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In many Canadian families or family-owned businesses, a simple and straightforward transfer of assets between generations is still very effective. But, as the complexities of today’s society bring issues of asset control, protection or tax reduction to the planning forefront, the use of formal trusts is increasing.

Trusts are structures through which property or assets are managed and administered in the interests of the trust’s beneficiaries. Trusts can be set up for tax and non-tax reasons. Clients might want to set up trusts for:

  • Income splitting to lower the family tax burden
  • Protecting assets for infants or mentally disabled or incompetent individuals
  • Estate freezes
  • Advisors who encounter trusts, either by assisting clients in setting one up, or becoming involved in a trust setup for a client under a will, can make the best investment selections for trust assets if they understand the basic rules.

    For an advisor, the usual “Know Your Client” is the best starting point. The “settler” of the trust (typically the individual who owned the assets and set up the trust) usually names the beneficiaries in the trust document. The beneficiaries can be “income,” “capital” or “income and capital” beneficiaries. An income beneficiary is entitled to the income of the trust, which is under the rules for trusts, interest, foreign or dividend income — but not capital gains or capital. A capital beneficiary is entitled to any proceeds from the sale of trust assets, dividends that are part of a corporate capital distribution or the proceeds of share redemptions, or to any of the original trust assets. The “trustee” is the party named to administer and oversee trust assets. Advisors can work with trustees to manage and invest trust assets.

    The investment rules

    One of the most important duties of a trustee is making investment decisions that make sure the trust meets its set objectives. The trustee must make investments to generate income for income beneficiaries or capital gains for capital beneficiaries ح or may need to produce a combination of the two for certain beneficiaries. Most provinces have specific legislation, referred to most often as the “Prudent Investor Rules.” These rules provide guidelines for trustees and their financial advisors to use when investing trust assets. The basic rules include:

  • Standard of Care: The trustee must exercise the care, skill, diligence and judgment that a prudent investor would use in making investments.
  • Authorized Investments: The trustee can invest trust assets in any form of investment that a prudent investor might choose.
  • Investment criteria: The trustee must consider the following in planning to invest the trust assets. These are in addition to any other criteria listed in the trust document:
    • General economic conditions
    • Possible effect of inflation or deflation
    • Expected tax consequences of investment decisions or strategies
    • Role that each investment or investment activity plays with the overall trust portfolio
    • Expected total return from income and capital appreciation
    • Liquidity requirements, regularity of income and preservation or appreciation of capital

    Here is a possible scenario. Duane is the trustee of a trust his late father set up in his will. Duane’s father wanted $100,000 of his estate to be held in a trust for Duane’s two young children, to be used for university tuition and to meet any needs that Duane, as trustee, feels are justified. The trust will continue until the youngest of the children reaches the age of 35. As the children are currently aged 8 and 5, this means that the trust will exist for 30 years. Each child is able to receive income and capital from the trust.

    Duane and his financial advisor establish a portfolio intended to provide primarily capital growth and minimal income. This is because the children are young and will not need income in the near future. As the children grow and their income needs increase, Duane and his advisor can add income-generating investments or reallocate assets periodically to accommodate the income needs of the children. As an overall strategy, maximizing compounding makes sense, and should be taken into consideration due to the long investment timeline. If a lump sum is needed for a particular child (such as funding for a car), Duane can withdraw capital from the trust. A capital distribution is non-taxable to the beneficiary.

    As the trust will exist for 30 years, Duane and his advisor will have to pay attention to any unrealized capital gains in the trust before the 21st anniversary of the trust. This is to ensure that no unanticipated tax will be payable. The 21-year rule is a special tax rule that forces a trust (other than qualifying spousal trusts or a revocable trust) to pay tax on unrealized capital gains every 21 years, unless the assets are transferred outright to the beneficiaries. The 21st anniversary of the trust would be the 21st anniversary of Duane’s father’s death.

    Investing in a trust takes strong investment expertise — and advisors can play an important role. While a trustee cannot be held liable for a loss to the trust due to a general market downturn, beneficiaries can make a case against the trustee if investment of the trust assets did not use reasonable assessments of risk and return.

    Carol Bezaire, PFPC, TEP, CLU, is the vice-president of tax and estate planning at Mackenzie Investments. Carol can be contacted at: cbezaire@mackenzieinvestments.com
    Originally published on Advisor.ca