Overview
Discretionary trusts have been used for many years as vehicles for splitting income among family members and reducing a family's overall tax burden. Although income earned by an inter vivos trust is taxed at the highest marginal tax rate, subsection 104(6) of the Income Tax Act (the "Act") provides that in calculating the income of a trust for tax purposes, the trust may deduct any amounts that became payable out of the trust's income to a beneficiary in the taxation year. Correspondingly, subsection 104(13) of the Act requires a beneficiary to include in his or her income for the year any amounts that became payable out of the trust's income to the beneficiary in the year. Therefore, by allocating all of its annual income and "sprinkling" this income among its beneficiaries, an inter vivos trust can eliminate its own high-tax income, while utilizing the graduated (and likely lower) marginal tax rates of its beneficiaries to minimize the overall tax exigible on that income.
In order for a trust to deduct amounts pursuant to subsection 104(6) of the Act, those amounts must have become payable to the beneficiaries in the taxation year. Subsection 104(24) of the Act provides that an amount will be deemed not to have been payable to a beneficiary in a taxation year unless it was: (a) paid in the year to the beneficiary; or (b) the beneficiary was entitled to enforce payment of it in the year. The Canada Revenue Agency ("CRA") has, in a number of instances, published its views regarding the circumstances in which an amount will be interpreted to have been "paid or payable" to a beneficiary.
CRA's guidelines state that making an amount "payable" to a beneficiary in a taxation year is a two-stage process. First, the trustees of the trust are required to exercise their discretion to allocate trust income to a beneficiary prior to the end of the trust's taxation year. The exercise of the trustees' discretion in this regard must be irrevocable, the apportionment of income to each beneficiary (either as a fixed amount or percentage of the trust's income) must be established (to the extent that it is ascertainable), and the entitlement of the beneficiary to enforce payment of the allocated amount in the year must be unconditional.
Once the trustees have exercised their discretion to allocate income to one or more beneficiaries in the manner set forth above, the second stage of the process requires that the beneficiaries be advised of their entitlements before the end of the year. While the CRA acknowledges that legal rights of beneficiaries may arise without these steps being made in writing, best practice would include documenting the trustees' exercise of discretion and the giving of notice to the beneficiaries.
Having established an amount as "payable" in the year, the trustees have the option of actually paying the amount in the year (i.e. by issuing a cheque to the beneficiary). If the trustees decide to issue a cheque as payment of the allocated amount, the cheque should be delivered to the beneficiary before the end of the taxation year and must not impose any additional restrictions on the beneficiary's entitlement (e.g. the cheque cannot be post-dated). Alternatively, the trustees can decide to defer the actual payment, provided that the beneficiary is aware of his/her entitlement and is satisfied to maintain this entitlement as a loan to the trust that is payable on demand and without restriction; this demand loan may be non-interest bearing and, following the advice of CRA, should be evidenced in writing (i.e. by a promissory note).
Finally, CRA has accepted that, in certain circumstances and where permitted by the terms of the trust, payments made from a trust to a third party on behalf of a beneficiary can be interpreted as having been "paid or payable" to that beneficiary. In particular, CRA has stated that, "where an amount of income is not paid directly to the individual so entitled, but is paid to another person for the benefit of the individual pursuant to the individual's direction or concurrence, that amount will be included in the individual's income." In the case of a minor beneficiary, payments to third parties for the benefit the minor (e.g. private school tuition) can be made at the direction or concurrence of the beneficiary's parent or legal guardian, or alternatively directly to the parent or legal guardian as a reimbursement of expenses previously paid on behalf of the beneficiary. As noted above, records such as the receipt of the third party (or the receipt obtained by the parent for the expenditure made on the minor's behalf) should be maintained as evidence of the expenditure for the benefit of the child.
The discretionary family trust has been, and will continue to be, an important tax planning tool. However, the trustees of these trusts should maintain compliance with CRA's published policies in connection with the distribution of income to beneficiaries in order to ensure that they are able to achieve their desired tax planning objectives.