Editor’s note: The case study below uses fictional characters. Any resemblance to real people is coincidental.
Ling, a middle-aged widow, has a big concern: her daughter Kai is a poor money manager. Ling thought Kai would become more responsible with money as she matured, but, with Kai now in her mid-30s, Ling is worried her daughter’s spendthrift ways will haunt her for the rest of her life.
Ling thus wants to make sure Kai’s inheritance is protected.
For Ling and thousands of other Canadians with similar concerns, the most common options to protect an inheritance are buying an annuity or creating a trust.
The annuity option
An annuity provides a fixed sum typically paid monthly or yearly. Ling can include a direction in her will that Kai’s share of any inheritance is to be used to purchase an annuity, ensuring Kai has a steady stream of income.
Typically, a direction to purchase an annuity is used in more modest estate plans where the cost of a trust is prohibitive. Ling could also invest in a segregated fund with an annuity option for Kai after Ling’s death.
Annuities to protect a beneficiary can be complex. The right option may depend on a range of factors, including the size of the inheritance and the beneficiary’s residency.
The trust option
Trusts allow Canadians to ensure that the needs of specific family members, such as disabled beneficiaries, minor children, spouses and spendthrift beneficiaries, are protected.
There are several factors to consider before deciding if a trust is the right tool to protect Kai, including the choice of trustee. Choosing a family member as trustee might have a detrimental effect on Kai’s relationship with the family, and may make it difficult for the trustee to make prudent decisions regarding Kai’s access to the funds.
Ling should also consider putting investment clauses in the will, which form the road map to how the funds in the trust may be invested. Some clauses to consider are:
Employment of an investment advisor
The provinces’ various trustee acts allow a trustee to retain an investment advisor on a discretionary basis. Ling could include a clause identifying which investment advisor she wants the trustee to retain.
Although the trustee isn’t bound to Ling’s choice, the clause provides guidance and is the best way for Ling to ensure her management team is available to Kai. The clause will also ensure the fees charged by the investment advisor are authorized as trust expenses.
A Haslam clause
Investment advisors often want to use mutual funds. In a trust, mutual funds ensure professional management and diversification. However, there’s a question as to whether an advisor retained by a trustee can use mutual funds.
Haslam v Haslam, a 1994 Ontario decision, held that a trustee’s delegation to an investment advisor does not authorize the advisor to sub-delegate to anyone else.
To remove any uncertainty and ensure mutual funds are available for the trust, a Haslam clause specifically authorizing their use is something Ling should consider.
Definition of income
Typically, a trust has two different beneficiaries: a life tenant and a residual beneficiary. The life tenant is usually entitled to the “net income” earned by the trust, whereas the residual beneficiary is entitled to the residue remaining in the trust when the trust is terminated. A trust may also be drafted to permit the life tenant access to the trust’s capital.
Trust law defines income differently than does the Income Tax Act. For instance, in a trust, a cash dividend (including a capital dividend) is income, whereas a stock dividend or proceeds from a share redemption is capital. For income tax purposes, all dividends (other than capital dividends) are included in income.
Depending on the investment tools used, the divergent definitions of income can lead to investment confusion and administrative burden.
Ling should thus consider whether she wants to include a clause redefining income to comply with tax and investment law as opposed to trust law.
Ability to encroach on the capital
One of the matters Ling must decide is whether Kai, as the life tenant, will have the ability to access the trust’s capital, and if so on what basis. If Ling wants Kai to have that access, she must decide how liberally or conservatively to allow it.
Even if Ling chooses not to allow Kai to access the capital, Ling should discuss with her investment advisor the types of investment tools to use when investing on behalf of the trust. For instance, if the investment advisor wishes to use mutual funds, they may have a return of capital where a small portion of capital is distributed as income. If so, Ling may wish to address this in her will, so the return of capital can be paid to Kai, as opposed to being re-capitalized.
One of the fundamental rules of trust law is that the trustee must consider the needs of both the life tenant and residual beneficiary when making decisions. In Ling’s case, her primary goal is to provide for Kai. Ling should consider including a clause stating that the trustee isn’t bound by the even-hand rule to ensure that, in investing the trust’s funds and in administering the trust, Kai is the primary concern.
Ling has a lot to consider. Once she decides whether an annuity or trust is the right solution for her, she should speak with her investment and legal professionals to ensure the right terms are in her will to protect Kai in the future.
Keith Masterman, LLB, TEP, is vice-president, Tax, Retirement and Estate Planning at CI Investments. He can be reached at email@example.com.