the distribution of indefeasible interest.
Planning for the application of the 21-year disposition rule is critical for trustees of family trusts, and planning should begin with settlement.
For more advice about planning with family trusts, KPMG Law’s Estates and Trusts group is here to help.
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