What is trust attribution?

Trusts can be effective planning vehicles for both tax and non-tax reasons. They can achieve great results for Canadians and their families when structured properly, when all the relevant pros and cons are properly assessed by qualified professionals.

While in some cases, these benefits can include the reduction of tax payable on certain income and capital, it is important to understand that there are many complex rules in the Income Ta x Act (ITA) designed to prevent the shifting of income and capital to lower-bracket family members to avoid the payment of tax at the rates of the transferor. One such provision is the tax on split income. Other such provisions are known as the attribution rules.

Where the attribution rules are triggered, income, gains and losses subsequently derived from the transferred property continue to be taxed in the hands of the transferor and not of the transferee, just as if the transfer had not taken place. There can be other negative consequences beyond this that taxpayers should be assessing with their own tax lawyers and accountants, such as the potential inability to multiply the lifetime capital gains exemption on qualified small business corporation shares.

This concept of attribution can be found throughout the ITA and often involves the assessment of multiple ITA provisions.

The attribution rules

The primary trust attribution rule can be found in subsection 75(2) of the ITA. This section is concerned with transfers of property to a trust where the property may ultimately revert to the settlor or contributor from whom it was directly or indirectly received, or where the property remains under the control of the person (i.e., the settlor) who contributed the property. Control in this context may be determined by whether the settlor/contributor can receive the trust property, or if they can determine how property can be disposed in the trust.

It is not unusual for a trust to have a settlor and one or more contributors. In those cases, the settlor — generally an unrelated third party or grandparent (depending on planning strategy) provides settlement property, which is followed by an additional contribution. (Settlement property may include a gold/silver coin, one or more bank notes or other clearly ascertainable property.) This additional contribution may come from others, but significant caution should be exercised in those instances.

Most modern trusts are generally designed to prevent the accidental triggering of subsection 75(2) by requiring the following:

that there is no ability for funds to revert to the settlor;
that the settlor shall have no control or discretion over management and activities of the trust after settlement (including the ability to appoint subsequent trustees, i.e., the protector); and
that any additional contributions to a trust are to be characterized as a loan rather than a contribution, preferably at the Canada Revenue Agency (CRA) prescribed interest rate or other (generally higher) commercially reasonable rate.

Another common attribution provision regarding trusts is subsection 74.3(1) of the ITA. It can apply where an individual has lent or transferred property (directly or indirectly, by any means) to a trust in which a designated person has a beneficial interest at any time. A designated person is generally a spouse/common-law partner or minor family member (including nieces and nephews).

The general concept is to determine the amount of any income or taxable capital gains that may be attributed to an individual where that taxpayer has transferred or lent property to a trust. This is a complex provision. The section is intended to be read in conjunction with other sections of the ITA, including 74.1 and 74.2.

Sections 74.1 and 74.2 are designed to prevent an individual from splitting income with family members through a transfer or loan of property, to or for the benefit of the individual’s spouse, common-law partner or certain minors. Where triggered — any income or loss from the transferred or loaned property (or property substituted therefor) and where the recipient is the individual’s spouse or common-law partner — any gains or losses on capital account from the disposition are attributed to the individual and are not taxed to the recipient.

Subsection 74.5(2) provides an exception to the application of the attribution rules where the transferred property is a loan for value, bearing at minimum, the CRA prescribed rate for loans at the time the loan was made — provided that the annual interest is paid within 30 days after the year-end of every year the loan is in place.

For this reason, it is common for a contributor to make an interest-bearing loan to a trust at the CRA prescribed rate, which could potentially be a trustee/parent/spouse. Provided that the interest is reasonable and paid annually, and any necessary safeguards are taken by the other trustees, the attribution rules in 74.1 and 74.2 generally will not apply where this is considered properly.

A hypothetical scenario

Mr. Singh settles a trust for the benefit of his spouse, Mrs. Singh, and their two adult children. The trust is settled with a silver coin and $1 million of inheritance in cash. This is a gift, not a loan.

The inheritance is to be invested for the benefit of the family and outside of Mr. Singh’s estate for, amongst other reasons, reduction of probate tax payable at his death. However, Mr. Singh wants to ensure his inheritance funds are properly managed and move according to his wishes.

The trustees of the Singh Family Trust are Mr. Singh, Mrs. Singh, and Mr. Lee (a family friend).

Mr. Singh is the person entitled to appoint trustees. He can appoint additional trustees and compel a trustee to resign. This is often referred to as a protector clause.

All parties live in Ontario. Mr. Singh has an annual taxable income of $260,000. Mrs. Singh has an annual taxable income of $25,000.

Decision-making for this trust is by majority, meaning Mr. and Mrs. Singh can outvote Mr. Lee. Mr. Lee is not a professional trustee. He acts without compensation, as a favour to Mr. Singh, and generally will follow what Mr. Singh suggests.

The trust deed contains a settlor reversion clause requiring that no distribution can be made that causes income or capital to revert to the settlor, directly or indirectly. Notwithstanding the majority vote provision, any amendment or variation to the trust deed requires the consent of all trustees, however the settlor reversion clause cannot be amended or removed.

All three trustees agree to make a $50,000 income distribution, which is the net income after trust expenses (including taxes), from the trust to Mrs. Singh. Mrs. Singh deposits the funds in the couple’s joint account, and claims the income as her own, at her own tax rates. Mr. Singh buys a new car using funds from the joint account.

Is there attribution in this scenario? Likely.

Mr. Singh is both settlor and a trustee. He is in a situation where he is likely able to exert control over the trust, even though the trust is designed for a majority vote. While Mrs. Singh and Mr. Lee can potentially outvote him, Mr. Singh is also able to force the resignation of any trustee and can determine additional trustees.

Put another way, there is some indication that the settlor controls the trust since he can remove whoever disagrees with him or could stack the deck with additional trustees who will vote his way.

Further, the income derived from the investments is intended to be taxed at Mrs. Singh’s rate, rather than Mr. Singh’s or the trust’s rate of tax. Both Mr. Singh and the trust would essentially be taxed at the highest marginal rate on this income.

It also appears evident that Mr. Singh obtains some benefit since the joint account belongs to both Mr. and Mrs. Singh. Whether that benefit was nominal, 50% or 100% may be the subject of dispute, and there could be cogent arguments for each assertion.

It appears that the distribution is contrary to the terms of the trust deed, as the funds have indirectly returned to the custody and control of Mr. Singh. Whether the joint account is indicative of a pooling of funds, it is potentially indicative of an arrangement between spouses to attribute income to a lower income spouse. (See for example Gosse v. R., 1993 CarswellNat 991, [1993] 2 C.T.C. 2205, 93 D.T.C. 1017 (Tax Court of Canada).)

Consider distributions and transactions carefully

Real-life situations are rarely so apparent and may not contain the number of obvious red flags present in the above illustration. For this reason, it is important to carefully consider potential trust distributions and transactions, as what could seem to be an innocuous chain of events could draw negative attention from the CRA.

This attention may result in an adverse tax consequence, or a costly audit, appeal or even tax litigation to prove that the series of transactions had an outcome that does not trigger the attribution rules.

While the facts of the scenario above could result in a conclusion that attribution rules do not apply, it would be strongly advised for the trust and its trustees to have operated differently to reduce the potential attribution risk while accomplishing Mr. Singh’s desired results.

It is also important to bear in mind that this type of trust has to report annually to CRA in Schedule 15 of its T3 return disclosing the settlor, trustees, beneficiaries and persons who exert influence on the trust. (The definition of settlor for schedule 15 purposes is found in subsection 17(15) and is much broader than the definition of settlor in subsection 108(1), which is typically used for the taxation of trusts.)

To mitigate the risks of triggering the attribution rules and potentially tainting the tax status of a trust, the following tips may prevent an accidental triggering of the complex regime:

Trusts are a highly complex area of law and often trust law and tax law can conflict or generate differing outcomes. Taxpayers considering a trust should always use qualified lawyers and accountants and engage them both when settling a trust as well as throughout the lifetime of the trust.
Be mindful of how funds enter and exit the trust. While most deeds drafted by experienced practitioners are designed to protect the integrity of the trust, the trustee, the settlor and the beneficiaries, situations change over time and seemingly benign actions can create problematic results.
Where loans are used to capitalize trusts, it may be prudent to have such loans be interest bearing at the CRA prescribed rate, with interest payments made annually every single year the trust is in existence, and with demonstrable proof of bona fide interest payments.
Wherever trusts have designated persons, significant care should be exercised in determining how, if at all, income and capital distributions can be made.