The Taxation of Trusts in Canada
Trusts receive special tax treatment under Canadian income tax laws. Corporations are taxed as entities separate from the individuals controlling them, and partnerships are taxed such that income earned by the partnership is taxed in the hands of the partners. However, the taxation of trusts is somewhat of a mixture of both: trusts may be taxed either at the level of the trust itself, separate from the beneficiaries entitled to the property it holds, or at the level of the beneficiaries. The dual nature of trust taxation makes trusts a very useful tool for estate planning and tax planning.
Taxpayers will usually find themselves dealing with a trust when the management and control of property in which they have an interest is vested in one person or persons (the “trustee” or “trustees”) and the enjoyment of the property is vested in another person or persons (the “beneficiary” or “beneficiaries”).
Types of Trusts in Canada
There are two kinds of trusts: those created by a living person (a “settlor”), which is called an inter vivos (i.e. “between the living”) trust, and those created in consequence of death, which is called a testamentary trust. The most common example of a testamentary trust is a trust created by a will. In estate law, the person who drafted the will is called the “testator”. In the case of a testamentary trust, the testator’s will creates a trust in consequence of the death of the testator.
The Income Tax Act makes no distinction between “trust” and “estate”, and instead refers to both these terms as a “trust”. This means that, for the purposes of income taxation, a “trustee” can refer to either a trustee dealing with the estate (i.e. all the assets and liabilities) of a deceased person (an “estate trustee”) or a trustee dealing with the property of living persons (a “non-estate trustee”).
Other terms of note — “personal representative”, “executor”, and “administrator” – refer to the person(s) to whom the deceased’s estate passes on death. Under the Income Tax Act, the personal representative is referred to as the “legal representative”. “Personal representative”, “executor”, “administrator”, and “estate trustee” are, for the purposes of taxation, interchangeable terms because the trust under which the property in question is being administered will be taxed in the same way regardless of whether the settlor or testator is alive or deceased.
Trusts and their Tax Rules
Sections 104-108 of the Income Tax Act provide the rules of taxation of the income of trusts and beneficiaries. Trusts are, like corporations, individuals for tax purposes, which means that they are taxed like individual taxpayers. Any property transferred to or from a trust is therefore considered a disposition of that property attracting tax on any taxable capital gains arising from that disposition. Avoiding capital gains tax can be a key driver in the way in which trusts are set up.
Capital gains tax on the disposition of property transferred to a trust is commonly incurred in the testamentary situation. Under the Income Tax Act, all capital property of a deceased taxpayer is deemed to have been disposed of, immediately before death, for proceeds of disposition equal to the fair market value of the property. The deceased is then liable to pay, on a “terminal return” for the tax period up to the date of death, tax on any taxable capital gains arising from the disposition of that property. Conversely, the deceased’s estate is deemed to acquire the property of the deceased at a cost equal to the fair market value of the property.
Poor estate planning can sometimes leave trusts or their beneficiaries needlessly liable to pay capital gains tax. However, testamentary and inter vivos trusts can use rollovers to avoid the deemed disposition of capital property as described above, and to thus avoid capital gains tax. “Rollovers” deem property transferred to or from a trust to have been disposed of for proceeds equal to the adjusted cost base (i.e. the original acquisition cost) of the property rather than its fair market value. This prevents the transfer of the property from incurring any capital gain or loss at the time of transfer. Any tax liability is instead deferred until the beneficiaries die (triggering the deemed disposition immediately before death as described above) or until the trust disposes of the property.
There are numerous estate planning techniques that rely on the unique tax treatment of trusts. If you have questions regarding your estate planning, trusts, or the taxation of trusts, call us today! We are here to help.
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.