Facing the fiscal death (21 years) of your trust

If you are a settlor, a beneficiary or a trustee of a trust established in the twenty-first (21^st) century, your legal or financial advisors may have already made you aware of the potential tax impact upon the expiry of a 21-year period following the date on which such trust was constituted.

In Canada, most personal trusts, whether created by a last will and testament upon death or during the lifetime of its settlor, are deemed to dispose of all capital assets and inventory for proceeds equal to fair market value at the end of the 21-year period. This tax event, if not thoughtfully planned though, can result in a very significant tax bill without the trust having the necessary liquidity to afford payment. Such tax consequences could also apply to a personal trust administered by trustees who are non-residents of Canada holding Canadian real estate.

Imagine the following situation. Your family trust was settled on December 31, 2002. At that time, your trust subscribed to shares of your professional services corporation for $10. The current fair market value of your corporation’s shares is estimated at $1,000,000. In the absence of planning, your trust will realize a deemed capital gain of $999,990 on December 31, 2023, resulting in a combined Quebec and Canadian tax of $266,500, payable no later than March 31, 2024.

The trustee’s liability

Whether the trust is constituted under the Civil Code of Québec or under Common Law, a trustee’s primary responsibility is to administer the trust assets in the interest of its beneficiaries that are consistent with the objectives set out in its constituting deed. In addition, a trustee must act within the limits permitted by law and in accordance with the powers granted by the settlor in the trust deed. In this context, failure to plan for the arrival of the deemed disposition, or acting without legal authority, may expose the trustee to personal liability under applicable law.

It is also important to take into consideration that a trustee who participates in the distribution of trust assets may incur personal tax liability with respect to any outstanding taxes owed by a trust or any taxes arising from the distribution of its property. In practice, it is therefore customary for a trustee to obtain a certificate of disposition from the appropriate tax authorities prior to any distribution made to beneficiaries in order to be released from any liability in this regard.

Fortunately, the tax impact of the 21-year deemed disposition is not inevitable and several legal procedures can generally be carried out to defer or minimize the tax burden for the trust patrimony. However, one needs to plan accordingly with sufficient time prior to the 21-year deemed disposition deadline since the strategy chosen to mitigate or defer tax could involve a number of complex legal operations.

Due diligence

The first step required to determine the most optimal strategy is a careful examination of all the facts at hand and to undertake a comprehensive analysis. In fact, such an optimal strategy from a taxation standpoint may not perfectly align with what is required by the trustee from a legal standpoint or may not be consistent with the objectives of the trust or the estate planning originally considered upon the trust’s settlement. With the help of professionals, a trustee should therefore undertake such a comprehensive analysis and seek answers to the following questions, in particular:

• What is the date of the expiration of the 21-year delay following the settlement of the trust?

• What were the settlor’s objectives when the trust was constituted? Have circumstances changed the ability for the trust to achieve such objectives?

• Does the trust deed grant full discretionary powers to its trustee, or are there provisions in the trust that limit the trustee’s powers to conduct certain transactions (estate freeze, income and capital distribution schedules, suspension of beneficiaries’ rights, etc.)?

• Is a trustee bound by a shareholders’ agreement requiring the consent of the other shareholders to certain transactions?

• What is the trust’s projected balance sheet upon expiry of its 21-year period? Is the trust expected to receive significant assets just prior to the expiry of its 21-year period, thereby increasing the potential tax burden upon the deemed disposition? What are the values that are to be considered?

• Is a tax-differed distribution strategy of trust property to beneficiaries in outright ownership consistent with protecting their best interests?

• Are there any prior transactions that could jeopardize from a tax standpoint, the tax-deferred distribution of trust property to its beneficiaries?

• Does the trust hold assets (e.g., shares, agricultural goods) where such disposition to its beneficiaries would qualify for a capital gains deduction (ie. $971,190 of exempt capital gains in 2023 per beneficiary)? If so, should the trustee consider moving such assets out of the trust patrimony before the expiry of its 21-year period to prevent loss of such tax benefit?

• Will the implementation of the strategy result in modifications to be made to the beneficiaries’ respective estate planning, namely to their last will and testament?

• Etc

Basic strategies.

Upon completing such comprehensive analysis, the trustee may determine that the preferred plan might be to adopt for a simple strategy. For example, rather than implementing a tax-deferral strategy, the trustee may simply decide to retain all or part of the assets in the trust and pay the taxes resulting from the deemed disposition, in order to protect the beneficiaries from their personal exposure to commercial risk. Alternatively, the trustee could transfer the assets to a second-generation beneficiary, with no immediate tax impact, thereby deferring taxation until the beneficiary’s death.

Advanced strategies.

However, your advisors on the other hand may recommend an advanced strategy to be implemented involving multiple legal transactions using multiple corporations found within your corporate structure.

For example, the directors of a corporation in which the trust is a shareholder might consider accelerating certain dividend distributions or anticipating the implementation of a corporate gifting plan. These transactions could reduce the taxable value of the trust’s shares upon the expiry of a 21-year period, in addition to generating corporate tax advantages that would allow shareholders access to tax-free corporate distributions.

You may also be advised to freeze the value of the trust shares for the benefit of another shareholder.

Some trusts also have capital loss carry forward that would remain trapped in the trust patrimony without efficient planning. Its trustees may therefore wish to voluntarily generate a capital gain on the wind-up of the trust by filing the appropriate tax elections. Conversely, if trust assets have declined in value since their acquisition, the chosen strategy could be to trigger the realization of these losses and apply them against potential gains on the deemed disposition.

Moreover, in certain cases, the option of converting a discretionary trust into an irrevocable non-discretionary trust would also allow the trust to avoid the deemed disposition upon the expiry of a 21-year period. Such conversion requires the supervision of a jurist specializing in tax and estate planning.

Risk analysis.

The current tax environment also necessitates a rigorous risk analysis of the solution(s) envisaged.

Legal mechanisms to counter aggressive planning

Certain tax provisions in the Income Tax Act are designed to restrict or even prevent the deferral of taxation upon the transfer of property from one trust to another. These tax provisions subject the receiving trust to the transferring trust’s 21-year period deadline, consequently preventing the receiving trust to have a new 21-year period of its own from the transfer of property.

Tax authorities also take a dim view of more creative planning aimed at circumventing the 21-year deadline. For example, such may be the case with respect to the distribution of dividends in favour of a corporation that is a beneficiary of a trust for the purpose of reducing of the value of the trust’s shares. This type of transaction could trigger the application of the general anti-avoidance rule (GAAR), which provides the government broad powers to prevent transactions to counter certain abusive tax planning.

Recent amendments to GAAR have considerably broadened its application and will be in force on January 1, 2024. As such, the application of GAAR will now result in penalties of up to 25% of the tax benefit. Voluntary disclosure mechanisms, however, make it possible to exempt a transaction from these penalties.

Disclosure obligations

As more fully discussed in a in previous publication of Levy Salis LLP[1], contemplated transactions need to be examined in light of new disclosure requirements. For example, if a transaction from a trust attempting to avoid taxation of a capital gain upon the end of the 21-year period deadline is subject to an indemnification agreement of the trustee by the beneficiaries, such transaction will have to be disclosed to the tax authorities, or otherwise face significant penalties.

In addition, tax authorities now have the power at any time and from time to time, by way of regulatory decree (Quebec) or joint decision between the Canada Revenue Agency and Finance Canada, to identify transactions that it would arguably deem more at risk such as those attempting to circumvent disclosure obligations. It is important to note that failure to disclose a transaction that is identical or similar in nature to a prior transaction flagged by the tax authorities would result in significant penalties for trustee and their advisors in addition to increasing the likelihood for tax assessments beyond the normal 3-tax-year period. In this context, it would be advisable for a trustee to consult with a lawyer or notary from the outset of the implementation of a transaction. Any exchanges of information and documents between a trustee and such professional would be considered privileged under a duty of professional confidentiality, and thus in theory be exempt in whole or in part, as the case may be, from disclosure obligations to the tax authorities. In this regard, a recent decision by the Supreme Court of British Columbia granted a petition for an injunction by Federation of Law Societies of Canada suspending the application of the new mandatory disclosure legislative provisions to members of the legal profession until a decision is rendered on their constitutionality.[2]

Obtaining an administrative decision in advance

Upon the completion of a thorough risk analysis of the proposed strategy, in order to provide you with the greatest level of comfort, your professionals may recommend obtaining from the Canada Revenue Agency and the Quebec Revenue Agency, an advance tax ruling regarding the tax treatment of the proposed

strategy before it occurs. Such a response from the Canada Revenue Agency and the Quebec Revenue Agency will assist taxpayers to understand and obtain a certain degree of assurance on the tax treatment. Consequently, this procedure will reduce the tax risk associated with the transaction, as well as providing a level of comfort required before filing mandatory disclosures, where applicable. Delays of approximately 6 months are generally to be expected when obtaining an advance tax ruling.

Conclusion

In conclusion, trustees must be prudent when planning for the 21-year period deadline. The many variables associated with every transaction, as well as our current complex tax environment, have made any operation, however simple on first appearance, a matter to be treated with the utmost care. Unfortunately, there are no longer any shortcuts to bare.

If you are a trustee and wish to plan with sufficient time in anticipation of your trust’s approaching 21-year period deadline, we invite you to consult with one of our professionals at Levy Salis LLP to inform you of your tax and legal obligations.  Our team will offer you its expertise in providing a comprehensive analysis and assist you in determining and implementing the best strategy for you and your loved ones.

[1] Levy Salis LLP, Blog Mai 05 2022,  “In the Era of Tax Transparency (Part 1)”

[2] Federation of Law Societies of Canada V. Canada (Attorney General), 2023 BCSC 2068.