ATTRIBUTION RULES

The Income Tax Act (ITA) contains a number of attribution rules which are meant to prevent the splitting of income and capital gains where property is transferred between persons who do not deal with each other at arm’s length including trusts. The attribution rules will generally deem the income on the property or an amount which approximates such income to be the income of the transferor and not the transferee.

SUBSECTION 75(2) REVERSIONARY TRUST RULE

Subsection 75(2) of the ITA contains what is known as the reversionary trust rule. Where the conditions set out in subsection 75(2) of the Act are met, all income and capital gains earned on property held by a trust will be automatically deemed to be the income or capital gains of the person who contributed such property (“Contributor”) to the trust. The conditions for triggering subsection 75(2) of the Act are as follows:

1. 1. property is held by a trust created in any manner whatever since 1934; and

   1. 1. the property or property substituted for it may either revert to the person from whom the property was directly or indirectly received; or

      2. the property may pass to persons to be determined by the Contributor at a time subsequent to the creation of the trust; or

      3. during the existence of the Contributor the property shall not be disposed of except with the Contributor’s consent or in accordance with the Contributor’s direction.

This attribution rule will apply to all income or losses from the property or substituted property and any taxable capital gains or allowable capital losses from the disposition of the property or substituted property. Subsection 75(2) of the ITA only applies during the time in which the Contributor is in existence and resident in Canada. The reversionary trust rule applies on a property by property basis and not to all of the income of the trust. Furthermore, subsection 75(2) does not apply to business income and losses generated by a trust. The attribution rule also does not apply to income earned by the trust on income. There are limited exceptions to subsection 75(2) for trusts set up for employee benefit plans, non-resident pension trusts and qualifying environmental trusts.

Dividends which are attributed to an individual as a result of the application of subsection 75(2) will retain their characteristic as dividends50 and be eligible for the dividend tax credit. The capital gain or capital loss which is deemed by subsection 75(2) of the Act to be the gain or loss of the Contributor will also be deemed to be a gain or loss for the purposes of the capital gains exemption in section 110.6 and the non-capital loss rules in section 111. Therefore, where the attribution rule in subsection 75(2) applies, there is a flow through of losses as well income and income will retain its characteristic when attributed out to the Contributor.

Accordingly, the key conditions for triggering the reversionary trust rule are that the property may revert to the Contributor or the Contributor can either determine to whom the property will be transferred or can veto any distribution. The reversionary trust rule can be triggered on a direct or indirect contribution and therefore may be inadvertently triggered where property was transferred from one individual to another and then to a trust for the benefit of the first mentioned individual.

The administrative position of the CRA is that the reversionary trust rule will not apply where property reverts to the Contributor strictly by operation of law such as where there has been a failure of the trust. The CRA has indicated that where a Contributor has the right to use property which is held by a trust, the reversionary rule could apply.

In order to avoid the application of subsection 75(2) of the ITA, we ensure that the terms of the trust provide that the contributed property or any property acquired in substitution for such original property cannot revert to the Contributor. One method of doing this is to ensure that the trust is settled by a person who is not a beneficiary or a trustee and including in the trust a clause stipulating that the capital of the trust can never revert to the settlor or any other person who has contributed property to the trust.

In some instances we wish to have subsection 75(2) apply, such as where the Contributor is exempt from income tax or will be taxable at a rate which is lower than the rate which would be applicable to the trust. Subsection 107(4.1) of the ITA provides that if subsection 75(2) applies to a trust, the normal rollout rule in subsection 107(2) of the ITA (see below) will not apply while the Contributor is in existence. The denial of the rollout does not apply if the property is transferred out of the trust to the Contributor, a spouse of the Contributor or another individual who is entitled to receive property on a tax deferred basis under subsection 73(1) of the ITA.

GENERAL ATTRIBUTION RULES

The general attribution rules are contained in sections 74.1 to 74.5 of the ITA.  These rules will attribute income and capital gains on property held by a person including a trust back to the person who directly or indirectly contributed the property to the trust. There is also an attribution rule for persons who have entered into a transaction with a corporation which enabled the trust to acquire shares of such corporation. The general attribution rules require that there be a transfer of property. A transfer includes a sale and a gift.

The attribution rules will apply where an individual transfers or loans property to a trust and a “designated person” in respect of the transferor is a beneficiary of the trust. “Designated person” is defined in subsection 74.5(5) of the ITA to be a spouse, a person who is under the age of 18, and either deals not at arm’s length with the transferor as well as the nieces and nephews of the transferor.

Where section 74.3 of the ITA applies, the income (but not capital gains) of the trust flowed out to the designated person will be taxed in the hands of the transferor. If the designated person is a spouse, the attribution rule will also apply to capital gains realized by the trust on the property. The attribution rules do not apply where property is sold to the trust by the transferor for fair market value consideration. However, if the trust is a spousal trust, the spouses must elect out of the automatic tax deferred transfer of property under subsection 73(1) of the Act in order to ensure that the attribution rule does not apply.

Where property is lent to a trust, the attribution rule will not apply if the loan bears interest at the rate prescribed in the Regulations to the ITA.  Where the anticipated rate of return on the investment is higher than the prescribed rate under the ITA, the differential can be taxed in the hands of the designated person and can result in some tax savings where that person is taxed at a lower rate than the person who loaned the funds to the trust.

The attribution rules apply to income from property and not to income from business. Therefore, if the property transferred to the trust generates business income, such income will be taxed in the hands of the beneficiaries at their marginal rates and not be subject to attribution. Subsection 74.4(2) of the ITA is the corporate attribution rule which applies where an individual has transferred property to a corporation and one of the purposes for such transfer was to benefit a designated person in respect of the transferor. This attribution rule can apply where an individual exchanges his or her common shares of a corporation for preferred shares in connection with an estate freeze that enables the trust to acquire new common shares of the corporation and to earn dividend income on such shares. Where the attribution rule in subsection 74.5(5) of the ITA applies, the transferor will be deemed to receive interest on the value of the property transferred (shares) at the prescribed rate. Under this rule there is the possibility of double taxation because it is not an attribution of income earned by a trust but income which is imputed to the transferor. Subsection 74.5(5) of the ITA does not apply where the property is transferred to a corporation which qualifies as a small business corporation within the meaning of the ITA and continues to so qualify throughout the period there is a designated person as beneficiary. A small business corporation is essentially a Canadian controlled corporation that has at least 90% of the fair market value of its assets attributed to assets that are used in an active business in Canada or shares of the capital stock of another small business corporation.  There is also a kiddie tax rule set out in section 120.4 which essentially provides that a minor child receiving passive income directly or indirectly through a trust will be taxed at the highest marginal tax rate where the income is earned on shares of a private corporation except where certain exceptions, as provided for in section 120.4 of the ITA, are set out.

The attribution rules can negate any tax advantages which may be associated with establishing a trust and may also result in double taxation. We often draft into trust deeds provisions that prevent the application of certain attribution rules including provisions that prevent minor beneficiaries from receiving any benefit of the income or capital of the trust until after they reach the age of 18.

There still remain certain income tax benefits that can be obtained from the use of trusts including the multiplication of the capital gains exemption and income splitting amongst children who are over the age of majority. In order to obtain such tax benefits, we ensure that the trust is established in a manner which does not trigger any of the applicable attribution rules.