For Canadian income tax purposes, a discretionary trust can be an effective vehicle—not only to facilitate multiplication of the lifetime capital gains exemption, but also to help taxpayers achieve their estate-planning objectives.
Despite this clear rationale for considering a trust when developing a client’s estate plan, there are limitations to consider as well—most notably due to the 21-year deemed disposition rule (commonly referred to as the “21-year rule”). As detailed in subsections 104(4) through 104(5.2) of the Income Tax Act (Canada)(“ITA”), on its 21-year anniversary, a trust will generally be deemed to have disposed of all capital property for proceeds equal to their fair market value. Accordingly, some sort of planning may be required to avoid triggering any unrealized gains for income tax purposes.
The 21-year deemed disposition date applies to most trusts, including discretionary family trusts and testamentary trusts. However, for other types of trusts, such as alter ego or spousal/joint partner trusts, the trust will be deemed to have disposed of its capital property on the death of the taxpayer (or on the later death of the taxpayer and their spouse, in the case of a spousal/joint partner trust). In such cases, planning cannot be used to defer the gain beyond death.
As a general rule, if there are any shares held in the trust, it is important to review a company’s articles of incorporation to confirm the rights and restrictions attached to those shares. In some cases, the shares held by the trust may be entitled to dividends but have no participatory rights on sale, dissolution, or winding-up. Accordingly, the value of such shares may be nominal, and the deemed realization would result in zero capital gains. It is also important to review the trust indenture to ensure that certain planning techniques, including those noted in this article, may be implemented.
Planning for the deemed realization
Here are four common techniques to minimize the tax effect of the 21-year rule:
1. Do nothing and pay the tax
If the income taxes from the deemed disposition are manageable, it would be sensible to do nothing and pay the tax—assuming the terms of the trust deed provide the ability to do so and the trust has sufficient liquidity. This simple solution is both practical and cost-effective, from a tax-planning perspective, when the amount of tax arising from the 21-year deemed disposition is minor.
2. Make a capital distribution of property to the beneficiaries
A deemed realization at fair market value can produce a significant tax liability. If the trust lacks the liquid assets needed to pay the resulting tax, it may be forced to sell non-liquid assets. To avoid this scenario, a personal trust can arrange to distribute trust property with an accrued gain to the capital beneficiaries on a tax-deferred, “roll-out” basis prior to the deemed realization date.
If the trust deed allows for a capital distribution to the beneficiaries and the beneficiaries are resident in Canada, it may be possible to roll out the capital property to the beneficiaries without triggering tax. The beneficiaries could then continue to hold the property until the disposition of the property or their respective deaths, whichever occurs first.
This option is often chosen when the capital property held by a trust has significant inherent capital gains that would otherwise be triggered on the deemed realization date. Additionally, this is often the preferred option when the trust has no liquid assets available to pay the tax or when there is reluctance to “prepay” the tax.
Pursuant to subsection 107(2.1) and 107(5) of the ITA, the ability to roll out the capital property of a trust at its cost is generally not available if the capital beneficiaries are non-residents of Canada. Properties rolled out to non-resident beneficiaries are rolled out at fair market value, which can potentially trigger the realization of accrued gains. However, these provisions should not apply when the distributed property is property described in subparagraphs 128.1(4)(b)(i) through (iii) of the ITA; this property includes real or immovable property situated in Canada, Canadian resource property, and timber resource property.
Note that if the trust document does not allow for capital encroachment, the trustees could seek legal advice to determine whether the terms of the trust could be amended to allow it.
3. Reorganize shares with a capital distribution
If a trust owns shares of an operating company, it may be beneficial to “freeze” the current common shares held by the trust and issue fixed-value preferred shares in exchange. These “freeze shares” could then be distributed to the beneficiaries, and the trust could subscribe for the company’s new growth shares. Taxpayers would need to exercise caution and review the facts, however, as the income or capital gains distributed through a trust could be subject to tax on split income. The new shares would also be subject to the deemed realization rules, but little or no tax would be triggered because their value would be nominal.
This planning should only be undertaken if there is some certainty that the beneficiaries (who hold the preferred shares) will not seek to retract their preferred shares if it is impractical for the company to fund the retraction.
4. Vest indefeasibly
An exception to the deemed realization rules is provided where all interests of the trust have vested indefeasibly in the beneficiaries. The interests of the beneficiaries are considered to have “vested indefeasibly” when the interest of each beneficiary is fixed and the trustee has no discretion to alter the interests. Planning could be implemented to “vest” the property to the beneficiaries, thereby deferring the tax until the earlier of the sale of the property or the death of the beneficiary. However, the implications of the vesting—including the potential for the beneficiaries to cause the trust to be wound up and the exposure of the vested interest to creditors of the beneficiaries—need to be considered.
Connect planning to client goals
Determining which of these techniques may be most effective in mitigating the effects of the 21-year rule will depend on the goals and objectives of the client. These goals and objectives are rarely top of mind, so it would be prudent for practitioners to broach the subject with clients and devise a plan to address the 21-year rule well before the deemed realization date.