Informal trust (ITF) accounts have been in existence for a long time in Canada. Now that more clients are moving from country to country, the use and value of these accounts are being questioned. As advisors it’s important that you keep the focus on the purpose and the tax implications of ITF accounts. Here are some points to think about when discussing ITFs with your clients.
ITFs are set up with financial institutions as a savings, investment and possible income-splitting vehicle. Parents/grandparents who contribute to the ITF are the “settlers” and minor children/grandchildren are the “beneficiaries”. A minor cannot be legally bound to a financial contract, so an adult generally enters into the contract on behalf of the child. This adult (the “trustee”) generally makes all the investment decisions in the best interests of the minor.
The advantages of an ITF are:
- Easy to set up at any financial institution
- No costs to set up the informal trust (compared to legal costs to set up a formal trust)
- No minimum or maximum investment criteria (although there may be criteria based on the type of investment used)
- No restrictions on the types of investments. The trustee however must make “presumed sound investments” under provincial rules for trustees.
- Income-splitting is possible since minor beneficiaries are liable for the tax on capital gains while the attribution rules under the Income Tax Act normally tax the settlor on any interest, foreign income and dividends generated in the account. The tax implications depend on the source of the funds – if beneficiaries receive their own funds (earned income, Child Tax Benefits) then all income is taxed to the child. If however the settlor is the source of the funds then the income-splitting rules apply.
- Improper set-up may result in the contributor being liable for the taxes on all investment income. This often occurs if the contributor is also the trustee of the account.
- The beneficiary is generally legally entitled to claim control of the trust assets upon attaining age of majority, and can therefore use the money for any purpose.
- If a beneficiary dies without a will, the ITF account will be distributed according to the laws of the province of residence.
With investors moving more often, the use and value of an ITF needs to be revisited. Some of the fallacies to ITFs that advisors can rectify are:
- An ITF cannot be used past the age of majority. FALSE – if the beneficiary agrees, in most provinces the ITF can remain under the direction of the Trustee. This is particularly useful in the case of an inheritance left for a minor that has age restrictions (1/3 at age 25, 1/3 at age 30, 1/3 at age 35). The ITF can be set up and follow the instructions in the will for individual beneficiaries. Many lawyers suggest an ITF for smaller inheritances so added cost and trust tax reporting for a formal trust are avoided. In this case, all investment income is taxable in the hands of the beneficiary.
- An ITF can be used to income-split with a non-resident parent or grandparent. FALSE – the Canadian Income Tax Act attribution rules cease upon non-residency. This means that the trustee will report all income derived in the ITF to the beneficiary (either paid or payable).
- An ITF is a useful income-splitting vehicle for a US citizen minor living in Canada. PARTIALLY FALSE – The income-splitting rules would apply for Canadian tax reporting (contributing adult is taxed on interest, foreign income and dividend income while the minor is taxed on any unrealized capital gain). However, from the perspective of U.S. – Canada Tax Protocol, the minor beneficiary would have to include all investment income and realized or unrealized capital gains in the U.S. income tax return annually, with no deferral allowed. In addition, if the ITF plus other accounts beneficially owned by the minor have an aggregate value that is $10,000USD or more, then a U.S. F-BAR information return must also be filed each year on behalf of the minor child. U.S. tax payable on the income can, under the Foreign Tax Credit rules, be claimed against tax payable in Canada on the same income.
- An ITF is an income-splitting vehicle for adults and minors no matter what the source of funds. FALSE – There are some exceptions where the investment income will always be taxed in the minor’s hands, as long as the child is a Canadian resident. If the source of funds is those of the child (Child Tax Benefit/Inheritance from a deceased parent or grandparent, gift to the child from a non-resident contributor) then all investment income will be taxed in the hands of the minor, with no attribution back to an adult donor or trustee.
- An ITF cannot be used in conjunction with any other account. FALSE – an ITF can be used to fund a Registered Education Savings Plan RESP), Registered Retirement Savings Plan (RRSP) or Registered Disability Savings Plan (RDSP) – as long as the plan used is an account only for the ITF beneficiary, and the ITF beneficiary meets the qualification to he a beneficiary of the new plan. An RDSP can be funded by anyone, so the trustee can contribute to the RDSP on behalf of a qualified disabled beneficiary. As a minor, the RDSP “account holder” will generally be a parent or guardian, who must approve the contribution to ensure the RDSP, is not in an over-contribution situation. This compares to the RESP and RRSP, where it is possible to name the ITF beneficiary as his/her own subscriber or annuitant contributor. This is allowed at some financial firms, such as Mackenzie Investments (the Mackenzie Client Services group can provide you and your clients with the appropriate account opening documentation to assist in this).
Helping your clients understand the opportunities and limitations of ITFs in their unique situations can ensure investments grow without unnecessary tax implications or cross-border complications.
Carol Bezaire, PFPC, TEP, CLU, is the vice-president of tax and estate planning at Mackenzie Investments. Carol can be contacted at: email@example.com