Trust Roll-out Strategy (and Tax Concerns)
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The 21-year rule under the Income Tax Act (Canada) deems most personal trusts to have disposed of their capital property at fair market value (FMV) every 21 years, potentially triggering a massive, dry tax liability. To mitigate this, a common strategy is a tax-deferred roll-out under subsection 107(2) of the Income Tax Act, which allows the trust to distribute capital property to Canadian-resident beneficiaries at its adjusted cost base (ACB). By transferring the assets before the 21st anniversary, the trust avoids the deemed disposition, and the tax liability on any accrued gains is deferred until the beneficiary actually sells the property or passes away. This strategy essentially resets the clock by removing the assets from the trust's ownership, placing them into the hands of the next generation or other intended recipients.
Implementing a roll-out requires careful legal due diligence to ensure the trust deed actually authorizes the trustees to distribute capital in this manner. If the trust document lacks an encroachment power or specific language allowing for capital distributions, the trustees may be legally barred from executing the roll-out without a court-ordered variation of the trust. Furthermore, the distribution must be in satisfaction of all or part of the beneficiary's capital interest in the trust. Trustees must also consider whether the beneficiaries are mature enough to receive the assets, as once the property is rolled out, the trustees lose their discretionary control over how those assets are managed or spent.
A primary tax concern when utilizing subsection 107(2) is the residency of the beneficiaries, as the tax-deferred rollover is generally unavailable if the recipient is a non-resident of Canada. Under subsection 107(5), a distribution to a non-resident beneficiary is deemed to occur at FMV, which would immediately trigger the very capital gains tax the strategy was intended to avoid. While some exceptions exist for specific types of taxable Canadian property, such as real estate, the general rule remains a significant hurdle for families with international members. Planning for these situations often involves complex reorganizations or alternative distribution patterns to ensure the tax-deferred status remains intact.
Another critical risk involves the anti-avoidance and attribution rules, specifically subsections 75(2) and 107(4.1) of the Income Tax Act. If a trust was funded in a way that allowed the settlor to retain certain powers or revert the property back to themselves, the trust may be tainted, making a tax-deferred roll-out to anyone other than the settlor or their spouse impossible. In such cases, any distribution to children or grandchildren would be forced to occur at FMV, triggering immediate taxes. In turn, the Canada Revenue Agency (CRA) has expressed growing concern regarding indirect trust-to-trust transfers or the use of corporate beneficiaries to circumvent the 21-year rule, often citing the General Anti-Avoidance Rule (GAAR) to challenge aggressive planning.
Furthermore, the shift of ownership from a trust to an individual beneficiary introduces non-tax risks, such as exposure to creditors and matrimonial claims. Once the property is rolled out, it becomes part of the beneficiary’s personal estate, making it potentially vulnerable in the event of a bankruptcy or a divorce settlement. Some legal and tax practitioners suggest freezing the trust's value into fixed-value preferred shares and distributing those while keeping growth shares in a new trust, though this adds significant administrative complexity. Ultimately, a successful roll-out strategy requires a delicate balance between tax efficiency, legal authority, and the long-term financial protection of the beneficiaries.
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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