Articles January 2007

The new income trust rules apply only to income trusts that are traded on public stock exchanges. The rules do not in any way affect family trusts, trusts established in wills and other forms of private (not publicly traded) trusts.

Private trusts continue to be an effective tax and estate planning tool.

While a special tax will apply to income earned by new income trusts, private trusts continue to have a choice about how trust income is taxed. If all the beneficiaries of the private trust are resident in Canada, the trust can choose to flow all its income through to those beneficiaries and have the income taxed as income of the beneficiaries. If the beneficiaries are in a lower tax bracket than the private trust, this makes good tax sense. Of course, this assumes that the terms of the trust allow for a full flow-through of income.

Private trusts continue to be useful in the following types of situations.

A married couple with adult children might own an asset that generates income and is also increasing in value. The parents want to continue to have access to the income but are concerned about the increasing value of the asset. On the death of the surviving parent, that value will be subject to capital gains tax (which means that less of the estate will be available for the children). In order to keep the looming capital gains tax problem from getting worse with time, the parents might choose to engage in an estate freeze transaction in which they “freeze” (or cap) the value of their interest in the asset. The parents would continue to receive the income but all future growth in capital value would accrue to a trust established for the children. As a result, that future increase in value will not be subject to capital gains tax on the death of the last surviving parent. This essentially defers tax on that future growth in value until the death of the children.

In the above situation, no actual income would have to be paid to the family trust. However, any income that is paid to the trust could be flowed out to the children and taxed as their income. This can be an advantage if the child is in a low tax bracket. For example, the child might be a university student. Given that university students generally have very little income and lots of deductions, a student can receive an appreciable amount of income and pay little or no tax on the income. Consequently, it is much cheaper for the student to earn the income through the trust (as opposed to the parent paying tax on the income and then gifting the after-tax amount to the student). Various restrictions limit the tax advantage in respect of children under the age of 18, however, if the income consists of dividends paid by a private family corporation.

A testamentary trust established in a will continues to pay tax as if it were a separate individual. As a result, it is sometimes beneficial for a will to establish a trust for beneficiaries. If the beneficiaries pay tax at the top tax rate, the trust might prefer to have its income taxed as income of the trust. The trust would pay tax at a 22% rate on its first $30,000 of taxable income, whereas the beneficiaries would pay 44% if the income were distributed to them and added to their other income. Once tax is paid in the trust, the after-tax amount can be distributed to the beneficiaries as tax-paid capital (without attracting further tax).

While income trusts likely will have disappeared from the Canadian landscape by the end of 2011, I foresee no imminent demise of the private family trust and private will trust. These types of private trusts will continue to be useful estate planning tools notwithstanding the new tax regime applicable to publicly-traded income trusts.

-- Blair P. Dwyer

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