Trust - Attribution Rules Strategies (and Tax Concerns)
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The use of a trust as an income-splitting mechanism requires a sophisticated approach to navigate the restrictive attribution rules found in the Income Tax Act (Canada). A primary strategy involves the use of prescribed rate loans, where an individual lends capital to a family trust at the government’s established interest rate instead of making an outright gift. By ensuring the trust pays this interest to the lender annually by January 30th, the attribution rules under Sections 74.1 through 74.3 of the Income Tax Act may be effectively bypassed, allowing income earned above the interest rate to be taxed in the hands of lower-income beneficiaries. This strategy is particularly effective for shifting dividends or interest to minor children or a lower-income spouse without the income reverting to the lender for tax purposes. To remain compliant, the loan must be documented with a formal promissory note, and the interest payments must be made consistently, as a single missed deadline permanently triggers attribution for the life of the loan [more on prescribed-rate loan strategy].
Beyond the method of funding, the structure and governance of the trust are critical in avoiding the super attribution rule under Subsection 75(2) of the Income Tax Act. This rule can trigger if the settlor or a contributor retains too much control over the trust assets or if the property could potentially revert to them. To mitigate this risk, tax planners often use a nominal settlor, a person like a grandparent who settles the trust with a small, one-time gift (like a silver coin) and then has no further involvement. Additionally, the individual providing the primary capital through a loan should generally not serve as the sole trustee or possess a veto over the distribution of trust property. By separating the roles of the funder, the settlor, and the trustees, the trust avoids the appearance of being a revocable or self-directed vehicle, which would otherwise result in all income and capital gains being taxed at the funder's high marginal rate.
Another vital strategy involves distinguishing between income and capital gains when making distributions to minor beneficiaries. While Subsection 74.1 attributes interest and dividends back to the transferor when gifted to a minor, Subsection 74.2 notably excludes capital gains from attribution to minors (though not to spouses). Consequently, a trust can be structured to hold growth-oriented investments, where the resulting capital gains are allocated to minor children or grandchildren to utilize their personal tax credits. This allows for significant tax-free or low-tax growth within the family unit, provided the trust deed explicitly grants the trustees the power to distinguish between income and capital. However, even with this strategy, the structuring must remain wary of the Tax on Split Income (TOSI) rules, which can apply the highest marginal tax rate to certain types of income regardless of the attribution rules if the income is derived from a related business [more on TOSI strategies].
The implementation of these strategies carries significant administrative and tax risks that must be managed over the trust's lifetime. For instance, the 21-year rule creates a deemed disposition of all trust assets at fair market value every 21 years, potentially triggering massive capital gains taxes even if no assets were sold. To address this, trustees often plan to distribute the assets to beneficiaries on a tax-deferred basis before the anniversary, but this requires the beneficiaries to be old enough and responsible enough to receive the property directly [more on trust roll-out strategies]. Also, new enhanced trust reporting requirements in Canada demand the disclosure of all "reportable entities," including the settlor, trustees, and beneficiaries. Failure to comply with these transparency rules can lead to substantial penalties and increased audit scrutiny from the Canada Revenue Agency (CRA), making meticulous record-keeping a non-negotiable part of the strategy.
In addition, the legal and economic costs of maintaining a trust can sometimes outweigh the tax benefits if the initial capital is not sufficiently large. Setting up a family trust involves legal fees for drafting the deed, accounting fees for annual T3 tax filings, and the complexity of maintaining separate bank accounts to prevent the co-mingling of funds. There is also the risk of joint and several liability, where both the transferor and the trust (or beneficiary) can be held responsible for taxes owing on attributed income. If the CRA successfully challenges the trust’s validity or the loan’s legitimacy, the family could face years of back taxes, interest, and penalties. Therefore, any trust strategy must be balanced against the potential for legislative changes, as the Canadian government frequently updates the Income Tax Act to close perceived loopholes in income-splitting arrangements.
Contact our law firm today to learn how our legal team can help you plan for the future, including wills, trusts, powers of attorney, personal directives and other estate planning documents, or deal with the legal demands associated with the passing of a loved one. Contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential initial consultation.
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