Clarity from Finance Minister Chrystia Freeland on changes affecting certain trusts could be included in pending draft legislation.Patrick Doyle/Reuters
Canadians using trusts for financial, estate and tax planning purposes are reviewing their structures and effectiveness in light of the pending hike to the capital gains inclusion rate.
Ottawa announced in its latest budget that trusts, alongside corporations, will see their capital gains inclusion rate increase to 66.67 per cent from 50 per cent annually starting June 25. The increase applies to capital gains earned within a trust. Individuals, including those who receive money from trusts (known as beneficiaries), will also see the same 33-per-cent increase but only on capital gains of more than $250,000 annually.
Trusts are used to control assets for beneficiaries such as spouses, minor children and dependents with special needs. They can also protect assets from family law claims, keep assets confidential and lower probate taxes. Individuals and business owners also set up trusts to split income and reduce a family’s overall tax bill.
While saving taxes isn’t always a top priority when setting up a trust, advisers say Ottawa’s changes could cause Canadians to rethink how trusts are used and structured.
“If you’re setting one up from scratch today … you might find there’s a real additional cost,” says Aaron Hector, private wealth adviser and certified financial planner at CWB Wealth Management in Calgary. “It’s going to impact, to an extent, the design of new trusts.”
Frank Di Pietro, assistant vice-president of tax and estate planning at Mackenzie Investments in Toronto, says many trusts flow taxable capital gains directly to beneficiaries. The structure makes even more sense now that the capital gains inclusion rate is being bumped higher.
“It might be advisable for those trusts to distribute taxable capital gains to beneficiaries so they can be taxed personally – at least for those below the $250,000 threshold,” he says.
While trusts designed to flow all income and capital gains to beneficiaries will be affected less by the new rules, Mr. Hector says trustees may want to consider how the gains will impact a beneficiary’s taxes, particularly if it results in more than $250,000 in capital gains for the taxation year.
Trusts that retain all their income and capital gains will be hardest hit, he says, because every dollar in gains will be subject to the higher inclusion rate. An example includes a grandmother who sets up a trust for her grandchildren, with plans to distribute the money to them only when they turn 30. As of June 25, the trust will pay an extra 33 per cent in taxes on any asset gain inside the trust if investments are sold before the grandchildren reach 30.
On the other hand, if the trust distributes the assets to the grandchildren in-kind and at book value when they turn 30, with the unrealized gain intact, the trust wouldn’t realize the gain, Mr. Hector says. The grandchildren would then decide when to sell the investment and bring that capital gain into income on their side.
Mr. Hector says the tax increase might deter some people from using the trust structure.
Trusts are also subject to the new alternative minimum tax (AMT). Fewer people will have AMT exposure under the new rules because the income exemption has been raised to $173,000 from $40,000 for individuals, Mr. Hector says. “But when it does kick in on larger-scale transactions, it’s been redesigned to be way more punitive than the old rules were.”
He says trusts set up to prevent the flow of capital gains to beneficiaries are even more susceptible to AMT because most don’t have access to the $173,000 income exemption. As a result, trusts are more likely to trigger AMT than individuals.
“So, before you rush out and make a sale, check the numbers,” Mr. Hector says. “You may be trying to avoid one rule change and then get captured by the other.”
There are other planning opportunities to avoid paying higher taxes after June 25 on capital gains earned in a trust.
Mr. Di Pietro says trusts are eligible for the same capital loss carry-back and carry-forward rules as individuals, which can help offset gains in a given year.
“It would only really be the case where you have a net capital gain that you might look at flowing out those gains to the beneficiary,” he says.
Maili Wong, senior wealth adviser and senior portfolio manager with The Wong Group at Wellington-Altus Private Wealth Inc. in Vancouver, says trusts can also use life insurance to offset higher taxes and help preserve an estate.
She notes that assets moved into a life insurance policy, including policies owned by trusts, may be tax-sheltered when the trust is the owner, payor and beneficiary.
“It creates a tax-free lump sum of money that will be paid upon the passing of the lives insured [who can be the business owners], and it’s liquid, so it can help pay the higher amount of taxes owed,” Ms. Wong says.
She adds that the 21-year deemed distribution rule for assets held within a trust doesn’t apply to life insurance policies held by a trust in Canada.
“Life insurance was a good tool before, but it could be even more important now,” Ms. Wong says.
Ethan Astaneh, a wealth adviser at Nicola Wealth Management Ltd. in Vancouver, says some Canadian families might consider adjusting their investment allocation within trusts in favour of more efficient dividend-income strategies to manage capital gains income.
“On a relative basis, dividends are more attractive due to the dividend tax credit that can apply,” he says. “Also, dividends don’t trigger the alternative minimum tax in the same way capital gains do when income is paid out to a beneficiary.”
He adds that the dual impact of increased capital gains in trusts and the AMT on the personal side could warrant a shift to a more dividend-focused strategy.