Family Trusts: CRA statement regarding “phantom income” underlines the importance of thorough Family Trust drafting

Sean Rheubottom, B.A., LL.B., TEP

At a recent CALU roundtable, the CRA made a statement about an issue relevant to Family Trust drafting. The statement shows how important it is to cover seemingly obscure or unlikely tax issues when drafting a Family Trust. This example is relevant in situations where large capital gains are being realized, as discussed below.

“Phantom income”

Certain amounts or events are treated as “income” under the Income Tax Act (ITA) of Canada, but under trust law, they are “nothing”. That is, trust law does not recognize the amount as income or capital that could be distributed to a beneficiary, because there is no actual amount. However, even though no actual amount has occurred or changed hands, an income inclusion may have been triggered under the ITA and the trust will have to pay tax on that amount. Ideally, the Trustee of the Trust wants to “pay” that amount out to beneficiaries who pay lower rates of tax. Essentially, the Trustee wants to put that income on the beneficiary’s tax return instead of the Trust’s return. But as noted, trust law doesn’t recognize that any income has occurred - so it can’t pay anything out, unless there are special provisions in the Trust to modify how trust law applies.

A trust must specifically authorize payments of “phantom income”

The CRA indicated that where an amount included (under the ITA) in the taxable income of a trust is not recognized as income or capital for trust law purposes (this is “phantom income”), the terms of the trust must specifically permit or authorize at the trustee’s discretion an amount equivalent to the phantom income to be paid. Otherwise, the amount can’t be paid out to a beneficiary, and higher tax may result. Sometimes extremely high tax, as discussed below.

This recent CRA statement was made in the context of a question about “foreign accrual property income (FAPI)” received from a “controlled foreign affiliate” (CFA). CRA has made similar statements about “phantom income” from a trust in several other contexts involving taxable income triggered by certain elections or deemed amounts.

This affects “21-year planning” for Family Trusts

There is a scenario that is not uncommon in typical Family Trust administration, in which the special provision about “phantom income” is very important and CRA’s comments are applicable. To get the desired tax result, the phantom income provision must have been included from the time the Trust was drafted. If it was not included, it may be possible to apply to the court for a Trust variation, but complex tax and legal issues may arise.

The common situation is the winding up of a Family Trust in advance of the “21-year rule” under the ITA. As explained here, the 21-year rule says that on the 21st anniversary of the creation of the Trust, and every 21 years thereafter, the Trust is deemed to have disposed of its assets for proceeds equal to fair market value (FMV).

Basic “rollout” plan

Very large capital gains may result. For example, let’s say you “froze” your interest in your private business corporation, using a Family Trust. In a typical “estate freeze”, the shares initially owned by the Family Trust would be worth a nominal amount like $100. As the family business grows, normally all the growth accrues to the shares held by the Family Trust. 21 years later, that $100 worth of shares may be worth much more, let’s say $5 million. If the 21-year anniversary happens and the shares are deemed disposed of, that’s a $5 million capital gain, and it’s going to be taxed in the trust at the highest marginal rate. At today’s tax rates, the tax would be close to $1,900,000. We don’t want to let that happen. The simplest solution is to distribute the shares to beneficiaries of the Trust before the 21-year date occurs. The tax rules applicable to Trusts allow the shares to be “rolled out” to a Canadian-resident beneficiary who is entitled to receive capital from the Trust. All Family Trusts should allow this and some even require it. The capital gains do not have to be realized by the beneficiaries until the shares are actually sold. That’s your basic 21-year plan.

Using the beneficiaries’ capital gains exemptions while maintaining control

However, sometimes there is a better tax plan. But your Trust has to specifically authorize it.

With a typical family owned business, the “capital gains exemption” is available, meaning essentially that anyone who realizes gains on the disposition of the shares can realize approximately $900,000 in gains without paying tax. In some cases it would be nice to simply allow the deemed capital gains to occur, but pay the taxable portion of the gains to beneficiaries, each of whom can use their exemption, sheltering some or all of the amount from tax, depending on the number of beneficiaries. The shares get a bumped-up “adjusted cost base” which reduces tax accordingly when the shares are later sold. The interesting thing about this plan is that the shares may not even have to be given to the beneficiaries - so you and your Trustee maintain more control over the value.

But there’s a hitch.

Normally when a Trust realizes a capital gain, for example by selling something it owns, or actually transferring something out to a beneficiary, the Trustee can pay out to the beneficiary the taxable portion of the gain (which happens to be capital for trust law purposes, but is income for tax purposes). But the problem is that in our scenario, this “gain” is merely a deemed disposition, not an actual sale or transfer. Under trust law, this amount is not income or capital - it’s nothing. It’s “phantom income”, or income only for tax purposes.

And as discussed above, CRA says that if your Family Trust does not specifically authorize payments of “phantom income”, it can’t be done. In that case, your deluxe 21-year tax plan may not be possible.

This issue underlines the importance of understanding the interaction of trust law and tax law when planning and drafting a Family Trust.

© Heritage Private Wealth Law

General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.