Most tax advisors are aware of the income tax rule which will deem a personal trust to dispose of and reacquire its assets on the 21st anniversary of the trust for an amount equal to the fair market value of the trust assets at that time. Often referred to simply as the ‘21-year rule’, planning steps should be undertaken prior to the 21st anniversary to mitigate the tax impact of any accrued, but unrealized capital gains, which may arise as a result of the deemed disposition. These steps often involve a distribution of the trust assets to the beneficiaries, which may generally occur on a tax-deferred basis where the beneficiaries are Canadian tax residents.
Failure to plan for the 21-year rule may be a significant issue for a trust owning assets which have increased substantially in value over the years. Consequently, the trust may struggle to raise sufficient cash in order to finance the tax liability on the deemed disposition. This may be the case with trusts which are put in place to hold private company shares, which is a situation common to many private company ownership structures. Similarly, trusts which have non-resident beneficiaries may not be able to take advantage of a tax-deferred distribution of trust assets and in such cases, additional planning steps may be required.
From a practical perspective, it is not difficult to imagine scenarios where the 21st anniversary could be missed. In certain circumstances in the past, personal trusts have not been required to file annual income tax returns. This is the case where the trust has no income or makes no capital distributions in a year. If the only trust assets are the shares of a private company, a trust return may not have been filed for a number of years, provided the shares haven’t paid dividends or personal use real estate. Therefore, tracking of the 21st anniversary may not be top of mind for the trustees.
The 2018 Budget introduced new measures which now require annual reporting and filing of trust returns starting in 2021. The changes will apply even in situations where the trust has had no activity during the year. While the increased reporting requirement presents an additional annual compliance cost for trustees, it would help to serve as a reminder each year to monitor the age of the trust. Additionally, it will allow for appropriate planning steps to be taken well in advance of the trust’s 21st anniversary.
21-year planning and GAAR
As prudent advisors plan for the 21-year rule, the impact of the General Anti-Avoidance Rule (GAAR) to certain types of planning arrangements should also be considered. It is not uncommon for situations to arise whereby the trustees determine that control over the trust assets should remain with the trustees. This could be the case with private company shares owned by the trust for the benefit of individuals who are not involved in the business (i.e. a trust set up for the benefit of grandchildren may come upon the 21- year rule while such individuals are still of school age).
The CRA provided their view1 on a particular series of transactions whereby the trust (Old Trust) assets were distributed to a Canadian resident corporate beneficiary (Canco). Canco was owned by a newly established discretionary trust resident in Canada (New Trust). As a beneficiary of Old Trust, Canco would generally be able to receive the assets of Old Trust on a tax-deferred basis. The result of the transaction effectively reset the 21-year clock by introducing New Trust into indirect ownership over Old Trust's assets. Specific rules in the Income Tax Act deny the ability to reset the 21-year clock by transferring Old Trust assets directly to New Trust. Simply interposing a corporate beneficiary to circumvent the rules was contrary to the object and spirit of the rules and accordingly, CRA indicated they would apply GAAR in such instances.
The comments and results above are a reminder to advisors and trustees alike to be vigilant when dealing with trusts that are coming up to the 21st anniversary. Having the appropriate expertise when planning for the 21-year rule for a trust is critical to ensure that the trustee and beneficiary objectives can be met in a tax efficient manner.