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FROM: SEP-OCT 2007 ISSUE | BY FRANCINE ST-ONGE
The Income Tax Act contains a series of rules known as attribution rules. These can cause any income realized on property transferred to other taxpayers to be assigned back to the transferor of the property, and they apply where the property is transferred directly or via a trust.
Attribution rules do not apply to a testamentary trust (one created on the death of the taxpayer), since the property transferred to the trust comes from a deceased person who no longer files income tax returns. In the case of inter vivos trusts, the attribution rules apply when the person who has transferred or lent property to the trust resides in Canada.
The most misunderstood attribution rule, and one that often poses a problem because of its scope, is the rule contained in subsection 75(2) of the Income Tax Act. This rule stipulates that trust income is attributed to the person who transferred the property to the trust when that person reserves the right to take back the property or retains some control over it. More specifically, this rule applies under any of the following three circumstances:
- The transferred property, or the property substituted for it, can revert to the transferor. This is the case, for example, where the transferor is the capital beneficiary of the trust. However, when the right of reversion is based in law, as in a situation where the trust no longer has any beneficiaries and the property would revert to the transferor under the legislation governing the trust, subsection 75(2) does not apply.
- The transferred property, or the property substituted for it, can be transferred to persons who may be designated by the transferor after the trust is created.
- During the lifetime of the transferor, the property cannot be disposed of except with his consent or in accordance with his instructions. Thus, the subsection 75(2) attribution rule applies where the transferor is the sole trustee or where he is one of several trustees if decisions must be made unanimously or he has a veto right.
When subsection 75(2) applies, income and capital gains from the property received by the trust from the transferor, or the property substituted for it, are deemed to be income of the transferor and not of the trust. In principle, the trust does not have to include this income in its income tax return. However, the Canada Revenue Agency (CRA) considers that the trust must nevertheless report the income on its T3 return and then deduct the same amount. Also, a T3 information slip must be prepared indicating that the income belongs to the transferor of the property.
The other attribution rules that require attention apply when the spouse, common-law partner, or minor children of the person who transferred or lent the property to the trust are beneficiaries of the trust (hereinafter called “designated beneficiaries”). In such a case, the income from this property or substituted property, which is paid or payable to these designated beneficiaries and deducted from the income of the trust, is attributed to the transferor.
When capital gains are realized on the transferred property or the substituted property, attribution to the transferor is limited to amounts to be included in the income of the spouse or common-law partner. Note that the attribution rules do not apply to amounts included in a minor’s split income.
To illustrate, say that Pierre transfers property valued at $500,000 to a trust for the benefit of his spouse Julie, his son Luc, 12, and his daughter Mary, 22. During the taxation year, the trust earns interest income of $27,000 and taxable capital gains of $12,000.
The trustee pays $13,000 to each beneficiary during the year, which is comprised of $9,000 of interest income and $4,000 of taxable capital gains, and deducts all amounts paid from the income of the trust.
In this example, Mary, who is an adult, will include $9,000 of interest income and $4,000 of taxable capital gains in her income. Luc, who is a minor, will be liable for tax on the capital gain of $4,000, since the attribution rule on capital gains does not apply to him. Julie has no amount to include in her income. Pierre will have to include $18,000 of interest income and $4,000 of capital gains in his income.
As in all tax planning, it’s imperative to not only recognize the rules which come into play and your understanding of them, but to also consider and research how far-reaching they can be. Many an otherwise valid tax plan has been destroyed by that failure.
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