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Taxation of Trusts – Trusts Series 6/6

Filing a tax return for a trust closely resembles filing one for an individual, as s.104(2) ITA treats trusts and estates as individuals for tax purposes. This allows trusts to deduct expenses related to earning income from their property on the T3 return. Taxable income is then calculated after accounting for any distributions made to beneficiaries. Therefore, if all trust income is distributed to beneficiaries within the tax year, a T3 return is still required, but no tax payment will be owed to the CRA.

In the second blog article of this “Trusts” series, we discussed that when an individual with assets passes away, an estate trust is created, and for CRA tax reporting purposes, the estate is treated separately from the deceased. Specifically:

  • Income earned before death is taxable to the deceased.
  • Income earned after death is taxable to the estate.

An exception under s.164(6) of the ITA permits the estate, during its first taxation year, to transfer capital and terminal losses to offset income in the deceased’s final tax year.

The Income Tax Act (ITA) allows a trust or estate to pass income through to beneficiaries and claim a deduction in two main scenarios:

  1. When the trust or estate actually distributes income to beneficiaries.
  2. When income is “payable” to beneficiaries, even if it hasn’t been paid.

Determining Trust Residence

The residence of a trust is generally based on the residence of the trustee(s) or other legal representative(s) who exercise central management and control over the trust assets. While the ITA lacks explicit provisions for determining a trust’s residence, s.104(1) ITA clarifies that references to a trust or estate should be read as references to the trustee, executor, or legal representative holding control over trust property. Residency is thus a matter of fact, determined by the specific circumstances of each case.

Tax Filing Procedures for Trusts

  • Determination of taxation year end
    • Inter vivos Trust:
      • Follows the calendar year, with a year-end of December 31.
    • Testamentary Trust:
      • Also follows the calendar year, but for the estate’s first 36 months, after a proper election, it might qualify for GRE (graduated rate estate). 
  • T3 (trust taxation) filing and payment deadline:
    • 90 days (not 3 months) after fiscal year end
  • Clearance Certificates
    • Before an estate trustee distributes the estate’s assets fully, they must obtain a Clearance Certificate from the CRA to ensure all taxes are settled. Distributing assets without this certificate leaves the estate trustee personally liable for outstanding taxes, up to the value of the distributed assets.

Trusts as a Taxable Entity

  1. Taxed on trust’s income in the taxation year, EXCEPT:

    • Income paid to beneficiaries

    • Income payable to beneficiaries

      • Under s.104(24), income is considered “payable” if the beneficiary is entitled to enforce payment. The CRA’s archived Interpretation Bulletin IT-286R2 (“Trusts – Amount Payable”) provides further guidance.

    • Preferred Beneficiaries (typically disabled individuals)

      • Certain beneficiaries, such as those eligible for the Disability Tax Credit or dependents, can elect to be taxed on income retained in the trust rather than having the trust itself taxed on it. This election allows eligible beneficiaries to assume tax liability for their portion of income that remains in the trust, potentially optimizing their overall tax outcome due to lower personal tax rates or available credits.

    • Taxable Benefits

      • If a trust pays for expenses related to property used by a beneficiary, such as maintenance or taxes, this is considered a taxable benefit for the beneficiary. Although it’s not direct income, the beneficiary must report this benefit on their tax return.

  2. No Personal Tax Credits:

    • Neither inter vivos trusts nor testamentary trusts are eligible for personal tax credits.

A Qualified Spousal Trust (QST) is a specific type of trust established for the benefit of a surviving spouse, with the primary purpose of deferring capital gains tax on transferred assets until the spouse’s death. For Canadian tax purposes, a QST allows assets to be transferred to the trust without triggering immediate capital gains tax, as long as certain conditions are met. A QST can be created either during the lifetime of the transferor (inter vivos) or through a will (testamentary) upon the transferor’s death.

Tax Benefits and Deferral of Capital Gains

For capital property transferred to a QST, s.70(6) ITA allows tax deferral by treating the transfer at the asset’s adjusted cost base rather than its fair market value. This “rollover” means that no capital gains tax is immediately due, deferring it until the surviving spouse’s death or when the property is otherwise disposed of. This tax deferral is beneficial in most cases, though some situations may purposely call for an immediate realization of capital gains, for example, if the surviving spouse has capital losses that could offset gains in the transfer year.

Eligibility Requirements for QST

To qualify for QST status, the trust and transferor must meet specific criteria, which differ slightly between testamentary and inter vivos QSTs:

  1. Testamentary QST eligibility requirements:
    • Both the transferor and trust must be Canadian residents.
    • The QST must be created through a will or court order.
    • Assets must be transferred at or after the transferor’s death.
    • The surviving spouse must be entitled to all income generated by the trust, this means no other person can access income or capital from the QST during the surviving spouse’s lifetime.
    • The property transferred must become indefeasibly vested onto the trust within 36 months of the transferor’s death.
  2. Inter vivos QST  eligibility requirements:
    • Both the settlor and the trust must be Canadian residents.
    • The settlor’s spouse must be entitled to receive all income from the trust, meaning no other individual can receive income or capital from the trust.

Taxation upon Death of the Surviving Spouse

The deferral of capital gains tax for assets held within a QST ends upon the death of the surviving spouse. At that point, the trust is deemed to have disposed of its assets at fair market value, triggering any capital gains or losses. This means that, ultimately, capital gains tax is payable on the appreciation of the assets held within the QST, but only when the surviving spouse passes away.

A Qualified Disability Trust (QDT) is a special type of testamentary trust designed for disabled beneficiaries who are eligible for the Disability Tax Credit. Created under a will, a QDT only takes effect after the death of the testator and offers significant tax advantages for the disabled beneficiary.

Key Benefits

Unlike most trusts, which are taxed at the highest marginal rate, a QDT benefits from graduated tax rates, permanently. 

Conditions for QDT Status

For a trust to qualify as a QDT, it must meet these specific criteria:

  1. It must be created upon the death of an individual, within Canada as its residence.
  2. A joint election must be made in the trust’s tax return between the trustee and one or more disabled beneficiaries (known as “electing beneficiaries”).
  3. The electing beneficiary must be a named beneficiary in the will.
  4. Each electing beneficiary can only claim QDT status with one trust per tax year.

Loss of QDT Status and Recovery Tax

If a QDT fails to meet the required conditions, it loses its QDT status and may face a recovery tax. This tax essentially recaptures tax benefits from prior years at the highest marginal rate. A QDT may lose its status if:

  • It has no electing beneficiary at year-end,
  • It is no longer a Canadian resident, or
  • It makes capital distributions to non-electing beneficiaries without following the required income deduction procedures.
  • General Transfer Rules:

    • Under s.54 ITA, transferring or gifting property to an inter vivos or testamentary trust is classified as a “disposition” for tax purposes. 

    • Since CRA assumes a trust and its settlor are non-arm’s length, s.69(1)(a) ITA stipulates that a “disposition” between two non-arm’s length parties generally results in capital gains or losses, as the property is deemed disposed of at fair market value (FMV), even though it seems to be a “gift for free” from the settlor. 

    • However, some settlor may consider transferring their property to the trust at a price above FMV, perhaps to use a significant capital loss or to boost the property’s adjusted cost base (ACB) within the trust for future tax savings on resale. Regardless of intent, such attempts are futile, as the CRA will still assess the transfer at the FMV, negating any tax-saving strategy based on an inflated transfer price.

  • Special Rules for Qualified Spousal Trusts (QST):

    • Transfers to Qualified Spousal Trusts (QSTs) may avoid immediate tax implications under s.70(5) and s.73 ITA.
    • For a testamentary or inter vivos QST, the property can be transferred to the trust at its adjusted cost base (ACB) or undepreciated capital cost, effectively allowing for a tax-free rollover.
    • This means that even though the transfer is considered a deemed disposition, no capital gains tax is triggered for the transferor, as the property is transferred at its original cost rather than fair market value.

s.74.1(1) and s.74.2(2) ITA contain the “attribution rules”, which are designed to attribute back to the transferor any income or capital gains generated from property transferred at less than FMV to a spouse to attribute income (but not capital gains) on similar transfers to a non-arm’s length minor. 

ss.74.1(1)-(2) refer to transfer of property between trust and beneficiaries, not settlor and trust, this means:

  • When a trust is created (by a settlor), it might seem like the property or assets are transferred to the trust itself. However, for tax purposes, this transfer is viewed differently. That is, instead of seeing the transfer as just between the settlor and the trust, the law considers that the assets have been transferred through the trust directly to the beneficiaries. This means that the beneficiaries are seen as having received the property from the settlor, even though it technically goes into the trust first.

    • Under s.74.5(9), when someone transfers or lends property to a trust in which they or another person has a beneficial interest (meaning they have a right to benefit from the trust’s income or capital), it’s treated as if they directly transferred or lent the property to that person. 
    • s.74.3(1) provides the calculation of how much income from a trust can be attributed back to the person who created the trust (settlor). This means if a settlor puts assets into a trust, and the trust earns income, that income might be considered the settlor’s for tax purposes, depending on the trust’s structure and your relationship with the beneficiaries.
    • Under s.75(2), the capital gains and income of trust get attributed back to the settlor, this means when someone puts property into a trust that they can get back or decide who will receive it later. This rule indicates that any income or capital gains from that trust are taxed as if they are still the property contributor’s income, not the trust’s. This can be a tax disadvantage for using trusts that the person can control or take back property from. Even if the trust is technically irrevocable and the contributor is not a beneficiary but has control as a trustee, the CRA may still apply this rule.
  • Income Paid or Payable to Beneficiaries

    • Under s.104(13) of ITA, income that is paid or payable to beneficiaries is taxed in their hands. However, in practice, trusts often pay the income tax on behalf of beneficiaries and may deduct an equivalent amount from their taxable income to avoid double taxation.

  • Capital vs. Income Beneficiaries

    • Most trusts distinguish between beneficiaries entitled to distributions from capital and those entitled to distributions from income. This separation affects how distributions are taxed and allocated.

  • Capital Loss Restrictions

    • The ITA does not allow net capital losses to be passed to beneficiaries, meaning that any capital losses within the trust are effectively “wasted” and cannot offset beneficiaries’ individual taxable income.

  • Deemed Disposition Every 21 Years

    • Under s.104 of the ITA, trusts cannot hold assets indefinitely to defer taxes. Every 21 years, trusts are subject to a deemed disposition at fair market value, triggering potential capital gains taxes on unrealized gains. A testamentary QST is an exception; it continues without deemed disposition until the death of the surviving spouse.

  • Personal Trust – Deferring Tax with a 21-Year Rollover

    • Trustees of personal trusts can avoid the 21-year deemed disposition by transferring assets to beneficiaries on a tax-deferred basis (a “rollover”) before reaching the 21-year limit. This allows beneficiaries to defer capital gains taxes until they choose to sell the assets, effectively extending the deferral period.

    • s.248(1) of ITA provides the definition of “personal trust” which means a trust (other than a trust that is, or was at any time after 1999, a unit trust) that is

      1. a graduated rate estate, or

      2. a trust in which no beneficial interest was acquired for consideration payable directly or indirectly to

        1. the trust, or
        2. any person or partnership that has made a contribution to the trust by way of transfer, assignment or other disposition of property
  • Commercial Trusts
    • Trusts that do not qualify as personal trusts are informally referred to as commercial trusts. Due to limited space, additional details on commercial trusts are not covered here.

Important Notice:

This blog series offers readers a basic understanding of the concept of “Trust.” It does not constitute legal advice from our firm. If you encounter any trust-related matters, it is essential to consult your lawyer and accountant. As always, it is best to leave professional matters to the professionals.