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The Canada Revenue Agency (“CRA”) has undertaken a special project of reviewing domestic inter vivos trusts. An inter vivos trust is simply a trust that a person settles during his or her lifetime. A trust can be a valuable tool for a family to use to minimize its overall tax burden by shifting income from a family member in the highest tax bracket to one or more members in a lower tax bracket as part of an estate plan or for income splitting purposes. CRA is aware of these uses and seems to be focusing its audit efforts on the income splitting objectives.
A trust reports all income earned on its assets and one of the deductions it is entitled to claim against this income, is a deduction for any amounts allocated to a beneficiary. CRA will likely review compliance with the rules that allow these trusts to deduct income allocated to beneficiaries. If a trust’s deduction of allocations is challenged, the benefits of income splitting will be negated as the trust will then be left with income that is taxed at the highest marginal rate.
In order to be deductible by the trust, allocations to a beneficiary must be paid or payable by December 31st of each year. Allocations not paid in cash should be evidenced by promissory notes dated no later than year end. If the obligation is not legally enforceable, CRA may challenge the trust’s deduction of the allocations.
In addition, in order to be deductible by the trust, funds allocated to a beneficiary must either be paid directly to the beneficiary for his or her own use or enjoyment or used to pay for things that benefit the beneficiary. If the trust makes a payment to a third party on behalf of the beneficiary, and wants to make sure the payment is deductible, care must be taken to keep proper documentation to support the deduction. This may include obtaining the concurrence of the beneficiary before making the payment. It is important that any decisions made by the trustee are evidenced by a resolution in writing and the beneficiary’s intentions are similarly documented. Records should be kept of any payments made by the trustee to a third party. Without this support, CRA may challenge the trust’s deduction of the allocations.
Once an allocation has been made and the beneficiary is entitled to the funds, it is important that proper documentation is kept to show that the funds were paid to the beneficiary. In some situations, parents are the trustees with their children as the beneficiaries, it is imperative that if the trust makes a payment, it goes to the children and not to the parents. If the adult children wish to gift funds to the parents, they can write a cheque to the parents after receiving the funds from the trust. The parents have no right to the funds in the trust that have been allocated to the children. If CRA determines that trust funds have been used for the trustees’ own use instead of for the benefit of the beneficiary, it may assess a taxable benefit to the trustees.
As part of the audit project by CRA, it may want to examine: the trust deed, the original settlement property, documentation supporting trustee meetings, and supporting documentation for any trustee decisions.
As it is the time of year for filing trust tax returns, now is an appropriate time to ensure that the trust has the supporting documentation on file. Compliance and administration of these trusts is very important so that no problems will arise with CRA and the trusts continue to remain effective tools for tax planning.
If you have any questions or need assistance concerning inter vivos trusts, please contact your local MNP Tax specialist.
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