In the earliest days of trusts, the knight would transfer title to his estate to a friend before he left for his crusade. The hope was that the friend would manage the home, land and other property in the knight’s favour and in favour of his family, and then transfer title back upon the knight’s return.
In certain circumstances, the friend would refuse, leaving the knight without the ability to recover his property. Out of this predicament the rules of equity developed such that though legal title to the property might be the hands of a certain person (that is, in “trust”), the “equitable” interest to the property would remain in the hands of the beneficiary—here, the knight, his spouse and his heirs.
Nowadays trusts are used for more prosaic purposes, and most typically to minimize tax. For certain trusts, the trustee might hold the property and distribute income to the beneficiaries as she chooses. The underlying property would appreciate in the hands of the trustee and the deemed disposition of the property on the death of the settlor of the trust would typically be avoided.
21 Year Rule
If not for the Income Tax Act rule known as the “21 Year Rule”, gain on property held in trust could be endlessly deferred. What this rule provides is that on the 21st anniversary of the settlement of the trust, and every 21 years thereafter, the trust will be deemed to have disposed (the “Deemed Disposition”) of its capital property for proceeds equal to the fair market value of that property, and to have reacquired that property for an amount equal to that fair market value.
The accrued gain on assets in a trust after 21 years can be significant, and proactive steps should be taken in order to avoid the tax bill that might otherwise result.
Gain is Pain
There are a number of methods of avoiding this tax. The simplest is to distribute the assets to the beneficiaries of the trust. This may be done on a “rollover”, or tax-deferred, basis in certain circumstances. However, the issue with this is that the trustee may not wish to put the voting or redeemable shares in the family company, or indeed other valuable assets, directly in the hands of the beneficiaries who might not be fully trustworthy, for whatever reason.
Another option is to continue to hold the assets in the trust, but to fix the interest of the beneficiaries such that their interests vest indefeasibly. There are issues with this method also. The flexibility for the trustee to allocate income or capital to one beneficiary as against another would be eliminated. In addition, if all the beneficiaries are of the age of majority and of full capacity, they could demand that the trust be collapsed and the assets distributed to them, with the same result as the first option.
There are other options that attempt to resolve these issues. A capital reorganization might be undertaken to keep voting non-participating shares in the trust while distributing non-voting participating shares to the beneficiaries. This option has its risks from a tax perspective in that the voting non-participating shares might still have value and result in tax to the trust, but might be worth the risk depending on the circumstances.
Other trusts might permit further options depending on their terms. In order to understand all options available, it is important to retain a tax professional to fully consider the terms of the trust deed.
If you are interested in learning more about the taxation of trusts and the 21 year rule, or wish to receive advice on these or other tax matters, please do not hesitate to contact the author at firstname.lastname@example.org.