Workings of a trust in Canada
Ever wondered how trusts work? They are like safety nets for your assets, involving important roles like the person who sets it up (Settlor), the person administers it (Trustee), and the person/people who benefit (Beneficiaries). This article will explain the fundamental workings of a trust in Canada and simplify the inherent complexities in this legal arrangement. Disclaimer: the insights presented here are general in nature, and not a substitute for professional legal counsel – if you want to find out more about trust structures and how/if you could benefit from this, please reach out to our team of experts for a consultation.
In order to legally exist, a trust must hold some property. The settlor is the person who creates the trust by contributing property to the trust. A trusted friend or family member (who is not a beneficiary) could be the settlor of this trust. Because the settlor must gift (or settle) property, this property should usually be of a type that does not generate income. In some instances, a $10 bill attached to the trust document is sufficient.
The trust is administered by persons called trustees. It is common for a family trust to have more than one trustees. In Ontario, the basic duties, rights, and obligations of trustees are set out in the Trustee Act. In addition, the law of equity places fiduciary obligations on trustees. The concept is akin to director’s practical role within a corporation, but not exactly the same from a legal perspective. The trust instrument itself can modify the duties under the Trustee Act, and can also impose additional duties on, or broaden the powers of, trustees.
The trustees have the responsibility for managing the affairs of the trust, selecting the investments that the trust will make and how long the trust will last until it is dissolved. Generally, a trustee owes a duty of loyalty to all the beneficiaries of the trust and is prohibited from acting in a manner which would prejudice any of the beneficiaries. Trustees cannot use trust property for their own benefit unless they are a beneficiary; if a trustee makes a decision on behalf of the trust which benefits the trustee in breach of his or her fiduciary obligations, the other beneficiaries can obtain a court order to divest the trustee of profits even where the beneficiaries were not prejudiced. Trustees must also avoid any conflict of interest that would arise where his or her interests compete with the interests of the other beneficiaries.
In making decisions on behalf of the Trust, the trustees must act with the degree of care that a prudent person would in managing his or her own affairs. Trustees cannot delegate their power to make decisions to anyone, except as provided in the legislation or the trust instrument. When making a decision, trustees must balance the interest of all beneficiaries; decisions which would create an advantage for one beneficiary but would prejudice another are generally not allowed. However, in this case, it is possible to make a distribution to one beneficiary and not another, as this discretion is granted in the trust instrument for the Trust and, provided a decision is made properly, this is not a prohibited decision.
The trustees also determine the distribution of the income of the trust and the distribution of the capital of the trust. This may be set out in the trust document.
For a discretionary trust, the purpose of the trust should be drafted as broadly as possible to allow for payments by the trust for purposes of the welfare and advancement in life of the beneficiaries. Even though the Trust is fully discretionary, the trustees must always turn their mind to the exercise of discretion. If a trustee blindly follows the orders of the settlor or a beneficiary, the trustee may be liable to the other beneficiaries for a breach of trust. When exercising discretion, a trustee must: (a) obtain all relevant information; (b) address how the discretion should be exercised; and (c) act honestly and in good faith. It is generally recommended that the trustee maintain a trust minute book so that the decision-making process is evidenced in the event that a decision is challenged by a disgruntled beneficiary.
The beneficiaries of the trust are the persons who are entitled to share in the income and the capital of the trust. The beneficiaries could be a spouse, their children and or a corporation that is wholly-owned by one or more beneficiaries.
Generally, the children would be described as a class and not specifically named.
It should be noted that any income distributed by the trust to beneficiaries would belong to the beneficiaries.
The trust property will initially be that contributed by the settlor (i.e., a $10 bill and other gifts). Thereafter, the trust will receive other properties. The trust can purchase common shares of a corporation. The trust will need money, which will be gifted by an arm’s-length person.
It is imperative that the property used to settle the trust (the $10.00 bill in our example) be retained by the trustee(s) in a secure place. Failure to retain the trust settlement property may terminate the trust and may cause significant adverse income tax consequences.
It is very important that the Settlor of the trust does not and will not have control over Settlement Property and the disposition and/or distribution of the trust property.
The powers that are conferred upon the trustees will ultimately determine what the trust may and may not invest in. In this case, the powers should be broad so that the trust could invest in virtually anything.
There are two main ways in which income of a trust can be distributed. It can be paid out to the beneficiaries, or it can be made payable to them on their demand.
Therefore, income will have to be paid or payable to the beneficiaries, in order for it to be taxed in the hands of the beneficiaries. This income will belong to the beneficiaries. It is recommended that a separate bank account be kept for the trust.
A trust is not designed to last forever and there are legal rules to prevent a trust from being of indefinite duration. As well, the Act provides for a deemed disposition of the trust’s capital property every 21 years. This means that for tax purposes, the trust will be considered to have sold all of its capital property at fair market value every 21 years. To avoid the operation of this rule, the trust property can be transferred to the beneficiaries within 21 years on a tax-free basis.
Below are some further points concerning trusts.
Rule in Saunders v. Vautier
There is an established principle of trust law (referred to as the rule of Saunders v. Vautier) which can apply where all of the beneficiaries of the trust are of the age of majority, have full legal capacity, are of one mind, and have interests in the trust which are vested and irrevocable. If so, then in some instances the trust may be modified or terminated by the beneficiaries prior to its termination date and without regard to the wishes of the settlor and the trustees.
In order for a trust to serve its purpose, the trust must be irrevocable. As a result, it is extremely difficult to amend the terms of a trust at a later date. However, the trustees do have the ability to decide from year to year which beneficiaries will receive how much money and when/if the trust is discretionary.
Where a parent or grandparent loans or transfers property directly or indirectly, even though a trust, to a child, then any income from the property will be attributed to and taxed in the hands of the parent or grandparent. Capital gains, however, will not be attributed.
Residence of Trustees
Residency of a trust is not determined by the provisions of the Act, but rather by case law. Previous case law suggested that a trust is resident where majority of the trustee’s are resident. However recent case law suggests that the residency of a trust is determined based on ‘mind and management’ of the trust, essentially where the day-to-day decisions of the trust are made.
If assets will be retained in the trust for more than 21 years, the trust will be subject to the deemed disposition rules under the Act. This will also mean that any capital gains not allocated to beneficiaries will be taxed in the trust every 21 years. Please ensure that the trust is structured so that any capital gains arising from the deemed disposition as well as an actual disposition can be allocated to beneficiaries. The trust document should state that deemed income for tax purposes can be paid or made payable to any one or more beneficiaries at the discretion of the trustees.
Trusts, like safety blankets for your wealth, are essential. But understanding them fully is not easy. That is why legal and strategic advice is crucial. Whether you're putting money into a trust, managing it, or benefiting from it, our experts can guide you, ensuring your financial security and peace of mind. If you want to find out more about trust structures and how/if you could benefit from this, please reach out to our team of experts for a consultation.