- Charles Rotenberg
Don't Forget the Interest Payments
Many years ago, high tax individuals used to lend money to spouses and children in order to generate investment income in the hands of lower rate family members. This included loans made directly to individuals and loans to family trusts. The Courts said, in many rulings that a loan is not a transfer. The income attribution rules were amended to include attribution on these loaned monies. If the loan proceeds were used to buy property, say shares of a family company, the attribution rules would apply to have all dividends paid on the shares, and all capital gains realized on disposition of the shares taxed in the hands of the lender. But there is an important exception for loans made that charge interest at the prescribed rate for income tax purposes (currently 1%).
If a high rate taxpayer lends funds to a lower rate taxpayer, or to a family trust, AND interest is charged at the prescribed rate and actually paid, the income and any capital gains generated will be taxed in the hands of the borrower, not the lender.
BUT in order to avoid the attribution of income on the loaned funds and any property purchased with the loaned funds, the interest has to be payable, and actually be paid, no later than 30 days after the end of the taxation year. Accordingly, interest on all interfamily loans designed to split income must be paid on or before January 30th of each year (not January 31st!!). If the loaned funds were used to buy new common shares of a company, the loan might only be a few hundred dollars and the interest may seem insignificant - it is often less than a dollar, particularly if the loan to purchase shares was made late in the year. If the interest is not actually paid, no matter how insignificant, there will be attribution on the income generated by the loaned funds. At the risk of belabouring the point, no matter how insignificant, this interest must be paid by January 30th and a paper trail should be kept. Not only should paperwork be kept to show the payment, but the lender should be including the interest received in his or her tax return for the year of receipt of the interest. A lot of good, and expensive, tax planning could go out the window for the lack of paying two or three dollars of interest.
There is another problem that can arise of the interest is not paid. Many taxpayers establish family trusts for the benefit of their various family members. At the end of 21 years, a trust is deemed to sell all of it property at fair market value, and a substantial taxable capital gain can arise. One of the solutions to this is to transfer the assets out of the trust to the beneficiaries. As long as the beneficiaries are residents of Canada for tax purposes, this can generally be done at the tax cost of the assets, without triggering any capital gain. BUT, if the interest on the loan has not been paid, EVERY YEAR, the ability to transfer the property out of the trust at its tax cost will be lost.
For those situations where the loan was $100 to purchase shares in a family company, the best course is to pay a dividend to the trust as soon as possible to repay the loan in full with interest, so there is no risk of forgetting in future years. But if the loan remains outstanding, don't forget the interest payments.
Changes to Testamentary Trust Rules
As you undoubtedly have read, the rules for testamentary trusts (trusts established under the terms of a Will) and certain other "life interest trusts" changed on January 1st, 2016.
The elimination of graduated tax rates for testamentary trusts is the most notable, or at least the most talked about. Prior to the rule changes, a testamentary trust did need not have a calendar year as its fiscal period, and it paid tax on a graduated scale, rather than at the top personal rate of tax. The difference between having the income taxed at the top tax bracket, and having the income taxed at graduated rates can be as much as $19,000 per year, at today's tax rates, depending upon the province of residence.
In addition, a testamentary trust will now have to remit quarterly installments, and will no longer be entitled to the basic $40,000 exemption in the calculation of Alternate Minimum Tax.
The biggest change, however, is in the deemed disposition rules.
Deemed Disposition on Death
Under the pre-2016 rules, if I leave assets in trust for my spouse for her lifetime, upon her death my estate will have a deemed disposition of the assets at fair market value, and will be liable for the tax arising from that deemed disposition. And, in the year of my spouse's death, she will be liable, on her terminal return, for the tax on any income that she has received in the year of death.
Starting in 2016, the deemed disposition will still take place on the death of my spouse. However, under the provisions enacted by the previous government, all of the trust's income for the tax year, including capital gains arising on the deemed disposition would be deemed to have been made payable to my spouse, and would be included in her terminal tax return. These rule changes would have been particularly onerous where a taxpayer had already died with planning in place that included a trust for his or her spouse - once the taxpayer has died, there is no opportunity to fix the problem.
In the "normal" course (of course, not so normal any more), where the individuals are in a first marriage and there is one group of children as beneficiaries of both estates, this change in rules really would have had little effect - the tax bill would be borne by the children.
However, if I am in a second marriage and leave my assets in trust for my current spouse and then to my children, the previously enacted deemed disposition rules would result in my spouse's estate being liable for the tax on the income in the year of her death, including the tax on the gains that arise as a result of the deemed disposition. This could result in my children getting the assets, and her children getting the tax burden.
The Department of Finance has listened to all of the representations made and, in proposals tabled January 15th, 2016, has reversed this position.
The proposed legislation essentially reverts back to the rules in place prior to the Conservatives' changes: the tax bill on my spouse's death would be paid by the spousal trust instead of falling on her estate.
But, for deaths occurring in 2016, to accommodate those who have done their planning around the previous rule changes, the draft rules also say that my executors and my spouse's estate could jointly elect to have the tax liability for the capital gain taxable in her estate. This could make sense if, for example, her estate has capital losses that would otherwise go unused. But there must be a joint election for this to happen; otherwise, the trust pays the tax.
It is good to see that the Department of Finance is listening.
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