Subsection 75(2)

The following article on subsection 75(2) of the Income Tax Act (Canada) appeared in the latest edition of the Hamilton Law Association Law Journal.

1 A former colleague of mine at a national accounting firm who is an expert in the taxation of trusts and estates once told me that, every now and then, she wakes up in a cold sweat late at night asking anxiously about some file or plan “Have I missed a 75(2) issue?”

Outline of Subsection 75(2)

2 Subsection 75(2) of the Income Tax Act[1] is an attribution rule that can apply in respect of property (or property substituted for that property) contributed to a trust by a person (the “contributor”). The subsection will apply if the property “is held on condition” that it

(1) may revert to the contributor,

(2) may pass to persons to be determined by the contributor, or

(3) shall not be disposed of except with the contributor’s consent or in accordance with his or her direction.

Consequences of the Application of 75(2)

3 What are the tax consequences if subsection 75(2) applies? First and foremost, subsection 75(2) is an attribution rule: the Act deems the contributor to be the recipient of all income or capital gains derived from the property while the contributor is alive and a resident of Canada for the purposes of the Act. If Mr. X contributes $1,000 to a trust of which he is a capital beneficiary, and the trust earns $100 of income interest using that contribution, Mr. X will be deemed to earn the income, not the trust. He will be required to report the income in his tax return in the year in which the trust earns it.

4 What is worse, however, if subsection 75(2) applied at any time to a trust, the trust will not be entitled to transfer capital property to a beneficiary on a rollover basis except in limited circumstances. A personal trust may transfer capital property to a beneficiary in satisfaction of all or a part of the beneficiary’s capital interest in the trust. In general, upon making such a transfer, the trust is deemed to dispose of the property for proceeds equal to the cost of the property; the beneficiary receives the property with that same tax cost. Neither the trust nor the beneficiary pays tax merely because of the transfer. This rollover, however, may not be available if subsection 75(2) applied at any time to the trust. In fact, the rollover may not be available even if income or capital gains aren’t actually attributed to anyone. For example, assume that Mr. X, instead of contributing $1,000 to the trust in the previous example, gave it a gold coin. Assume that the trust never disposes of the gold coin. Subsection 75(2) is still applicable to the trust because the coin could revert to Mr. X (he is a capital beneficiary). As a result, the trust will not be entitled to transfer any of its capital property (not just the gold coin) to its beneficiaries on a tax-deferred rollover basis, and the beneficiaries will be unhappy.[2]

5 Subsection 75(2), then, is to be avoided. What must practitioners guard against? A review of all of the ins and outs of the subsection in light of the administrative practices of the Canada Revenue Agency (the “CRA”) is beyond the scope of this article, but the following guidelines should help with the more common situations encountered when establishing a trust.

Contributions

6 Subsection 75(2) presents problems for taxpayers partly because “contribution”, especially as the CRA interprets it, includes almost any transfer of property to a trust. The question then becomes whether the trust holds the property on the conditions outlined in subsection 75(2) outlined above. Genuine loans are not caught, but the CRA will look closely at a loan to determine whether it is genuine. The CRA will look for a written loan agreement under which the borrower agrees to repay the loan within a reasonable period of time. The CRA might also expect the trust to provide security for the loan, pay interest on it or make regular payments of principal and interest. The question is whether the loan is “exterior and independent from the terms and conditions of the trust.”[3]

7 Howson v. The Queen[4], however, shows that the CRA’s requirements will not always be those of the courts. The Howsons wished to immigrate to Canada from South Africa. As part of the move, they established the Howson Family Trust. Mr. and Mrs. Howson were beneficiaries of the trust. In June, 1994, the Howsons advanced funds to the trust. In June, 1997, the trust executed a loan agreement in respect of the advance, which agreement purported to be pursuant to an oral agreement effective as of the date of the advance. The agreement allowed, but did not require, the lender to charge interest. The lender was also entitled to demand repayment on three-months’ notice. The agreement also required the trust to repay all capital and interest owing on the loan within 10 years from the date of the advance.

8 The CRA tried to argue that the Howsons had contributed funds to the trust and that the funds were held on condition that they could revert to the Howsons. The Court disagreed.

[15] It stands to reason that a bona fide loan is, on its face, not subject to reversion by the terms of the Trust. It returns to the lender by operation of the loan itself and the law of creditor rights. The Respondent did suggest that there may be circumstances where an arrangement that may look like a loan could be caught by this condition of reversion. The Respondent did stress, however, that this was not one of those cases. This was simply a case of there not being a loan, but that the 748,000 Rand on balance represented a contribution to the corpus or capital of the Trust. With respect, I disagree.

9 The Court held that the parties intended, and created, a valid loan in 1994 so that subsection 75(2) did not apply to the trust. The Howsons testified that they always intended that the funds would be repaid. The agreement was signed after the fact, but there was no evidence to suggest that it was anything other than what it purported to be: a document that set out on paper the pre-existing agreement between the parties. Moreover, financial statements for the trust in 1996, 1997 and 1998 reflected the amount advanced as a loan. The Court even held that the use of sophisticated tax advisers made it extremely unlikely that the parties would be mistaken about such a simple point (the nature of the advance). The Crown also argued that the fact the arrangement did not provide for interest or security suggested no bona fide loan existed. The Court disagreed. The Court pointed out that legally a lender need not charge interest or require security. The Court also noted that it would have been silly for the lenders to require security when the borrower was a trust for the benefit of the lenders and their children.

Contributors

10 Assuming that a contribution has been made to a trust, the analysis under subsection 75(2) is driven by the identity of the contributor of a trust, questions about his or her entitlement under its terms and his or her continuing power, if any, over the trust’s property.

Entitlement

11 If an individual settles $100 on a trust, and the individual is a capital beneficiary of the trust, then subsection 75(2) will apply. So much is obvious. According to the CRA, however, the subsection will also apply even if the reversion is only possible but not probable. If Grandfather contributes a coin to a trust and the trust provides that the coin will revert to him if the trust’s beneficiaries—his eight grandchildren—pre-decease him, then subsection 75(2) will apply to the trust. The subsection applies even though the reversion is highly unlikely (because it is highly unlikely that Grandfather will survive all eight of his grandchildren).

12 What happens if Mr. X transfers property to a trust, Mrs. X is one of its beneficiaries and Mrs. X, by the terms of the trust, is given a power of appointment that she can exercise through her Will. The CRA has taken the position that subsection 75(2) will apply to the trust because Mrs. X could appoint her husband as a beneficiary of the trust and so trust property could revert to him. To anticipate this result, the trust agreement should contain a clause preventing the spouse from directing trust property to her husband in her will.[5]

13 The CRA has stated that the position will be different where the property could revert to the contributor merely because the spouse’s estate will acquire trust property and that property could be distributed to the husband.[6]

14 What about common disaster clauses? A trust agreement might provide that, if no beneficiaries of the trust remain, then its property should be distributed in accordance with the rules that would apply where the spouse or some other relative of a contributor died intestate. Under those rules, trust property could revert to the contributor. Will subsection 75(2) apply? Presumably not because the CRA has stated that subsection 75(2) does not apply if the reversion will occur “by operation of law only […] and not pursuant to any condition under the trust indenture.”[7]

15 In light of the foregoing, the cautious drafter might insert a clause in the trust agreement that specifically prohibits reversion under any circumstances. If a contributor wishes to retain some right to funds transferred to the trust, the contributor should consider lending the funds instead.

Power

16 Assume that an individual settles $100 on a trust. The individual is not a beneficiary of the trust, and the trust document provides that under no circumstances can the $100 revert to the individual. So far, so good. Unfortunately, the individual is also the sole trustee of the trust. Subsection 75(2) will apply, then, because the individual can determine to whom the $100 will pass among the beneficiaries of the trust.

17 What is the result if the contributor is only one of two or more trustees? Subsection 75(2) will not apply if the trust agreement specifies how the property contributed by the contributor must be distributed. Subsection 75(2) will also generally not apply where the trustees have discretion about making distributions, there are two or more trustees and decisions must be made by a majority of trustees or unanimously. The subsection could apply, however, if the trust’s terms provide that the contributor must be a part of that majority.[8]

18 The rationale underlying these positions is difficult to discern and the CRA has expressed its views on this subject cautiously. It has left open the possibility that it could change its approach. Caution would recommend ensuring that the contributor will not be a trustee of the trust and that he or she will not be given any other say in how trust property is distributed.

Summary

19 In reviewing the foregoing, it is apparent that part of the difficulty in working with subsection 75(2) lies in the fact that is has not been the subject of a thorough analysis by the courts and the CRA has taken some relatively aggressive interpretative stances in the hope of stemming tax avoidance.

20 Nonetheless, a lawyer can minimize the risk that subsection 75(2) will apply to a trust by carefully considering the following questions in light of the foregoing discussion:

(1) What property has been or can be “contributed” to a trust?

(2) Who has made or can make contributions to the trust?

(3) Does a contributor have rights under the trust agreement to receive back property contributed to the trust?

(4) Does a contributor have any right to govern the distribution or transfer of property he or she contributed to the trust?

21 The provisions of subsection 75(2), the case law and even the CRA’s own administrative positions allow for more aggressive planning where necessary, but if in a case caution is economical, then simple answers to the foregoing four questions will ensure that the difficulties of the subsection will be avoided.

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[1] R.S.C. 1985, c. 1 (5th Supp.) (the “Act”). All statutory references in this article are to the Act unless otherwise noted.

[2] The Act permits a trust to distribute property on a rollover basis to the person who contributed the property or that person’s spouse even if subsection 75(2) applied to the trust. In addition, the rollover denial rule ceases to apply once the person who contributed the property is no longer “in existence”.

[3] CCH Window on Canadian Tax, ¶8614.

[4] 2006 TCC 644.

[5] CCH Window on Canadian Tax, ¶7386. In fact, the CRA stated that subsection 75(2) will apply to any trust where a person is given the right to appoint new capital beneficiaries, even if the person is unrelated to the contributor. The CRA stated that “We generally consider that subsection 75(2) of the Act applies, with respect to a person who transferred property to a trust, where a trust indenture confers a power of appointment that gives the donee of the power, the right to appoint any person as a capital beneficiary of the trust. In these circumstances, the person who transferred the property to the trust could be appointed as a capital beneficiary.”

[6] CCH Window on Canadian Tax, ¶7098.

[7] CCH Window on Canadian Tax, ¶6993.

[8] CCH Window on Canadian Tax, ¶7022.