What is a trust in most of Canada?
Everywhere in Canada except for Quebec, a trust is way for 1 person (called the settlor) to place assets or property in the care of another person (the trustee) to benefit a third person (the beneficiary). It’s a legal relationship that imposes certain restrictions and conditions over the property held and administered by the trustee.
To be valid, a trust must have these 3 basic requirements also known as certainties:
- Certainty of intention – The settlor must intend to create a trust
- Certainty of subject matter – It must be defined what property is part of the trust
- Certainty of object – It must be clear who the beneficiaries of the trust are
About the settlor
The settlor establishes the trust by contributing the initial property to the trust. Once the trust is “settled”, the settlor’s role is complete. The settlor isn’t usually a beneficiary of the trust. In some trusts, a settlor can also be a trustee.
About the trustee
The trustee manages the property held in the trust and distributes assets to beneficiaries according to the terms of the trust, including how, why and when trust assets may be distributed to the beneficiaries.
The trustee can have discretionary powers and these may allow them to make certain decisions, but these have to be allowed by the terms of the trust and the applicable law.
Generally, the role of trustees in relation to beneficiaries requires them to:
- Act with prudence, diligence, honesty and loyalty
- Follow the terms of the trust and applicable law
- Avoid conflicts of interest
- Be accountable to beneficiaries
The settlor may appoint themselves as a sole trustee to administer the trust. However, doing so for some types of trusts may trigger tax attribution rules.
About the beneficiary
The beneficiary is the person(s) entitled to receive the trust’s property as determined by the terms of the trust and the applicable law.
In a family trust, for example, beneficiaries are often members of the same family. A corporation or another trust can also be beneficiaries of a trust.
What is a trust in Quebec?
Trusts in Quebec are different from trusts in the rest of Canada.
Quebec law relies on the concept of patrimony, which is generally understood as a person’s property and assets. To create a trust, the settlor must first transfer their own property to a patrimony separate from their own, called the trust patrimony, for a particular purpose.
The trust patrimony is autonomous and distinct from that of the settlor, the beneficiary and the trustee. That means none of them can claim ownership of the assets under the trust though assets are generally held in the name of the trustee on behalf of the trust.
Under Quebec law, a trust can be established by a:
- Contract
- Will
- Law (such as a pension plan governed by the Supplemental Pension Plans Act)
- Court order if authorized by the law
In Quebec, trustees are only administrators. They don’t have ownership rights over the trust patrimony.
Why establish a trust
There are several reasons why someone might establish a trust:
Reduce income taxes
Subject to certain tax attribution and anti-avoidance rules, once assets are placed in a trust, the assets and the income they generate are no longer part of the settlor’s estate. When income is distributed to the beneficiaries, they must include the income received in their own tax returns. This may help reduce the amount of income tax ultimately paid.
Reduce taxes payable at death
Incorporated business owners may be able to use a trust as part of their corporate structuring to reduce the tax payable upon their death.
Through an “estate freeze”, the value and tax liability associated with appreciating business assets can be locked-in, and their future growth and resulting tax can be transferred to other persons or to a trust.
When structured properly, an estate freeze that includes a trust will allow the increase in the value of the appreciating assets to occur within the trust, which means that tax on capital gains can be deferred, and will not be taxable to the business owner at the time of their death.
Tax on the appreciating assets will need to be paid when there is an actual disposition of the assets held by the trust (e.g., a sale).
In the case of an estate freeze, using a family trust can provide a great deal of flexibility in transferring the business to the next generation.
Also, in provinces other than Quebec, estates are required to pay probate fees (estate administration tax) on the value of the estate property. When property is placed in a trust during the settlor’s lifetime, however it’s no longer subject to probate fees because it’s not part of the deceased’s estate. Depending on the deceased’s province of residence and the value of the property that would otherwise be part of the estate, the savings on probate fees may be substantial.
Estate planning
Trusts can be used as part of an estate plan to pass wealth to other family members. They let you specify who should receive assets and/or income from the trust, and what it should be used for during the settlor’s lifetime or after their death. A trust can prevent children or other beneficiaries from frittering away an inheritance.
Protect assets from creditors
A trust holds property on behalf of the beneficiaries and may protect it from the settlor’s creditors. Generally, trust assets can’t be seized in a lawsuit or personal bankruptcy of the settlor unless the insolvency difficulties began before the trust was created. For certain types of trusts in Canada, assets in the trust may also be protected from creditors of the trust beneficiaries. Keep in mind there are many exceptions which may still allow assets in the trust to be seized.
Protect a child
A trust may be used to give a child a gift without just handing it to them. For instance, you can use a trust to provide for grandchildren or the future maintenance of a child with a disability, poor money management skills, or a substance abuse problem. The trust can include rules on how and when children who are trust beneficiaries receive the money.
Types of trusts in Canada and how they work
A trust can be either a testamentary trust or an inter-vivos trust.
A testamentary trust is one created as a result of the settlor’s death and is usually included in the terms of a will.
An inter-vivos or living trust, is a trust that is created while the settlor is still alive.
The Canada Revenue Agency (CRA) and Revenu Quebec identify numerous types of testamentary and living trusts and how they will be taxed based on their characteristics.
Some of the more common types of trusts
- Alter-ego trust – An inter-vivos trust used for tax efficiency and estate planning that can be created by a settlor aged 65 or older. The settlor is the only one who can receive income or capital from the trust during the settlor’s lifetime. This trust also allows naming a beneficiary who will receive the trust property after the settlor’s death therefore bypassing the individual’s estate.
- Family trust – An inter-vivos or testamentary trust, typically used to split income with family members along with other tax planning strategies (i.e., income splitting, using prescribed rate loans or estate freezes), or used to safeguard the interests of spendthrift or minor beneficiaries related to the settlor. As a result, family trusts are more commonly created as inter-vivos trusts.
- Henson trust – An inter-vivos or testamentary trust used in estate planning for the benefit of disabled individuals. Often, a family member of a disabled beneficiary creates a Henson trust with funds to support that beneficiary in a way that allows the beneficiary to remain eligible for provincial disability benefits. The rules of each province’s social assistance program may affect the availability or effectiveness of a Henson trust.
How trusts are taxed
A trust is not a legal entity. However, for income tax purposes, a trust is treated as an individual “taxpayer”. They must file their own tax return and report income. The income tax rate for trusts is the highest marginal rate except in the case of an estate (which is considered a trust for tax purposes) in the first 3 years (Graduated Rate Estate) or if the beneficiary of the trust is entitled to the disability tax credit.
There are increased tax-reporting and disclosure requirements intended to improve CRA’s ability to collect information on the ownership of trusts and assess the tax liability for trusts and their beneficiaries.
What are attribution rules?
To limit people from using trusts for income splitting purposes, there are circumstances in which tax law will attribute trust income to the person who contributed the property to the trust.
Generally, these attribution rules apply when the beneficiary is either a spouse or child (including grandchild, niece or nephew) under the age of 18 of the settlor or person who contributed the property to the trust. Attribution rules don’t generally apply if the beneficiary is an adult child, or adult grandchild, niece, or nephew of the person who contributed the property to the trust.
Other rules attribute the income from trust assets to a transferor who can effectively control, or reclaim, the assets in the trust.
Attribution rules are complex. You should seek the advice of a qualified tax advisor when you create your trust.
The 21-year deemed disposition rule
Under the Income Tax Act, 21 years after a trust is created, it’s deemed to have sold all the assets in the trust at fair market value, and all the unrealized capital gains are taxed. This can result in a significant taxable event if not planned for properly and the value of the trust’s capital assets have increased.
The 21-year deemed disposition rule is intended to prevent a trust from holding property and deferring capital gain tax for an indefinite period.
Life insurance policies (excluding segregated funds) held in a trust, are not considered capital property of the trust and are not subject to the 21-year rule.
How to create a trust
In general, here are the steps you’d take to create a trust:
- Engage your legal and or tax professionals to help you determine whether you would benefit from an inter-vivos or a testamentary trust. For an inter-vivos trust, create the trust agreement with the help of a legal and tax professional. You’ll need to determine who the settlor, trustee and beneficiary(s) of the trust will be, and any terms you want to include like when and how the funds can be used.
- Determine how you’ll fund the trust going forward by transferring assets such as real property, vehicles, works of art, collectibles and heirlooms, bank accounts, company shares and other investments.
- Open account(s) for the trust property to be transferred into (if applicable), and transfer initial assets to the trust.
- Register the trust if it’s required in your province. Your lawyer and/or accountant can advise you on this. In Quebec, a notary can do this.
There are fees associated with creating a trust, including the fees of legal and tax advisors who you should consult. You should ask about anticipated fees before you begin so there are no surprises.