Trusts are on the Canada Revenue Agency’s watchlist. As a result, clients who use trusts for tax planning will have to be especially vigilant in the future about how their trusts are structured and documented.

Trusts came under the CRA’s eye late last year, when the agency uncovered sloppy paperwork in the documentation of certain inter vivos trusts. Such trusts are sometimes used for income-splitting and are set up during the lifetime of the creator of the trust.

Family trusts are also on the CRA’s radar. These increasingly popular vehicles are typically set up by a family member to hold family assets or to operate a family business in a tax-protected environment.

In several cases recently reviewed by the CRA, the distributions from trusts to beneficiaries were not being paid in cash. Instead, promissory notes were being used. This practice raised concerns that the money or assets from the trust was not actually being paid out to the beneficiaries, explains Jamie Golombek, managing director, tax and estate planning, with Toronto-based Canadian Imperial Bank of Commerce’s private wealth-management division. “There was concern over enforcement, in terms of where the money was going.”

In other situations in which a parent was acting as trustee for children, the CRA was concerned that parents were taking cash out of the trust for their own personal use rather than for the benefit of the children.

“In these cases,” says Golombek, “what the CRA is concerned about is that the trust claimed a deduction for the amount distributed to the children, but then it really didn’t go to the beneficiaries.”

To combat this potential misuse of the trust vehicle, the CRA is now reviewing a number of these trust structures to determine whether they comply with the provisions of the federal Income Tax Act.

The CRA also distributed a PowerPoint presentation among the tax advisory community in December of last year to outline the CRA’s top eight concerns. Chief among those were a trust’s setup, the fees associated with managing the trust and the residency of trusts.

By keeping a closer watch on these items, the CRA is basically “shaking the tree” to see how loosely the rules are being followed, says Jason Safar, partner, tax services, with Toronto-based PricewaterhouseCoopers LLP: “It’s an area that didn’t get checked for a while. And this is a luggage check to see what the pulse of adherence to trust rules is.”

Aside from sloppy record-keeping, says Safar, the CRA also has turned up the heat on family trusts because they have become more popular as tax-planning tools in the past decade.

But because creating a trust doesn’t have the same range of technical requirements as setting up a corporation, there is greater likelihood that some individuals will be less diligent when it comes to the record-keeping that is required when a trust is created.

“Trusts don’t have the same discipline as a corporation that has to file corporate returns,” says Safar. “With a corporate return, you have to file annual financial statements. A trust is more like an individual, and there is no financial statement requirement.”

One of the high-priority items the CRA is asking to see when auditing family trusts is the original “gold coin” that was used to set up the trust. “It’s an administrative housekeeping issue,” says Safar. “The CRA is coming in and saying, ‘Do you have [records of] the original settled property?’”@page_break@The CRA also wants to know that the trust is being properly maintained, says Charley Tsai, vice president of wealth-planning support with Toronto-based TD Waterhouse Canada Inc. : “They want to know if there are trust resolutions in place. Are the minutes of trust meetings being recorded?”

That is why Tsai suggests that clients keep a logbook that records not only the activities of the trustee and the beneficiary when it comes to dealing with the trust but also the location of the trust’s records. Says Tsai: “The more evidence the CRA can see, the better.”

Aside from the records of trust-related meetings, the CRA is also looking for records that the appropriate trust bank accounts have been set up for the trust’s assets, says Tsai: “A trust needs to be set up with a trust account, not as an individual [personal] account.”

For example, if you wanted to open a bank account for a trust, it should be under a trust title, such as “In trust for John Smith” instead of directly under the beneficiary’s or trustee’s name.

In trusts for which children are the beneficiaries, the CRA wants evidence that shows that the income is in fact going to the beneficiary. The CRA needs as much proof as possible that the deductions made from a trust are solely for the benefit of the child beneficiaries. This means keeping a record of all receipts and expenses that have been paid to the children, says Safar: “They want to make sure the actual filings of the trust match the actions of the trust.”

Although it is possible to allocate income to a beneficiary without paying it out, adds Safer, in those cases, the CRA wants to know if a promissory note is in place, so that the CRA can monitor who the payee is. In essence, he says, the CRA wants to know whether the trustee paid “the person you said you were going to pay.”

The issue of a trust’s residency — the jurisdiction in which the trust pays taxes — has been another issue to come up in the past year. Prior to the judgments in Garron Family Trust v. The Queen, and Paul Antle v. The Queen, which were both released in 2009, determining a trust’s residency used to be relatively straightforward: residency turned solely on where the majority of trustees for the trust resided, says David Louis, chairman of the tax group in Vancouver with Toronto-based Minden Gross LLP. “You could set up a trust in Barbados and, as long as two of the three trustees resided there, it was considered a Barbados trust.”

But as a result of the Garron ruling, which involved a resident of Toronto controlling a trust that was registered in Barbados and had a trustee resident in Barbados, there is a new test for residency. That test uses the “central management and control” of the trust to establish the jurisdiction in which the trust will be taxed. So, if a trustee is resident in the low-tax jurisdiction of Barbados but the trust is effectively controlled by a Canadian resident, the trust will be subject to taxation in Canada.

Garron has huge implications for offshore trusts and interprovincial trusts that involve a low tax rate province like Alberta, says Golombek, because residency of the trust had been a strategy used to help affluent clients obtain a lower tax rate than what was applicable in their home jurisdiction — which typically was where the wealth was generated to begin with. With offshore trusts, many wealthy Canadian families had been exempt from paying Canadian taxes altogether. Says Golombek: “Clients are now really going to have to be mindful [about where the trust is resident].”

The Garron case is being appealed, however, which could make the situation even more confusing, depending on the result. Says Safar: “It’s an area that is in flux.”

It’s unlikely the CRA will back off on the trust issue any time soon, given their growing use.

Says Safar: “Families are becoming more aware of how flexible trusts can be, which has increased their popularity.”

IE