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Is Your Family Trust Prepared for the CRA Audit?

12/04/2011


A discretionary family trust can be a practical and useful tool for estate and tax planning, as discussed in Kim Drever’s June 16, 2010 blog post. When properly utilized, it has many potential benefits, including:

  • Cap or limit tax on death
  • Provide additional certainty with respect to the amount of tax that will be paid on death
  • Provide additional certainty with respect to the transfer of wealth and assets to family members
  • Provide flexibility and control with respect to income splitting among beneficiaries
  • Provide additional protection with respect to creditors and matrimonial property (this may depend somewhat on the province in which the beneficiaries reside)
  • Reduce the amount of tax that will be paid on death

In order to reap the benefits of a discretionary family trust, it is critical that steps are taken to ensure that the trust is properly settled and that care is taken to ensure the administrative matters of the trust are dealt with. In recent months, Canada Revenue Agency (“CRA”) has undertaken an audit program of T3 Trust Returns, which highlights the importance of ensuring that these matters are properly dealt with. Failure to do so can have adverse tax implications. Issues the CRA is looking at include:

  • Trustee minutes supporting and authorizing income allocations, as well as evidence that income allocated to beneficiaries has been paid to the beneficiary. This can be a critical area. In order for income allocations to be deductible by the trust, the income must be paid or made payable to the beneficiary. Further, the decision with respect to the income allocations must be made by the year-end of the trust. The failure to have supporting documentation for income allocations to beneficiaries can result in the denial of the deduction of these allocations to the trust, which is taxed at the highest marginal tax rate.
  • Evidence of the original settlement property of the trust. Because a trust is not a legal entity, but a relationship based on three certainties (object, intent and subject) it is important that there is evidence to support that the relationship exists. Whether it is a silver wafer, a gold coin or even a dollar bill, the original property, or evidence of it (i.e. a photocopy of the property that shows a serial number or some other distinguishing feature) should be retained by the trustees. After all, this is the property (i.e. the subject) that the settlor has entrusted to the trustees to manage and secure on behalf of the beneficiaries.
  • Compliance with the 21-year deemed disposition rule. For income tax purposes, a trust is required to recognize all accrued capital gains on the trust property on its 21 year anniversary. The trust is deemed to have disposed of, and immediately reacquired, the trust property on that date. In most cases, a trust will be wound up prior to this date, and all of the trust property will be distributed to its beneficiaries. However, care must be taken to ensure that this anniversary date is not missed, and that proper planning has been done in advance of this date.
  • Trustees using trust property for their own benefit. Whether it is cash or the family cottage, trust property should be used only for the benefit of beneficiaries. In cases where trustees are not beneficiaries, then the value of any taxable benefit that has been provided to a trustee should be included in their income. Alternatively, fair market value rent should be paid to the trust. Lack of proper documentation can also create an issue. Trustees should pay all amounts directly to the beneficiary where possible, rather than reimbursing costs to avoid the perception that allocation decisions are being made after the fact (i.e. retroactive tax planning).
  • Enforceability of promissory notes issued by the trustees. CRA has considered whether application of a provincial Limitations Act could make a promissory note unenforceable such that the income of a trust is not legally payable. There is some doubt as to the validity of this position, however the important take away is that when income is made payable to a beneficiary by way of a promissory note, the beneficiary does have the right to demand payment, in accordance with the terms of the note.
  • Residency of the trust. As discussed in Phillip Yaniw’s December 21, 2010 blog post, two recent Federal Court of Appeal cases (Garron Family Trust and St. Michael Trust Corp.) have modified the factors used to determine the residency of a trust. Where we used to simply look at where a majority of trustees resided, we now must consider where the “mind and management” of the trust is located. In situations where the beneficiaries of a trust reside in one province, or where the trust property is located in a province that is different from where the trustees reside, consideration should be given to ensure that the situs of the trust is reported correctly.

The use of discretionary family trusts often results in significant income tax, estate planning and succession planning benefits. These benefits often carry on for a number of years. I believe it is prudent to ensure that your trust is prepared for any review or scrutiny by CRA to ensure that you can continue to fully realize these benefits.

To have your family trust reviewed to ensure that all accounting, tax and trust documents are properly in order, contact me or your local MNP tax advisor.

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