Using Family Trusts for Income Splitting

Paul Taylor for TEL
Jan 15, 2019
3 min read

If you are a high income-earner and have minor children in private school or with other significant expenses (e.g. summer camp, extra-curricular activities), you may wish to divert income to a family trust in order to pay for these expenses in a tax-efficient manner. While the Income Tax Act contains attribution rules which typically do not allow you to split income with your spouse or minor children, an exception is made where funds are loaned to the spouse, or to a family trust (in the case of minor children), and interest is paid on the loan at the CRA’s prescribed interest rate.

As of March 31st, 2018, the rate for prescribed interest rate loans will double, from 1 percent to 2 percent, so going forward this strategy will become less attractive. If you already have a family trust, you may consider making an additional prescribed interest rate loan before March 31st so you can “lock-in” the 1 percent rate; otherwise, time still remains to establish a family trust before the deadline.

Here is how this tax planning strategy works. The first step is to have a qualified lawyer create the discretionary family trust deed. In this case, where the prescribed rate loan is contemplated, the trust deed would typically include the parents as trustees and the minor children as beneficiaries. Other trustees and beneficiaries can also be included depending on what the client desires.

The trust deed will need to be formally “settled”, which means that a third party (often a grandparent) will need to be involved in order to establish the trust (e.g., with cash or a gold coin). The parents (or grandparents) will then make the loan to the trust at the prescribed interest rate, typically with a demand loan or promissory note. Once the loan has been received by the trust, it will then invest the funds, with the requirement that it must pay the 1% interest by January 30th of the following year to the person who made the loan.

The person who makes the loan must report the interest earned on the loan in their personal income tax return and the trust is entitled to an interest expense deduction for the interest paid. The income earned by the trust less the interest expense paid is then distributed out to the minor beneficiaries (or else the child’s expenses are paid directly by the trustees), and the distributed income is then taxable to the minor beneficiaries. Since minor beneficiaries typically do not have other sources of income, the distributions from the trust will typically result in no income tax payable.

Many people ask what expenses can be paid by the trust and are surprised to learn that the definition is very broad. According to the CRA, qualifying expenses can

include amounts paid for the support, maintenance, care, education, enjoyment and advancement of the child, including the child’s necessaries of life. While there is no official list of qualifying expenses, the guiding principle is that the expense must be for the sole benefit of the child beneficiary. Basically, the expense will qualify as long as it cannot be construed as benefiting someone else in the household or the household as a whole.

Whether you are a candidate for this tax planning strategy will depend on two main factors: first, is the person making the loan to the trust a high income earner who could benefit from diverting income to a lower income earner(s)? And second, does the person making the loan to the trust personally hold the cash or liquid assets required to make the loan? This last factor is important since in 2000 the government introduced section 120.4 to the Income Tax Act, the so-called kiddie tax, which effectively put an end to income splitting with minor children using corporate assets.

Before deciding whether this tax planning strategy is right for you, it is important to consult with a qualified accountant or lawyer.

If you would like more information, please contact Paul Taylor at Taylor Estates Law. Paul’s practice includes preparation of wills, powers of attorney and trusts.

For more information please contact us

Tel: 416-995-4024 or email: paul@taylorestateslaw.com.