This Blog was written by Joanna Mazin, Estate and Trust Planning Lead at MD Financial Management Inc. which is part of Scotia Wealth Management
In an age when it is becoming increasingly difficult to income-split, here is a planning strategy that could be available to high-income earners who are looking to provide tax-efficient financial support to a low-income child for private school tuition, post-secondary school fees, lessons, camps, or other expenses benefiting the minor: the age 40 trust. It is a trust which meets the requirements of section 104(18) of the federal Income Tax Act:
- Income of the trust is not paid or payable to the beneficiary while under age 21
- The trust was created when beneficiary was under age 21
- The trust capital is clearly vested in the beneficiary
- There are no future conditions on the beneficiary, other than surviving to age 40
- The trust must be wound up before the beneficiary reaches age 40
“Age 40 trusts” are often structured with the following characteristics:
- The settlor transfers funds to the trust to accumulate and grow over the lifetime of the trust. The transfer is often made by way of an interest free loan, or a loan made at the prescribed rate, since it would allow the settlor to have access to the loan capital at any time. The settlor could recall any part of the balance of the loan at any time, up to the full value of the loan. The settlor could also choose to forgive the loan upon their death, in their Will.
- Anyone under age 21 when the trust was created could be a beneficiary of the trust. While not a requirement under the Income Tax Act, financial institutions implementing age 40 trusts often require that there is only one beneficiary per trust to ensure the beneficiary has an immediate fixed right to present or future income.
- The beneficiary could access the capital in the trust, over and above the value of the loan balance outstanding, before the beneficiary turns age 21, and anytime until the beneficiary turns age 40.
- The beneficiary could access the investment income earned after the beneficiary turns age 21, anytime.
Taxation of capital gains:
- Capital gains earned on the trust’s investments are taxable in the hands of the beneficiary rather than the settlor.
Taxation of income:
- Until the beneficiary reaches age 18: If the trust earns income other than capital gains, and the trust was funded with a zero-rate loan, the income will be attributed back to and reported as the settlor’s income. Alternatively, if interest on the loan is charged at the prescribed rate and paid on a timely basis, then the attribution of income back to the settlor can be avoided and the income earned in the trust, would be taxable in the hands of the beneficiary. That income would be capitalized in the trust, even though it is taxed in the hands of the beneficiary.
- After the beneficiary reaches age 18: Regardless of whether the trust was funded with a zero-rate, or prescribed rate loan, any type of income earned in the trust can be reported on the beneficiary’s tax return.
21-Year Deemed Disposition Rule
As with most other types of trusts, under the federal Income Tax Act, an age 40 trust will be subject to the 21-year deemed disposition rule. That is, the trust will be deemed to have disposed of its capital assets every 21 years at their fair market value. This rule does not mean that the trust is terminated or wound up after 21 years (unless the trust deed states otherwise), rather the accrued capital gain is taxed in the hands of the trust, and the trust continues on. Therefore, if such a trust holds appreciated capital property, capital gains will arise on this “deemed disposition” and the trust will pay income tax on such accrued capital gains every 21 years.
Multiple financial institutions offer easy implementation of this type of age 40 trust for their clients with a minimum initial contribution or loan amount and for an annual fee. Individuals considering creating an age 40 trust should review its potential benefits with their professional tax and legal advisors to determine whether this strategy would be appropriate for them.