Family trusts: the aftermath

The last 24 months have seen a deluge of tax announcements from Ottawa with adverse impacts on private family businesses and corresponding family members. Announcements were implemented, modified and shelved, so taxpayers and advisors are still coping with the changes. Many taxpayers are understandably confused about which planning strategies remain available.

Two changes (discussed in previous Baker Tilly publications), impact the use of family trusts (herein referred to simply as “trusts”):  

1. Expanded “kiddie tax” rules, or tax on split income (TOSI), subject additional sources of income to tax at the top marginal rate.
2. Taxpayers involved or connected with a trust will have personal details disclosed to the Canada Revenue Agency (CRA) as part of expanded trust disclosure requirements effective for the 2021 year.¹ These new requirements will increase the work and costs of maintaining a trust.

In a standard income-splitting scenario, the trust-owned shares of a private family business facilitate the allocation of dividends to family members at lower marginal tax rates. This income-splitting approach has been substantially restricted by the TOSI rules. Each existing trust situation will now require a TOSI review² to evaluate whether this dividend procedure continues to permit family members to access lower marginal tax rates. Unless the beneficiary receiving the dividend is actively engaged on a regular, continuous and substantial basis in the business generating the dividend, there may be a risk that dividends from the trust will be taxed at the top marginal rate.³ Even if the beneficiary is actively engaged, they must document the aforementioned work activity to the CRA’s audit satisfaction using currently unclear procedures and guidelines.

If standard income-splitting techniques using trusts are potentially less effective, and the costs of maintaining trusts are increasing, are trusts still a valid tool for the private business owner? The answer is a resounding yes!

Trust concepts were created centuries ago, but Canadian politicians only implemented the temporary income tax system in the early 1900s. Long before Canada established its income tax system, trusts effectively achieved asset protection, family ownership continuity, privacy, and other wealth-management objectives. 

Non-tax reasons for a trust can be just as important today, though the benefits are normally realized over a longer time frame compared to annual income-splitting savings. Non-tax issues may still be valid reasons to keep an existing trust in existence for future use, even if TOSI prevents effective income splitting now. No steps should be taken to wind up a trust without appropriate due diligence and consultation with a Baker Tilly advisor.

Trusts may still be used to realize income-splitting tax savings in specific situations. A beneficiary who receives split income could avoid the TOSI rules if they qualify for a particular excluded amount. Another key to success in this new environment is to fall outside the definitions of “split income” and “related business,” thus also avoiding the TOSI rules.

Several examples demonstrate how income splitting via a trust remains an effective strategy. If a trust directly owns an investment portfolio of securities traded on specified public exchanges, the dividends, interest and capital gain realized on those marketable securities are not split income. Interest or capital gains realized on Canadian government debt (federal, provincial or municipal) are not split income. The investment return from a portfolio of this nature will not be subject to TOSI.

When setting up and funding a trust, care is required to prevent application of the attribution rules.⁴ However, the attribution rules have existed for many years, and there are well-known strategies for avoiding those constraints. Those strategies must be followed strictly, so any investment purchases by the family trust should be reviewed prior to implementation.

Some tax advisors have noted recently that new passive investment rules that erode the small business deduction will cause business owners to avoid passive investments in operating or holding companies. To facilitate income splitting to lower-rate family members, a family may centralize its unregistered investments in a trust, without losing the small business tax rate on income in the related corporate group. Family investment trusts may become the second evolution of former family investment holding companies.⁵

The trust structure remains a valid mechanism to share capital gains realized on certain private company share investments among family members. If the person receiving a trust allocation from a disposition of private company shares is 18 or older, and the property creating the gain is at the time of disposition a “qualified small business corporation share” or a “qualified farm or fishing property,” the gain is split income but is specifically excluded from the TOSI rules. It does not matter whether the beneficiary receiving the allocation of the capital gain actually uses the capital gain exemption; the key is whether the property qualifies. Thus, a trust is a valid tool to multiply the benefits of the capital gain exemption and equity share among family members. If there is not a significant need or desire to pay annual dividends, the trust mechanism still achieves a similar result to the pre-TOSI situation. 

The trust structure also remains a valid income-splitting mechanism for property income earned by a trust from the rental of property to third parties. In order to avoid TOSI though, the individual receiving the income cannot be related to an individual, actively engaged in the activities of the rental property.  Many private business owners invest in commercial or residential real estate rented to third parties. Often, such investments are supplemental to ownership of the building used for their main business operations. By default, many of these assets are acquired from existing operating or holding companies. As discussed above, it is often a matter of purchasing the right investments in the right entity. If the trust structure is correctly set-up and rental properties are acquired by a trust, income splitting may be possible.

How can Baker Tilly help taxpayers deal with TOSI and their trusts? First, it is critical to maintain assets that are not subject to TOSI in the correct structure. Assets that otherwise escape TOSI provisions may fall under the TOSI regime if purchased by corporate entities. Seek advice early in the investment process so that trusts and other non-corporate entities can be factored into the overall business/financial structure.

If a business owner already has income-earning assets in corporate entities, which could escape TOSI if the assets are not held in a private corporation, it may be possible to reorganize in a tax-friendly manner in order to move assets to a more optimal part of the business/financial structure. Any transactions of this nature should be subject to proper due diligence and advice to avoid premature recognition of accrued gains. Contact your Baker Tilly advisor for help.