The reversionary trust tax nightmare

Avoiding capital gains tax on 21st anniversary of a trust

For discretionary family trusts, 21 years is an important anniversary. As I showed in my previous article, that’s because they only have a tax life span of 21 years. Last time I warned of tax traps involving distributions, and suggested considering winding up a trust and distributing the trust capital to the beneficiaries before the 21st anniversary. One of the more dangerous tax traps is the application of the attribution rule commonly referred to as the “reversionary trust rule."

How to avoid the reversionary trust trap

In a nutshell, if the reversionary trust rule is ever applied to a trust (even for one moment in time), then you lose the ability to distribute capital out of the trust on a tax-deferred basis, even if to a Canadian resident beneficiary. So in order to avoid this trap, it is important to understand when the reversionary trust rules will apply.

The following scenarios should be kept in mind so that you don’t trip over this rule, and essentially fall into a tax nightmare.

* You contribute property to the trust and you are a beneficiary of the trust. This includes if you are a contingent beneficiary, e.g., you are not a primary beneficiary but could benefit under the trust once the primary beneficiaries pass away. (However, there is a distinction where the trust property reverts to you by operation of law because of a failure of the trust, e.g., if the trust fails because there are no beneficiaries left to whom the property can be distributed).

* The trust trips over a subsection 75(2) “technicality.” One example is if the trust contains a default distribution mechanism (e.g., if the trustees fail to exercise their discretion to distribute), which is dependent upon the provisions of the contributor’s will – i.e., because the property may pass to a person ultimately determined by the contributor through his or her will.

* A beneficiary pays expenses on behalf of the trust or contributes cash to allow it to do so. One possible example is where a trust must pay its professional fees (e.g., paying an accounting firm for preparing and filing the trust’s tax returns). Suppose that the beneficiary writes out a cheque directly to the accounting firm to defray these expenses. Even though the funds are not first paid to the trust, and are paid directly to the accountant, arguably, at least, the beneficiary has effectively “contributed” to the trust.

* The contributor has a “veto” over the distribution of the trust property (or the power to determine who the property can pass to). For example, the contributor is a trustee and the trust stipulates that he or she must be part of any majority decisions by the trustees. Another instance in which a contributor may fall into these circumstances is if the other trustees resign or pass away, leaving the contributor as the sole trustee or one of two trustees.

With respect to the last point, where the contributor is one of two trustees, the CRA has indicated some leniency in applying this attribution rule where the contributor is one of two trustees. So long as the acts of the contributor as trustee stem from the exercise of his or her duty as a trustee (and not under a greater power), then the CRA has stated that it won’t apply the attribution rule. But the moment you give the contributor extra powers (i.e., veto power on distribution decisions), then you will run afoul of the rule.

As a result of some case law, however, it is possible for a beneficiary to sell property to the trust, as long as it is for fair market value. A beneficiary can also lend money to a trust (even if such a loan is not at commercial terms, i.e., interest-free) without offending this rule. However, it would be prudent to document the loan as such, just in case the CRA comes knocking on your door.

Samantha Prasad, LL.B., is a Partner with Toronto law firm Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate, estate, and international tax planning. She writes frequently on tax issues, and is the co-author of Tax and Family Business Succession Planning, 3^rd Edition. She is also co-editor of various Wolters Kluwer Ltd. tax publications. This article first appeared in The TaxLetter, © 2021 by MPL Communications Ltd. Used with permission.

Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.