Part II – Trust Attribution

This blog has been written by Pritika Deepak /Associate at Fasken LLP

This is Part II of a three-part blog series which provides an overview of the ‘attribution rules’ contained in the Income Tax Act (Canada)[1] (the “Act”). Part I, which summarizes the scope and application of the personal attribution rules, can be found here: https://www.allaboutestates.ca/no-good-deed-goes-unpunished-by-the-cra/

Part II of the blog addresses the application of the attribution of income and/or capital gains in certain situations involving transfers or loans to a trust.

Specifically, subsection 74.3(1) of the Act provides that where an individual has transferred or loaned property (directly or indirectly) (the “Transferor”), to a trust in which another individual who is at any time a “designated person” in respect of the Transferor, who is beneficially interested at any time, then any income or loss from the property (or substituted property), or capital gains/losses from the disposition of the property or substituted property (where the “designated person” is a spouse), which would ordinarily be included in the income of the beneficiary as a result of a distribution from a trust, is instead attributed to the Transferor.

The phrases “designated person” and “beneficially interested” are defined in subsection 74.5(5) and 248(25) of the Act, respectively.

Subsection 74.5(5) defines a “designated person” to mean the transferor or lender’s:

(i) spouse or common-law partner, and

(ii) a person under the age of 18 years who either:

a. does not deal at arm’s length with the transferor/lender (i.e. persons who are related by blood, marriage or adoption), or

b. is a niece or nephew of the transferor/lender.

Subsection 248 (25) provides that a person is considered to be “beneficially interested” in a particular trust where they have any right – whether immediate or future, absolute or contingent, conditional or subject to the discretion of the trustees– as a beneficiary to receive income or capital (directly or indirectly) from the trust.

Based on the broad definitions above, the trust attribution rules in subsection 74.3(1) will generally apply to situations involving inter vivos family trusts settled by a family member for the benefit of his or her family, such as spouses, minor children and/or nieces and nephews.

An additional attribution rule outlined in subsection 56(4.1) of the Act may apply in circumstances involving loans to or by trusts. Particularly, this rule applies when an individual or a trust to which the individual has transferred property, makes a loan to a ‘non-arm’s length individual’ (commonly, a related person), including adults, or to a trust in which a non-arm’s length individual has a beneficial interest, and one of the main reasons for making the loan can reasonably be considered to be the reduction or avoidance of tax. As a result of the application of subsection 56(4.1), any income generated from loaned property, property acquired with the loaned property or substituted property is attributed to the lender.

The attribution of income under subsection 74.3(1) and subsection 56(4.1) of the Act can be avoided where loans are made on arm’s length terms. In practice, this means that:

a. The interest charged on the loan is equal to or greater than:

(i) the prescribed rate of interest in effect at the time the loan was made; and

(ii) the rate that would have been agreed on if the parties were dealing with each other at arm’s length, and

b. the interest accrued in a tax year is paid within 30 days after the end of the taxation year.

In the event that the interest payable is not paid within the 30-day time frame (usually by January 30^th or the following calendar year), the attribution rules will apply in that year and every subsequent year in which the transferee continues to earn income from the property that was originally loaned, or from property acquired with the original loan.

For example, consider the following hypothetical fact scenario:

Frank is a successful business owner and founder. He is happily married to Mark, a homemaker, and they have 2 minor children. Frank settles “The Home Family Trust” for the benefit of his spouse, Mark, their 2 children and their issue on January 1^st, 2024, with a gold coin. On the same date, Frank loans $100,000 to The Home Family Trust at the prescribed rate of interest in effect at the time of the loan, being 6%. The loaned funds are used to purchase interest earning investments.

To avoid the application of the trust attribution rules outlined above, The Home Family Trust must pay Frank $6,000 by January 30^th, 2025. Failure to make such payment will result in the attribution of income earned by the investments to Frank. It is important to highlight that such income attribution shall continue to apply for as along as The Home Family Trust earns income from the investments.

Given the punitive nature of the trust attribution rules that may apply, it is important to use effective planning techniques to mitigate or avoid unintended tax consequences.

Stay tuned for Part III of the series which will discuss the corporate attribution rules and some useful planning techniques to avoid the application of such rules.

[1]      Income Tax Act (RSC, 1985, c.1 (5th Supp.)