Is This the End of Tax-Motivated Family Trusts?

Author: MaryAnne Loney

Proposed tax changes affecting private corporations will significantly reduce the tax advantages of owning shares of corporations in family trusts. These changes, along with others over the past few years, mean trusts with shares of private corporations will need to determine whether their current structure is still advisable.

On July 18th, 2017, the Department of Finance released proposed changes to the Income Tax Act (the "Act"). These changes have the stated aim of eliminating many of the tax advantages of private corporations.

Two of the main tax advantages of trusts are that trusts can be used for income splitting and multiplication of the lifetime capital gains exemption ("LCGE"). As a result, many owners of corporations have set up family trusts.

These advantages are possible because income and gains earned by a trust may be attributed to the trust's beneficiaries. Therefore, if a trust was paid dividends, those dividends could be paid out by the trust to beneficiaries in low tax brackets, allowing them to be taxed in those tax brackets. Likewise, if a trust sold property is eligible for the LCGE, the capital gain could be paid out to multiple beneficiaries, allowing each beneficiary to use their own LCGE to offset their allocated gain.

The proposed rules take specific aim at income splitting, including capital gains to allow access to multiple LCGEs. A summary of the proposed  changes can be found here. The gist of the changes are that the Department of Finance is proposing to extend "kiddie tax", being a tax on income from a non-arm's length person's business ("Split Income") at the top marginal tax rate in the following ways:

1. by making payments to adults from a business where a related person has significant influence over the business included in Split Income, unless the income or gains paid are "reasonable";
2. by denying the LCGE on gains included in Split Income; and
3. where the related individual is under 25, by including any income earned on Split Income itself in Split Income.

These changes cover payments made through a trust. However, in two ways the proposed changes are specifically punitive to trusts.

First, if income would have been Split Income if paid directly to an individual under 25 when they were under 18, if the income was instead paid to a trust any income earned on the income allocated to the individual under 25 will still be Split Income. The punitive factor here is that the original payment is treated as if it were paid while the individual was under 18, and therefore no consideration will be made as to whether the original payment was reasonable. This effectively eliminates any advantages of attempting to use trusts to split income with individuals under 25.

Second, an individual will no longer be eligible to claim LCGE exemption in respect of capital gains that accrue during the period a trust holds the property unless the trust is spousal or common-law partner trust or alter ego trust. This means that there is a potential tax cost of holding property which could potentially qualify for the LCGE in a trust if the beneficiaries could otherwise benefit from the LCGE.

These changes only apply starting in 2018. As a result, income splitting opportunities will continue to exist for 2017. Additionally, the proposed legislation has provided that taxpayers who under the current rules are eligible for the LCGE may elect in 2018 to have a deemed disposition and reacquisition, thereby allowing them to claim the LCGE and bump up the cost of the property. However, after 2018, where a family trust is only in place for purely tax reasons, it may make sense to wind up the trust.

What Should Trustees Do
The above described changes potentially require trustees to take active steps to avoid negative tax consequences. Further, the changes proposed by the Department of Finance on July 18th are just two of the latest in a string of several significant tax changes which have been enacted over the last few years effecting corporations and trusts. Alone, any of these changes would be significant, but together the aggregate effect is that most structures involving private corporations put into place a few years ago are no longer effective and may not be advisable.

As a result, we recommend that trustees of family trusts with corporate shares should consult with a tax advisor regarding what, if any, steps should be taken in light of the changes. As any additional income splitting will need to be done in 2017 and, if it makes sense to do so, the LCGE election will need to be made in 2018. We would therefore recommend speaking to a tax advisor before the end of the fall 2017.

Click here to read our alert on how the proposed changes to the Income Tax Act may require estates to take steps to trigger losses during the first year.