If you’re contemplating a trust, there are a number of factors to keep in mind to ensure it achieves your objectives while meeting the CRA’s expectations.
Many owners of manufacturing companies rely on family trusts to achieve a variety of financial and tax goals. In fact, since trusts have become so popular, the Canada Revenue Agency (CRA) is increasingly scrutinizing them and penalizing or disallowing those that aren’t properly established and maintained. If you’ve already established one, be sure to review its “trustworthiness” before the CRA does. If you’re contemplating a trust, there are a number of factors to keep in mind to ensure it achieves your objectives while meeting the government’s expectations.
First some background. Inter-vivos trusts or “trusts of the living” transfer the benefits of owning assets (such as shares of a corporation, a building or land) to others while retaining control of them. Business owners often use trusts to assist with managing assets, succession planning, optimizing tax exemptions, reducing probate fees, income splitting with family members, providing for disabled family members, asset protection, charitable gifting and supporting a will.
For example, trusts used in an estate freeze will allow future growth in the value of your company to accrue to beneficiaries while you retain control. One way to accomplish this is to transfer the shares of the corporation to a new holding company in exchange for preferred and common shares of the new company. As the owner, you hold the voting preferred shares and control of the company while your beneficiaries hold the common or growth shares. All future growth accrues to the common shares, held in trust.
When the common shares are sold, the capital gain is allocated to the beneficiaries. Since there is an enhanced capital gains exemption available on the sale of shares of privately owned Canadian small businesses, each beneficiary can shelter up to $750,000 of the gain if the conditions for the exemption are met.
Inter-vivos trusts must calculate income, file a tax return and pay taxes. Since trust income can be allocated to beneficiaries and taxed in their hands, this arrangement produces most of the tax benefits – and receives most of the focus of CRA audits.
The CRA, not fond of income splitting because it reduces government revenues, looks at three key issues:
• Has the trust been properly formed? The CRA may request the original signed trust document, including a description of the beneficiaries and the settled property. A trust set up by a lawyer shouldn’t be a concern. The CRA will also expect to see evidence of trustee decisions, such as minutes. If the CRA determines the trust was not formed properly, there may be adverse tax consequences.
• Where trust income has been allocated to beneficiaries, was the income actually paid; or is there a genuine obligation to pay that income to a particular beneficiary? The CRA will review documentation to substantiate payments. Documents may include trustee resolutions that allocate the trust’s income, proof of payment for income paid during the year and promissory notes or other evidence that the trust has made the income payable to specific beneficiaries. If these documents are not available or are not adequate, the income may still belong to the trust and will be taxed at top rates.
• Where trustees make payments to third parties, did they benefit the beneficiary? Another way to pay income to a beneficiary is to make payments to third parties for their benefit. The CRA wants to ensure funds paid by the trustees are benefiting the beneficiaries and not someone else, so it will want to see the documentation of payments and evidence they benefit a particular beneficiary. If, for example, a trustee is the parent of a child beneficiary and the parent is reimbursed for expenses incurred on behalf of the child, there should be expense receipts to prove the funds were not spent for the parent’s benefit.
The CRA will also be reviewing trust records to determine whether income has been calculated and reported properly. Auditors will expect to see relevant bank and investment
accounts, and appropriate maintenance of records.
Having the necessary records and strategy in place will ensure your family trust stands up to CRA scruntiny. After all, you need to be able to trust that your family trust will achieve your goals.
Bruce Ball is the national tax partner of BDO Canada LLP (www.bdo.ca) and co-author of BDO’s Guide to the Family Business. Call (416) 865-0111 or e-mail firstname.lastname@example.org.