All About Estates

A family trust and its beneficiaries – think twice before including your niece or nephew

Discretionary family trusts used to be a staple in most private company corporate structures. The income splitting benefits were obvious, and professionals were more than happy to implement a family trust in almost any corporate structure. The popularity of using family trusts eventually led to complacency from some professionals in understanding the detailed tax rules that applied to implementing those trusts.

In the earlier years of drafting trust documents, professionals would normally limit the beneficiaries to the shareholder’s immediate family: spouse, children, and sometimes, parents. As time went on, the list of beneficiaries went outside of the immediate family and started to include other family members such as nieces and nephews, and in some cases, non-family members.

This expansion of beneficiaries to extended family members, which seems innocent enough, can become problematic when carrying out corporate restructurings.

The situation

It is typical for a profitable company to build up excess cash, which is not required for active operations. In order to protect this excess cash from potential liabilities, or to ensure that the company remains a small business corporation, a corporate restructuring is usually implemented. The overall objective of the corporate restructuring, regardless of how it is implemented, is to remove the excess cash from the profitable company on a tax-deferred basis.

A common restructuring technique is called a “single-wing butterfly”. This is where the investments are spun off into a separate company through a series of transactions. Without going into detail, this series of transactions results in the reallocation of the investments to a new company on a tax-deferred basis due to the tax-free status of the resulting dividends between the profitable company and the new company.

This spin-off will be accomplished on a tax-deferred basis as long as subsection 55(2) of the Income Tax Act (ITA) does not apply to recharacterize these tax-free intercompany dividends into taxable capital gains. This subsection can apply when there is a significant reduction in the fair market value of the shares of the company, and since the objective of the restructuring is to remove excess cash from the company, it would appear that subsection 55(2) is on the table[1].  In order to avoid the application of subsection 55(2), we need to place reliance on the related party exception contained in paragraph 55(3)(a) of the Income Tax Act.

The problem

This related party exception only applies when there is no disposition or significant increase in interest in a corporation to an “unrelated person”. Therefore, the definition of related person is critical to the its success.

This is where complacency in the set-up of a family trust has led to potential problems. For those shareholder’s that have added their niece or nephew as a beneficiary of their family trust, the ability to rely on the related party exception is more difficult.

The shareholder’s problem lies in subparagraphs (e)(ii) and (e)(iii) of subsection 55(5), which state that a person is only related to a trust if that person is related to each beneficiary of that trust. The definition of related persons under subsection 251(2) of the Income Tax Act does not include nieces, nephews or cousins. Therefore, a shareholder’s “unrelated” niece or nephew, listed as a beneficiary of the family trust, taints the ability for the immediate family to be related to each beneficiary. As a result, no one is related to the trust.

This oversight, both when setting up the family trust and advising on the corporate restructuring, could cause a normally tax-deferred spin-off of excess cash into a taxable transaction.

The moral

Complacency and the Income Tax Act is a dangerous combination.

[1] The purpose of this blog is to discuss the related person status of a trust under paragraphs (e)(ii) & (e)(iii) of subsection 55(5) of the Income Tax Act. In order to discuss these subparagraphs, a high-level discussion of section 55 is required. As a result, readers are cautioned that this high-level discussion lacks sufficient details necessary to properly navigate this complex section.

About John Oakey
National Tax Director for Baker Tilly Canada. John has extensive experience with Canadian corporate and personal income taxes with specialization in the areas of corporate reorganizations, estate planning, succession planning and tax compliance. He also has significant experience dealing with GST/HST issues and U.S. citizen cross-border tax reporting issues.

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