Trusts are widely used in tax planning for a variety of reasons, including their flexibility in managing and distributing assets, their ability to facilitate intergenerational wealth transfers, and their role in tax deferral and minimization strategies. The use of trusts, however, can also add some complexity to tax planning and compliance issues. One such issue is the concept of the 21-year anniversary rule.
Generally, most personal trusts are subject to the 21-year anniversary rule which provides that all capital property and land inventory is deemed to be disposed of at their fair market value and reacquired at that same value on the 21-year anniversary from the date of settlement of the trust and then every 21 years thereafter.
The 21-year anniversary rule is intended to prevent trusts from being used to defer the realization and taxation of accrued capital gains indefinitely, which could otherwise occur if property remained in trust for multiple generations without triggering a taxable event. Note however, that the 21-year anniversary rule does not require that the trust be wound up on that date.
Trusts that are excepted from the 21-year anniversary rule are spousal/common-law trusts and alter-ego/joint spousal trusts which will only realize the deemed disposition of assets on the death of the spousal beneficiary or settlor of the trust, and then every 21 years thereafter.
For personal trusts where a deemed capital gain will occur on the 21-year anniversary, there are some tax planning techniques to defer the tax that would be otherwise triggered:
1. Capital distribution to beneficiaries
Probably the easiest tax planning technique to defer tax on the 21-year anniversary deemed disposition is for the trust to distribute the assets to the beneficiaries before this date. Provided the beneficiaries are Canadian residents and the trust deed allows for the distribution of capital property to beneficiaries, assets can be distributed on a tax-deferred basis. As a result, no gain will be recognized by the trust and the beneficiaries will be responsible for the tax on the future disposition of the property.
Note that capital distributions to non-residents of Canada are deemed to take place at fair market value and no deferral of tax will be available to the trust in those cases.
This option will often be beneficial where the property held by the trust has a significant unrealized capital gain as well as very little liquid assets and there is a reluctance to “prepay” the tax on the deemed disposition of the assets.
2. Share reorganization planning
Where the trust owns shares of a private corporation, it may be beneficial to effect a “freeze” of the corporation and exchange the common shares owned by the trust for fixed-value preferred shares at a date close to the 21-year anniversary. These preferred shares could then be distributed to the beneficiaries and the trust could subscribe to new common shares. While there would still be a deemed disposition of these new common shares at the 21-year anniversary date, the capital gain to be realized would be nominal, if any.
This type of planning would be effective where the beneficiaries do not have plans to redeem the preferred shares received from the trust and there are no concerns with the possibility of the holder demanding their redemption. Accordingly, the inherent tax in their value would be deferred to a future date, while the growth in the value of the common shares from that point will accumulate within the trust and can be dealt with over the following 21 years. Similar planning could be undertaken where the trust owns other assets, such as marketable securities or rental property if these assets were first transferred on a tax-deferred basis to a corporation in exchange for share consideration.
Where there may be some hesitancy or concern to provide beneficiaries with control over the corporate assets, an alternative share reorganization plan could be implemented which could allow shares to be distributed to beneficiaries in such a manner that does not provide them with voting rights or the ability to have the shares redeemed. This would be a more complicated reorganization plan which would generally involve distributing a class of shares to beneficiaries that represent the value of the trust’s assets at the time of distribution, while the trust would retain voting rights and future growth in the value of the assets.
In some circumstances, it may be appropriate to simply recognize the deemed disposition of the assets held in trust on the 21-year anniversary date. For example, consider the following situations:
- The trust may hold portfolio investments where the inherent gain is nominal. Therefore, recognition of the deemed disposition will result in minimal taxes and the trust can continue for another 21 years.
- The trust may hold shares of a qualified small business corporation and the capital gain on the deemed disposition could be distributed to beneficiaries and be eligible for the capital gains exemption. In this situation, it would be important to confirm that the trust deed allows for the distribution of the deemed capital gain (or “phantom income”) as the trust will not actually receive proceeds of disposition.
- If an actual sale of the assets is imminent, it may be better to recognize the deemed capital gain in the trust such that the proceeds from the actual sale will continue to be held in the trust, which may facilitate future income splitting with family members.
Where a capital gain is to be recognized in the trust, it is important to ensure appropriate liquidity in order to pay the tax liability. This may be a challenge given the assets are not actually being sold. However, some relief is available if an election is filed using Form T2223 to pay the tax resulting from the deemed disposition of non-depreciable capital property and land inventory in up to 10 equal annual instalments. Note, however, that a trust cannot defer tax arising on a deemed disposition of depreciable property and resource property by making this election. Where such an election is filed, security will have to be provided, and interest expense will be applicable to any deferred tax.
Trust Wind-Up Considerations
Where the assets of the trust are to be distributed as part of the 21-year anniversary planning, it may also be appropriate to consider a subsequent wind-up of the trust if it is no longer considered necessary.
Where the choice is made to wind-up the trust, there are several steps which should be undertaken:
- The trust deed should be reviewed to understand the terms of the trust and any special provisions relating to the dissolution of the trust and distribution of assets.
- The bookkeeping for the trust should be brought up to date to determine any balance owing to/from the trust. All debts of the trust, including any loans that were made to the trust for the purpose of subscribing for shares, as well as balances owing to CRA, should be cleared prior to the wind-up of the trust. Consideration should also be given to applying for a CRA Clearance Certificate to ensure the trust is up-to-date with all tax compliance filings and payments prior to asset distributions.
- Assets should be distributed by the trust, considering the provisions of the trust deed. Asset distributions should also be appropriately documented by trustee resolutions. Note that the original settlement property is also an asset of the trust that requires distribution.
- A trust dissolution agreement should be prepared which officially documents the decision to wind-up the trust and how assets are to be distributed to beneficiaries. This document can be very beneficial in the event of subsequent follow-up by CRA.
Note that a trust lawyer should be involved with all aspects of the trust dissolution process to ensure that the steps are properly documented, and the trust is successfully wound-up.
For further guidance on the impact of the 21-year anniversary rule and trust wind-up considerations, please contact your Welch LLP advisor.
