What is the reversionary trust rule?
A trust is a relationship where a person, called the settlor, provides cash or other property in trust for the benefit of others, known as the beneficiaries. Although a trust is not a legal entity for most purposes, it is considered a "person" and a "taxpayer" for income tax purposes. The individual or individuals responsible for managing the trust's affairs are referred to as the trustee (or trustees).
Subsection 75(2) of the Canadian Income Tax Act is an anti-avoidance provision that effectively disregards the existence of a trust when the person who contributed property to the trust can reclaim it or determine who receives it. This provision is very broadly worded and can apply in many unexpected situations. Unlike many other attribution rules, which explicitly or implicitly require an intent on the part of the taxpayer to reduce or avoid tax and/or benefit a related person, subsection 75(2) can apply even if the trust was established for purely non-tax-related reasons.
What is the effect of s.75(2) of the Income Tax Act
If applicable, subsection 75(2) deems that any income, losses, taxable capital gains, or allowable capital losses generated by the trust property—whether directly or indirectly transferred to the trust, or substituted for the property—are to be considered the income, gains, or losses of the person transferring the property, rather than those of the trust, while the person is alive and residing in Canada if:
- The property may revert to the transferor,
- The property may pass to individuals determined at a future time by the transferor, or
- The property cannot be disposed of during the transferor's lifetime without their consent or according to their direction.
The property to which subsection 75(2) applies includes any property substituted for the original property. According to subsection 248(5) of the Income Tax Act, if one property is disposed of or exchanged and a second property is acquired as a substitute, and then that second property is disposed of or exchanged for a third property, the third property is deemed to have been substituted for the original property. This deeming rule continues to apply for any subsequent properties acquired in substitution.
Subsection 75(2) applies not only when its conditions are met in theory but also when the contribution is made directly or indirectly. For instance, if property is transferred to a taxpayer who later (even years after the land transfer) establishes a trust and names the original transferor as a beneficiary, subsection 75(2) may be triggered. Consider a scenario where parents gifts property to their child, who, years later, transfers it to an inter vivos family trust. The primary beneficiaries of this trust are the child's spouse and children, but the trust terms include the parent as a contingent residual beneficiary. In such cases, subsection 75(2) may attribute any income, loss, etc., from the property to the parent.
Exceptions to subsection 75(2) of the Income Tax Act
The reversionary trust rule does not apply in the following situations:
- When the transferor lends cash or other property to the trust at the prescribed interest rate,
- If the transferor ceases to be a resident of Canada,
- If the transferor is no longer alive,
- To most deferred income plans that are trusts, such as registered retirement savings plans, tax-free savings accounts, and registered education savings plans and employee benefits plans.
- If the transferor is only an income beneficiary and cannot receive the property or capital from the trust.
- If the settlor(transferor) is also a trustee, there must be at least two other trustees and decisions are made based on the majority vote.
Pro tax tip – s.75(2) applies as long as there is a possibility of reversion
Paragraph 75(2)(a) can apply whenever, under the terms of a trust, there is a possibility that trust property could revert to the person who contributed it, even if the likelihood of reversion is remote. For example, it may apply when the contributor has a contingent capital interest under a "disaster" clause. The CRA also affirmed this position in Document No. 2002-0162855 that the word "may" implies that the subsection applies even if there is only a possibility that the property reverts to the transferor. It is important to note that the condition found in subparagraph 75(2)(a)(i) of the Act does not involve the notions of control or certainty. However, the CRA also stated that if the terms of the power prevented the settlor(transferor) from appointing the taxpayer, subsection 75(2) would not apply because the property could not return to the taxpayer through the operation of the trust. Therefore, it is highly recommended that taxpayers consult with an experienced Toronto tax lawyer when establishing a trust to avoid the potential trap of the reversionary trust rule.
FAQ:
What is the reversionary trust rule?
Trust income may be attributed to the settlor of the trust under subsection 75(2) of the Canadian Income Tax Act. This provision attributes to the settlor the income from property that the settlor transferred to a Canadian resident trust if either:
- under the terms of the trust, the property may revert to the settlor;
- the settlor has the power to determine, after the creation of the trust, who receives the property; or
- during the settlor's life, the trust can't distribute the property without the settlor's consent.
If a taxpayer settles a trust, and his/her spouse is the trustee, will the reversionary trust apply?
No, as long as the spouse trustee fulfills his/her duty as a trustee and the settlor cannot determine how the trust property is distributed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.