Trusts are meant to hold property for the benefit of someone (beneficiary) other than the person who put that property in the trust (settlor). So, from the moment a settlor transfers an asset into the trust, this asset belongs to the trust and no longer belongs to the settlor. If the settlor has some ability to get the property back as a beneficiary, or to control the property as a trustee, section 75(2) of the Income Tax Act will attribute any income, gains or losses from that asset back to the settlor. From a tax perspective, it is as if the asset was never transferred at all.
It is possible to undo the income attribution damage by removing settlor as a beneficiary or adding more trustees. But, capital attribution cannot be avoided once section 75(2) invoked at any time during existence of the trust, the trust loses its roll-out at cost ability, except back to the settlor.
For example, if an asset went into the trust at $50,000 (cost), and now worth $100,000 (fair market value):
|Section 75(2) was invoked||Section 75(2) never invoked|
|· When asset comes out, the trust has to report $50,000 gain;
· Gain is attributed back to settlor, who pays the tax;
· Beneficiary acquires the asset at the fair market value of $100,000.
|· Trust can transfer the asset out at the $50,000 cost base;
· Beneficiary gets the asset at $50,000 cost and doesn’t pay tax until the asset is sold;
· If beneficiary sells the asset when it is worth $150,000, beneficiary pays the tax at that time on the entire gain of $100,000.
To avoid application of section 75(2) it is best for a person to settle a trust and then have no further involvement with it. However, that is not always possible. The settlor-trustee’s control over the asset shall be limited to the extent that the settlor cannot revert it to himself.
Multiple trustees: A person cannot both settle and be the sole trustee of a trust without invoking 75(2). If settlor wants to play both roles, there must be at least two other trustees and majority shall rule. That way, the settlor-trustee does not have a controlling interest and does not have a veto right. If a co-trustee dies, resigns or becomes incapacitated someone else should be appointed to automatically replace that co-trustee.
Loan the property at prescribed interest – If a trust beneficiary wants to contribute property to it, s/he can loan property at fair market value or trust shall obtain a bank loan to purchase this property, so that the beneficiary does not contribute the funds that are used to buy the property.
Sell the property to the trust at fair market value – Section 75(2) can be avoided if a settlor sells property to the trust. But, it’s important to make sure the sale doesn’t look like a gift, because that would invoke 75(2). The sale must be at fair market value, so going through a valuation process is usually the safest. If CRA determines the amount unreasonable, it could argue the settlor invoked 75(2).
Don’t contribute later – Beneficiaries may inadvertently contribute to a trust years after it was created, so it is important for them to remain vigilant. For example, a mother sets up a trust for her children and, 10 years later, all the children happen to add property to the trust, those children would be treated as if they were settlors for tax purposes, triggering 75(2).