Implications of the Government’s Consultation Paper on the Use of Trusts

September 2017

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The proposed changes announced in the federal government’s recent consultation paper may require modifications to the way that trusts are used as part of a businesses’ financial planning strategies. These changes, announced in the “Tax Planning Using Private Corporations” consultation paper released on July 18, 2017 by the federal government, are intended to close loopholes and address perceived issues of fairness in three main areas:

  1. Income splitting with family members to reduce the total family tax burden.
  2. Passive investment portfolios owned by private corporations.
  3. Strategies that convert regular or dividend income into capital gains.

The measures around income splitting and changes to the availability of the lifetime capital gains exemption (LCGE), if implemented as proposed, could have significant implications for the use of trusts.

Changes to income splitting using trusts

Income splitting is a commonly used strategy to reduce a family’s total tax burden. Under the current rules, if a trust that owned shares of a small business was paid a dividend, that money could then be distributed to any adult family member who was a beneficiary of the trust and taxed at the individual’s marginal tax rate. If this income was split with a low-income individual—a student away at school for example—that often meant no or low tax on that dividend.

The government is now proposing a considerable extension of the tax on split income (TOSI) rules. Under current tax law, these rules prevent the allocation of certain income types to minor children by taxing any split income at the top federal personal tax rate. Under the proposed legislation, if enacted, the TOSI rules would apply to any Canadian resident, regardless of age, who receives split income that does not meet new reasonableness tests. This means that any adult individual that is a beneficiary of the trust but is not involved in the active business will have dividends received taxed at the highest personal tax rate, under the proposed changes. This negates any tax advantage of using a trust for income splitting, and could very well result in more tax being paid by the family.

Capital gains on the sale of a business

Another high-impact element of the government’s consultation paper is the proposal to limit access to the LCGE. The LCGE provides a tax exemption for capital gains realized by individuals on the disposition of qualified small business shares or qualified farm or fishing property, to a lifetime maximum amount. Within the current landscape, multiple family members can claim the LCGE provided that they are legal owners of the business. Should the proposed changes take effect, only adult family members who are actively involved in the business, through their sweat equity labour contribution, by taking on risk or contributing capital, can use the capital gains exemption on the sale of qualified shares.

This change is taken one step further with respect to discretionary family trusts. The proposed rules state that gains accrued during the period in which a trust owns the share will not be eligible for the LCGE. This has several implications that business owners need to be aware of, especially surrounding the sale of shares for business succession or estate planning. Business owners need to consider whether they are going to sell their company and the possible method of the sale before deciding to use a trust to hold corporate shares. These rules will apply not only to dividends, but to any gains on shares owned by the trust.

In many cases, this will significantly limit or eliminate any possible tax advantage that could previously be gained through the use of trusts.

Future planning considerations

In light of the government’s proposed changes, business owners and family members using trusts as part of their financial planning should consider the following steps:

  1. Take advantage of the current landscape. The proposed rules will not take effect until January 1, 2018, which provides business owners an opportunity to make the most of the remaining time. In situations where income splitting makes sense, business owners are encouraged to consider taking full advantage of the current tax law to reduce the total family tax burden.
  2. Consider the future of shares held in trusts. The proposed loss of the LCGE for some individuals on the sale of qualified small business shares means that owners must give careful consideration to whether those shares are likely to be sold in coming years. There is an election that owners, spouses or adult family members can make in 2018 that allows you to bump up your cost base to an amount between cost and fair market value and thus gain access to the LCGE. However, before making this election, owners are strongly encouraged to speak to their tax advisor to ensure that this is the appropriate course of action.
  3. Evaluate the contents of your trust. Not everything that can be held within a trust will be caught by the new rules. For example, if you have a family trust, of which your children are beneficiaries, with an investment portfolio that makes $5,000 a year from a mutual fund, that amount does not appear to be caught by these new rules as it is not income coming directly or indirectly from a small business. However, if your corporation pays a dividend into the trust next year and the trust uses that for investment, it could “taint” funds such that the income from those investments may become caught by these new provisions, to the extent that the income is subsequently distributed to your children under the age of 25. Individuals are encouraged to take a close look at what is currently held within the trust, whether shares or funds should be pulled from the trust before the implementation of these provisions, and whether the trust should be frozen and a new trust created.
  4. Prepare for change—but don’t hit the “go” button just yet. Now is the perfect time to re-evaluate your tax strategy in light of the proposed changes. As the year progresses, it is likely that tax advisors and lawyers will be busy helping clients prepare for these changes, so business owners are encouraged to reach out now. Once you have created your new plan, hold tight. Further changes or modifications to these proposals may occur and you need to remain ready to adapt.

Recommendations on how to provide feedback on the proposed changes

Trusts can offer advantages in many situations. Tax advantages gained through income splitting and access to the LCGE were only some of the benefits that trusts could provide. Trusts are still useful in many situations, including: providing greater privacy to protect the business, separating ownership and control of assets held in the trust and the ability to, in the future, decide which beneficiaries will benefit from trust property.

While the changes put forth by the Department of Finance have yet to be finalized, the materials released surrounding income splitting and capital gains include draft legislation and a detailed whitepaper. We can assume that there will be minor tweaks and modifications before these changes become law. Despite this, all Canadians affected by these and other proposed changes are strongly encouraged to share their opinion on these measures by providing feedback to their advisors, and communicating with relevant professional organizations.

Trusts will remain an important part of the financial planning landscape for small business owners, but a re-evaluation of your current trust use should be a priority. For advice and support on these proposed changes, speak to your BDO advisor.

View all of BDO's related content in our Private Corporation Tax Changes Round-up resource.

Contributor

Eric Wipf
Partner, Canadian Tax


The information in this publication is current as of September 8, 2017.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.