One of the problems that has continued to be perpetrated under Canadian Income Tax law is that family income is, in many cases, all taxed in the hands of one individual. It is not the purpose of this chapter to argue this aspect of Canadian tax law from a philosophic point of view, but it will be immediately obvious that a considerable tax saving can be achieved if income is "sprinkled" among more than one family member! Consider the following example (1996 tax rates are used throughout this chapter):
| Total Family Income | $50,000 |
| Tax (Federal and Provincial assuming a 50% provincial rate) if income | |
| reported by husband who supports his wife | $12,736 |
| Tax on same basis if $25,000 each earned by husband and wife | $ 9,646 |
The difference in tax to two families in the same basic gross income position is over $3,000. The message seems to be to arrange your income so it is divided between family members - you'll pay less tax. Unfortunately, this tax planning device is seldom available where income from employment is concerned, but it does make a good case for joint tax returns!
It is clear that it is not often possible to split earned income between family members unless such members are employed in a family business of one kind or another. However, earned income aside for the present, the next best thing might be to divide investment income between various members of a family. It is not difficult to understand that if father is in a 45% tax bracket he will save tax if he can transfer part or all of his investment income to his wife and children who would pay tax at much lower rates in most cases.
So generally speaking, the ability to spread income between family members will result in significant income tax savings. It follows that income splitting arrangements are one of the most popular pastimes of tax planners, and it is the intent of this exercise to examine the process of income splitting from the practical, results oriented view point, together with examples of necessary documentation.
Before we discuss the necessity for planning to split investment income, the logical question might be - what planning? It would seem only right that if a person were to gift money or assets to another person, that other person should be taxable on subsequent earnings generated by the asset transferred since the new owner has legal title. Unfortunately the Income Tax Act provides otherwise in a number of specific instances, and so an outright gift of money or an investment might not achieve an income split. We'll go into this in detail later, but for the moment let's consider gifts without worrying about the tax considerations.
When one person wants to confer a benefit on another for whatever reason, a gift results at the time the transfer occurs. Most gifts naturally occur between close family members, and they usually entail the transfer of property from father to mother, mother to father, father or mother to child, grandparent to grandchild, etc. The reasons for making a gift are almost endless, but some of the more common include:
There is no limitation on the amount that one person can gift to another. However, there are other factors to be considered when one contemplates making a substantial gift. Some of these are as follows:
In short, a would be donor may have any number of misgivings about the consequences of arranging a gift if it involves losing all control over the subject of the gift. Incidentally, in case I have not mentioned it before, the donor is the person making a gift and the donee is the person who receives it. We will also refer to transferor - a person who sells or gifts property - and transferee - the person who acquires the property.
In order to make a valid gift, the transfer of money or property must be absolute and indefeasible. What it means is that after the gift is made, the donee must be able to deal with the property as would any owner, and the donor must not be able to recover the property given.
So, if a donor simply passes title to cash or property to a donee, all control over the property is lost to the donor and the donee can generally do what he likes with the property. This is a cause of the misgivings previously mentioned. It also is one of the reasons persons contemplating making gifts often seek professional advice, and indeed there are ways to arrange gifts so that the donor gives up ownership of the property but retains some control over access to the property by the intended donee.
There are no direct taxes on gifts in any province since Quebec abolished gift taxes and succession duties in 1985. There are however, some tax concerns when a gift of property is contemplated:
In summary then, when a gift is contemplated, there are two major tax considerations:
Capital Gains On Taxable Capital Properties
First of all - gifts of property to a spouse. This is the exception to the rule. Property transferred to a spouse is transferred at its cost to the transferor spouse, and generally speaking, any capital gain or loss is deferred until the property is disposed of by the donee spouse. In some cases, it may be advantageous to recognize a capital gain in the hands of the donor spouse. For instance, the donor might have substantial capital losses and would like to arrange a capital gain to absorb part or all of the losses not otherwise deductible in the year. A gift of property in a gain position to a spouse would not normally trigger a capital gain, but the donor can elect under Section 73 of the Income Tax Act to recognize a capital gain on a property gifted to a spouse, and thus could create a gain to absorb unapplied capital losses.
However, it is usually the case that the donor wants to avoid capital gains tax where property is being gifted. There is no problem where the donee is a spouse, but what to do in the case of a gift of property to a child? If the property is in a gain position at the time of transfer, a direct gift to a child will trigger a disposition subject to a deemed capital gain - regardless of the age of the child. Where the subject of a gift consists of farm land or shares of a family farm corporation, there are special provisions in the Income Tax Act that permit non-taxable rollovers of such property to children.
Accordingly, there are two basic situations involving capital gains on the transfer of taxable capital property by way of gift:
Subject to the exceptions to the rule involving farms, there really is no way to avoid the recognition of a capital gain on the transfer of other capital property to a child. This fact may discourage a potential donor from transferring say, shares of any of Investors equity funds to a child, and yet, if the gift is not made in accordance with the wishes of the taxpayer, his capital gains position is only deferred until death when presumably the child will inherit the property in any event - and death triggers a "deemed" disposition. If the donor does nothing, i.e., he simply retains the shares until death, any growth in the value of the shares will increase the capital gain and possible tax to the donor or his estate. There is a way to ensure that the donor does not increase his liability for capital gains tax. The procedure would involve the transfer of his investments in taxable capital properties to a personal or family investment corporation. The properties in the portfolio could be rolled into the corporation at their cost base to the taxpayer under Section 85 of the Income Tax Act and the taxpayer could take back preferred shares, debt, or a combination of both as consideration for the assets transferred. The intended donee (child or children) would acquire the common shares of the company at a nominal value, and would thus be entitled to all of the growth which the portfolio might accrue from the date of rollover to the date of death. This procedure is commonly known as an "estate freeze," and is very useful where there is considerable growth potential in a portfolio of investments and where the owner wishes to benefit heirs during his lifetime with the added feature of reducing the potential tax on capital gains on both a direct gift and at death. Note that until the child reaches age 18, the taxpayer will be subject to a deemed interest benefit under section 74.4 of the Income Tax Act (commonly referred to as the corporate attribution rules).
We have observed that if a taxpayer makes a direct gift of property to a spouse or minor child, the taxpayer remains taxable on the income from the original property which was gifted. However it is important to note that the income earned on the reinvestment of the income, i.e. the compound interest, is taxable in the hands of the donee. The donor is only taxable on the income earned each year on the original gift. For example, assume an interest rate of 10%. Father gives mother $10,000 and mother invests the proceeds of the gift in a term deposit that pays 10%. The income is $1,000, and father must include it in his income. Mother simply reinvests the $11,000 and next year the income is $1,100. Father should still declare $1,000, and the additional $100 is taxable in mother's hands. Where income is reinvested, it is easy to see that the delineation between father's and mother's interest for tax purposes could easily be lost sight of. A good approach to keep track of income reinvestment on direct gifts is for the donee, mother, to invest the gift in a vehicle such as Investors One + One Program such that the earnings are reinvested in a separate account or fund quarterly (or monthly if elected on income GIC) so that the amount attributable to father is always easy to identify because it always comes from only one source. The point here is that even a direct gift will result in a growing income split just through mother's subsequent earnings on reinvested income.
Remember that father is taxable on income on the original gift because of the attribution rules in the Income Tax Act. You have likely guessed or were already aware that these rules of attributing income to a person other than the registered owner of the investment have a purpose which is to prevent the sprinkling of income among family members, thus preventing a reduction in the rate of tax that would otherwise apply.
Direct gifts have the advantage of being simple to arrange and they provide immediate and irrevocable benefit to the donee - without any extra administration. But they also have limited appeal because of the disadvantages discussed earlier:
In spite of the disadvantages, it is not unusual for parents and grandparents to want to provide for the needs of children and grandchildren - but in a great many cases, the donor wants to retain control over capital.
It should be noted that a gift can consist of cash or property. For the balance of this discussion, we will concentrate on cash transfers since the capital gains implications on property transfers have been discussed earlier. Further, it may be impractical to consider gifts of such properties as existing bonds, GICs, or IDCs because of assignment restrictions or due to the fact that on the gift of a right to income, the donor becomes taxable on the income accumulated to the date of the gift. Note that, as discussed in Chapter 5, it is possible to assign an IDC to a spouse at its cost base thereby avoiding immediate taxation on accumulated income.
We have seen that a direct gift has the advantage of simplicity without further administration. Where a minor is involved, and any of our lump sum products is the subject of the gift, the minor's name may be inserted as the owner on the application form. Remember to have the parent or guardian initial the acknowledgment area on the application form.
In the case of an owner that is a minor, there will likely be restrictions or prohibitions on any transactions on the account. See Appendix 3 for further details in this area.
An installment certificate cannot be purchased in the name of a minor even by direct gift because the minor cannot bind himself to a contractual obligation.
Where the donee is not a minor, then it follows that the donee's name will appear as the owner and the donee should sign the application as well. If the donor signed the application, the donee might have some difficulty in future in dealing with the account in that a guarantee of signature and identity could be required.
So there are disadvantages in direct gifts as well as advantages and in many cases these disadvantages outweigh the advantage. Let's consider how the disadvantage might be overcome.
This area is really the nitty gritty of this chapter. Over the years, tax planners have tried to develop methods of meeting the desire of an individual to transfer assets to intended beneficiaries during the lifetime of the benefactor and at the same time avoid attribution and loss of total control. The process of spreading income between family members is commonly referred to as "income splitting" and in order to achieve an income split on the transfer of property to a spouse or minor child, the transfer cannot be characterized as a gift. So the key to the process is to transfer property to an intended beneficiary so that it is like a transfer, but technically is not a transfer.
Prior to the implementation of the May 23, 1985 Federal budget (Bill C-84), it was possible to effect an income split by making a loan to the intended beneficiary as for purposes of the attribution rules, a loan was not considered to be a transfer of property. Bill C-84 introduced new Section 74.1 to the Income Tax Act and this section states that loans are considered transfers for purposes of the attribution rules. Sec. 74.1 does not apply with respect to any loan to a spouse or minor (or a trust for the benefit of a minor) which was outstanding on May 22, 1985 if such loan was repaid before January 1, 1988. If these loans were not repaid prior to 1/1/1988, the attribution rules apply only to simple income earned after the end of 1987 on the original loan amount. Compounding income (i.e. income on income) continues to be unaffected by the attribution rules. To illustrate how pre - 5/23/85 loans are affected, assume that Mrs. A loaned her husband $20,000 via promissory note in 1980. Mr. A invested the loan amount at 10% and the value of the investment grew to about $43,000 at the end of 1987. If Mr. A did not repay the loan at the end of 1987, simple income of $2,000 (10% of $20,000 original loan amount) will be attributed to Mrs. A for tax purposes in 1988 and each subsequent year. All other income earned on the investment will be taxed to Mr. A.
In essence, what Sec. 74.1 has done is to ensure that post-May 22, 1985 loans to a spouse or minor are taxed in the same manner as a gift. The section contemplates many potential schemes designed to avoid the attribution rules. For example, the attribution rules do not apply to arm's length, commercial basis loans, but Sec. 74.5(7) provides rules to ensure that attribution cannot be avoided where an individual undertakes to guarantee the repayment of a loan made by any person to another person who is a specified person in respect of the individual. Where such an undertaking is given, the individual is deemed to have made the loan to the specified person and, subject to the exemption for commercial loans, any income from the property loaned or from property substituted therefore is attributed to the individual. A specified person in respect of an individual means a person who is or who has since become the individual's spouse, a person who is under 18 years of age or a corporation, other than a small business corporation in which such a person has a direct or indirect interest.
What this means is that if you try to avoid attribution by having your spouse, for example, borrow funds from a bank for investment purposes, the income earned on the borrowed funds will be attributed to you if you repay the bank loan or even guarantee the repayment of the loan. Sec. 74.5(11) provides rules to ensure that a taxpayer cannot engage in a transaction or a series of transactions the principal purpose of which is to have the attribution rules apply to artificially attribute income of a taxpayer to another person who would pay less tax on that income than the taxpayer would.
For example, Mr. X may buy a $10,000 bond with his own funds. If this were done, Mr. X would be taxed on the interest earned. If the bond were transferred to Mrs. X, the interest would still be taxed to Mr. X by Sec. 74.1. Mr. X may consider attempting to artificially have the interest taxed in his wife's hands. For example, Mrs. X borrows $10,000 from the bank in order to make an interest free $10,000 loan to Mr. X to buy the bond. Mr. X then uses his own cash to repay the loan from his wife who in turn repays the bank. Without Sec. 74.5(11), the attribution rules would apply to attribute the interest earned by Mr. X on the bond to his wife. This subsection ensures that the "artificial" attribution will not occur.
Prior to the implementation of Sec. 74.1 it was possible for a taxpayer to split investment income with a spouse or person under 18 by transferring investment capital to a corporation in exchange for preferred shares and/or debt of the corporation. Investment income earned by the corporation would then be flowed to the spouse and/or persons under age 18 via dividends from the corporation. Sec. 74.4 of the Act now applies the attribution rules on loans or transfers of property to a corporation unless that corporation is a small business corporation. A small business corporation is defined as a Canadian-controlled private corporation, all or substantially all of the assets of which are assets used in an active business carried on in Canada.
It is therefore still possible to income split by transferring assets to a small business corporation of which the shareholders may be a spouse and/or persons under age 18 (whose shares would be held by a trust). Section 85 of the Act contains the rules whereby personal assets, including a proprietorship interest in a business, may be transferred to a Canadian corporation. Common shares of the corporation may now be issued to a spouse and/or minor and business income flowed to these individuals via dividends. This technique is commonly referred to as "dividend sprinkling". The technique is discussed in detail in Chapter 7 of the Library.
Where an existing corporation has a capital structure not conducive to its changing equity ownership objectives; for instance, it is desired to freeze the interest of the principal shareholder and transfer growth and perhaps control to children, a corporate reorganization may be the answer under the provisions of Section 86 of the Income Tax Act. Again, you may refer o Chapter 7 of the Library for further details on the use of Section 86.
To this point we have seen that income splitting is possible through family ownership of a small business corporation, but Sec. 74.1 has made interest free loans a less attractive method of splitting income with a spouse or minor. That is not to say that the new attribution rules have killed income splitting, however. There are still several ways of achieving an income split, such as the following:
We've already seen that a transfer of property to a spouse via a gift or loan will cause the attribution rules to apply to simple income (and capital gains/losses) earned on the property transferred. Let's take a step back in order to determine why someone would want to split income with a spouse. The following chart illustrates the benefits of having investment income taxed in the hands of a spouse who has no other income.
Assumptions:
| Investment income transferred | $539 | $1,500 | $5,500 | $10,000 |
| Tax saved by taxpayer spouse @ 45% | 243 | 675 | 2,475 | 4,500 |
| Reduction in married credit (fed./prov.) | --- | ( 250) | ( 1,290) | ( 1,400) |
| Tax payable by transferee spouse | --- | --- | --- | ( 921) |
| Net tax savings from income split | $243 | $ 425 | $1,185 | $ 2,179 |
It is easy to see how savings result on the transfer of only $539 of income. The taxpayer reduces his income by $539 and the increase in his spouse's income doesn't affect his married credit. The $915 married credit is reduced by 17% of the spouse's income in excess of $539, but as the chart shows, the tax savings from the income split increase as the amount of income transferred increases. Note also that even when the transferee spouse is taxed on investment income transferred (see column showing transfer of $10,000), the income split is still effective since the transferee spouse pays tax at a lower rate than the transferor spouse.
It should be evident that there is still a benefit to split investment income between spouses, but the question arises as to how we can achieve the split. Given that the attribution rules apply equally to loans or gifts between spouses, why bother with a loan? Well, some clients may still wish to take back a promissory note simply as a method of retaining control over capital in the event of disagreement over assets or in the case of marriage breakdown. You should ask the client if he will be wanting to use a promissory note, a copy of which is presented on page 14.
To achieve the desired split, we would recommend that the taxpayer spouse loan capital to his spouse for investment in his/her own name. Simple income earned on the investment will be attributed to the transferor but compounding income (i.e. income on income) will be taxed in the hands of the transferee spouse. The following chart illustrates the benefits of the income split even when simple income is attributed to the transferor spouse:
| Loan amount | $25,000 | |||||
| Annual rate of return on investment | 10.5% | |||||
| Year | 1 | 2 | 3 | 4 | 5 | |
| Attributed income | $2,625 | $2,625 | $2,625 | $2,625 | $2,625 | |
| Non-attributed income | --- | 276 | 580 | 917 | 1,288 | |
| Year | 6 | 7 | 8 | 9 | 10 |
| Attributed income | $2,625 | $2,625 | $2,625 | $2,625 | $2,625 |
| Non-attributed income | 1,700 | 2,153 | 2,656 | 3,210 | 3,822 |
| Total attributed income | $26,250 | |
| Total non-attributed income | $16,602 |
Over the 10 year period shown above, $16,602 of income that would have been taxed in the hands of the transferor spouse has been taxed in the hands of the transferee spouse. Assuming that the transferor spouse was taxed at a 45% combined federal/provincial tax rate, the tax savings over a 10 year period are about $4,260 from having made the loan. This tax saving is based on the assumption that the transferor's married credit was reduced by 17% of each dollar of non-attributed income in excess of $539 and that the transferee spouse had no other income. While the $4,260 taxes saved over a 10 year period doesn't seem like a lot, consider that the investment has grown in value to $67,852. If the transferor were to call his loan of $25,000 at the end of year 10, the transferee would be left with $42,852 of capital. All income earned on this amount in the future is not subject to attribution (the loan has been repaid) and is taxed in the hands of the transferee spouse.
In the chart above, an assumption has been made that the 10.5% income was compounded annually and the rate of return did not change even the 10 year period illustrated. This assumption greatly simplified the process of determining the amount of income attributed to the transferor each year versus the amount of income to be taxed in the hands of the transferee spouse. In most cases, however, the determination of simple versus compounding income is not so easy. For example, consider Mortgage, Corporate Bond, Government Bond or Global Bond Fund, where income is compounded on a monthly basis. A dollar averaging (D/A) program would make the calculations even more complex.
To solve the problem, you could use the One + One program. The transferor will loan (or gift if a loan is considered unnecessary) capital to the transferee for investment in, for example, Corporate Bond, Government Bond, Global Bond, Mortgage, Dividend Fund, Merrill Lynch World Bond, Rothschild Income Plus, Income Portfolio or Income Plus Portfolio. The quarterly income from the investment will automatically be transferred to a second account, also set up in the name of the transferee spouse. What the One + One does is to automatically separate simple from compounded income whether a D/A is added or not. The transferor reports for tax all income earned on the first account (even though the T-slip is issued in the name of the transferee spouse) as required by the attribution rules. If the first account is Dividend Fund, the transferor is also able to claim the dividend tax credit. The reason this example uses Government Bond, Corporate Bond, Global Bond, Mortgage, Dividend Fund, Merrill Lynch World Bond, Rothschild Income Plus or Income Plus Portfolios as investment vehicles is that they are not growth oriented equities. In an equity based investment the return is primarily capital gains. While the recognition of capital gains is often deferred, the capital gain will in the end be attributed back to the transferor.
Here is a chart which illustrates just how the One + One income splitting program works:
| Step.1: | transferor gifts or loans capital to transferee | |
| Step 2: | transferee invests the capital in a non-equity based fund , such as Corporate Bond, Government Bond, Global Bond, Mortgage, Dividend Fund, Income Portfolio, Income Plus Portfolio, Income GIC (Account #1) | |
| Step 3: | quarterly income (including capital gains dividends, if any) from Account #1 automatically transferred to Bond, Global Bond and/or Mortgage Fund Account or Income or Income Plus Portfolios (Account #2) in the name of the transferee |
Note that if Account #1 is invested in Dividend Fund, capital gains dividends will also be automatically transferred to Account #2, but will be attributed to the transferor for tax purposes. Capital gains realized on a disposition of shares in Account #1 will also be attributed to the transferor for tax purposes.
For further details on the One + One income splitting program refer to Sales Information Bulletin #3369 (October 8, 1995). A copy of the bulletin is included at the end of the chapter as Appendix #2. The bulletin shows projected results of the program at various levels of investment using Dividend Fund as the underlying investment vehicle for Account #1. All projections attached to the bulletin have been updated to include current tax rates. Using Corporate Bond, Government Bond, Global Bond, Mortgage Fund, Income Portfolio, Merrill Lynch World Bond, Rothschild Income Plus or an income GIC in Account #1 rather than Dividend or Income Plus Portfolio has the advantage of generating greater cash flow on a quarterly basis which, in turn, places more capital in the hands of the transferee spouse. The disadvantage of using Corporate Bond/Government Bond/Mortgage/Global Bond/Income Portfolio, Merrill Lynch World Bond, Rothschild Income Plus or GIC versus Dividend or Income Plus Portfolio is that quarterly income is higher, meaning that larger amounts are attributed to the transferor who will be taxed on the attributed interest.
Note that it is certainly possible for Account #2 to be an equity investment. Remember that Account #2 is the legal property of the transferee spouse and any income or capital gain earned on this account is taxed in the hands of the transferee.
In summary, the circumstances where income splitting is a benefit between spouses are when taxes on investment income are reduced through the utilization of the transferee spouse's lower marginal rate of tax. The income split is accomplished by having the transferor spouse loan or gift investment capital to the transferee spouse. Simple income is taxed to the transferor spouse but becomes the legal property of the transferee spouse. Income earned on this income (compound income) is then taxed to the transferee spouse. A fairly simple concept, but one which may save your clients thousands of dollars in future taxes.
First, let's review the attribution rules with regard to transfers of capital to a minor. Section 74.1 of the Income Tax Act provides that simple income earned on a transfer of property to a minor is attributed to the transferor until the year in which the minor reaches age 18. The attribution rules cease to apply in the year of the death of the transferor or when the transferor ceases to reside in Canada. The attribution rules relating to transfers of property to a minor are different from the rules relating to transfers between spouses in that future capital gains/losses realized on property transferred are not subject to attribution even if the gain/loss is realized by the transferee while he/she is still under the age of 18. When a capital property is transferred to a minor, the transfer is deemed to take place at fair market value as opposed to adjusted cost base where the transferee is the spouse of the transferor. Thus, the transferor must realize any accrued capital gain in the year the property is transferred to the minor.
The following chart illustrates the benefit of splitting investment income with a minor who has no other income:
Assumptions:
| Investment income transferred | $2,500 | $6,000 | $10,000 |
| Tax savings to transferor @ 45% | 1,125 | 2,700 | 4,500 |
| Tax payable to minor | --- | --- | (921) |
| Net annual tax savings | $1,125 | $2,700 | $ 3,579 |
As shown in the chart, substantial annual tax savings may be achieved by having investment income taxed in the hands of a minor even when the amount transferred is large enough to cause the minor to be taxable in his/her own regard.
We noted earlier in the chapter that an income split with a minor is normally achieved using a family trust. The trust is used where the transferor wishes to retain control over capital. You'll recall from the last section on income splitting with a spouse that control over capital could be achieved by a loan, evidenced by a promissory note signed by the transferee spouse. Unfortunately, the use of the promissory note when loaning capital to a minor will not achieve the desired objective of retaining control over capital loaned. This is because a promissory note is a contract between lender and borrower and a contract entered into by a minor is not enforceable if the minor should subsequently refute it. This problem is solved by the creation of a family trust. The transferor loans the desired amount of capital to the trustee of the trust who invests the capital on behalf of the minor beneficiary of the trust. Just as with a loan of capital to a spouse, a loan to a minor (either directly or via a trust) will trigger attribution of simple income earned on the original loan amount. Compounding income will be taxed in the hands of the minor as will any realized capital gains and capital gains dividends realized on the investment of the loaned capital. Again, the One + One program could be utilized to simplify the problem of separating simple from compounding income.
Let's look at how a trust could be established:
Finally, if the purpose of the trust is to income split in order to reduce taxes, remember that intervivos trusts are taxed at the highest individual marginal rate of tax and are not permitted to claim personal tax credits. Therefore, the goal is to have the income of the trust taxed in the hands of the beneficiary. Unless the preferred beneficiary election is available (discussed later), a trust will only be entitled to claim a deduction in regard to amounts payable to a beneficiary in the year. If income and realized capital gains earned within a trust are not payable to a beneficiary in the year (or deemed payable to a beneficiary by a provision of the Income Tax Act which we will discuss), such amounts will be taxed within the trust at the highest individual marginal rate. It should be remembered that realized capital gains include capital gains distributions from mutual fund trusts.
When will an amount be considered payable?
An amount (income or capital gain) will be considered payable to a beneficiary in a taxation year if it was paid in the year to the beneficiary or the beneficiary was entitled in the year to enforce payment of the amount. Direct payments to third parties for the benefit of a beneficiary will usually be considered to be "paid" to the beneficiary.
A trust can be drafted in terms that make the income and/or the capital gains of the trust payable in the year to the beneficiaries. If, however, the terms of the trust leave the payment of income or capital to the discretion of the trustee (such a trust is commonly referred to as a "discretionary" trust), the trustee must take a positive and irrevocable step to segregate the income or capital, as the case may be, from the trust in order for the amount to be considered payable to the beneficiary. Such a step could include issuing a cheque to the beneficiary, executing a promissory note payable to the beneficiary on demand or paying an amount to a third party for the benefit of the beneficiary.
When a minor is the beneficiary, only payments made to third parties for goods and services in excess of the necessities of life will be considered payments made for the "benefit" of the minor. Payments made for things that a parent has a legal responsibility to provide a child will not be deductible. Direct payments to third parties for private school tuition, music lessons and hockey camp are just a few examples of the types of payments that could be made for the benefit of a minor beneficiary and would be deductible to a trust. If a client is concerned over whether a particular type of expense will be deductible if paid by a trust, the matter should be raised with their solicitor, preferably during their initial discussions regarding the creation of a family trust.
Special Rules for Non-Discretionary Trusts with Minor Beneficiaries
Where the terms of a trust specify the beneficiary's entitlement to income and capital (in other words the terms are "non-discretionary" with respect to the payment of income and capital gains accumulating within the trust), subsection 104(18) of the Income Tax Act makes special provision for the deduction of amounts allocated but not paid in the year to minor beneficiaries. For taxation years that begin after 1995, an amount will be deemed to be payable to a beneficiary, and therefore deductible by the trust, if all of the following conditions are met:
In other words:
then,
Although the terms of the trust can restrict the beneficiary's right to enforce payment of an amount, the trustees could also be given the discretion to make payments out of a particular beneficiary's share, to or for the benefit of the particular beneficiary, before the beneficiary attains the specified age.
The income and realized capital gains that accumulate each year after the beneficiary reaches the age of 21 will be taxed in the trust (at the highest marginal rate), unless the amounts are actually paid or made payable to the beneficiary.
Preferred Beneficiary Election
Where the preferred beneficiary election is available, income may be allocated to a beneficiary and a deduction claimed by the trust (even though the allocated share of the trust income is not payable to the beneficiary in the year). After 1995 the preferred beneficiary election is only available where the beneficiary qualifies for the disability tax credit Please refer to Chapter 12 of the tax Library for a more detailed discussion of the preferred beneficiary election.
Here is a chart which illustrates just how the One + One program works within a trust:
| Step 1 | - creation of family trust; | |
| Step 2 | - trustee opens trust bank account; | |
| Step 3 | settlor loans capital to trustee who invests the capital in his/her own name followed by the words "In Trust" (or one of the other registration options noted in point 3 above). Equity funds are typically chosen, as capital gains will not be subject to attribution (Account #1); | |
| Step 4 | - quarterly income (including capital gains and capital gain dividends) from Account #1 automatically transferred to any other account (Account #2) in the name of the trustee "In Trust". |
For a detailed discussion of the pros and cons of the methods to income split with a minor, refer to Appendix 3.
In addition to the attribution rules dealing with transfers of property to a spouse or minor, effective January 1, 1989 rules were implemented to inhibit income splitting with all other non-arm's length persons - such as adult children, parents and so on. Where a person has loaned property interest free or at low interest and where it may reasonably be considered that one of the main reasons for the loan was to reduce or avoid tax, the income generated will be attributed to the lender. Note that the rules apply to loans made prior to 1989 but only to income earned after 1988. Once again, the rules do not apply to income on income (compounding income). Thus, a One + One program could be used to have compounding income taxed in the hands of the non-arm's length borrower.
Only simple income would be taxed to the lender. As with transfers of property to a minor, the rules do not apply to capital gains realized by the borrower.
Note that the rules do not apply to outright gifts to a non-arm's length person. This is unlike the attribution rules dealing with a spouse, for example, as a gift of property to a spouse will result in income attribution.
One final point in this area - Revenue Canada has stated that where the purpose of the low or no interest loan to a non-arm's length person was for the purchase of a principal residence, the rules do not apply.
The following matrix summarized the application of the attribution rules in the various situations described on the previous pages:
