For the tax years starting in 2023 onwards, individuals overseeing "bare trusts" are obligated to file a T3 tax return within Canada, risking penalties and adverse tax consequences if overlooked. The critical deadline for submitting these initial returns under the new regulations is quickly drawing near: April 2, 2024.
Per the Income Tax Act (Canada), a "bare trust" is characterized by a trustee functioning essentially as an agent for the beneficiaries, managing all interactions with the trust's assets. This legal structure, while seemingly straightforward, can be perplexing.
The realm of bare trusts, potentially undocumented, is murky for many. A significant number of Canadians could unknowingly find themselves as bare trustees for relatives, corporations, or business partners. Discerning a bare trust necessitates a grasp of trust law, a domain with which many taxpayers are not intimately familiar.
Recognizing the complexity and the widespread confusion, we at Capex CPA have devised a straightforward Basic Guide and a Four-Step Bare Trust Identification Test. This initiative is specially designed to assist Canadian taxpayers and their advisors, particularly those who have not delved into the specifics of trust law, in navigating the intricacies of identifying bare trusts.
What is a bare Trust?
A bare trust, in essence, functions as a mechanism by which property is held: the name on the legal documents belongs to one individual, while the actual enjoyment and obligations associated with the property fall to another. This arrangement allows the latter to benefit from the property's income, bear its costs, and retain any profits from a sale. In such a setup, the legal owner's role is confined strictly to possessing the title, without engaging in the broader financial or managerial aspects of the property.
When are Bare Trusts used?
Bare trusts are utilized more frequently than many realize, serving as a strategic tool for both individuals and businesses to navigate various legal and financial landscapes. The separation of legal and beneficial ownership through bare trusts is motivated by several compelling reasons:
Creditor Protection: Individuals might transfer legal ownership of assets to family members to shield these assets from potential creditors, effectively reducing the assets' visibility while retaining the benefits of ownership.
Estate Planning: Incorporating adult children into the legal title of a property is a strategy employed to simplify probate processes post-mortem, ensuring that parents maintain beneficial ownership and the right to the property's use during their lifetime.
Accessing Exclusive Benefits: Bare trusts enable beneficial owners to tap into advantages typically reserved for legal owners. This includes:
Financing: Where legal owners, often parents, secure mortgages on behalf of their adult children who may not independently qualify, assuming legal title to facilitate property purchase.
Reduced Fees: Beneficial owners, such as corporations, often face higher fees than individuals. A bare trust arrangement can result in lower account fees for the legal owner.
Favorable Insurance Premiums: Similarly, insurance costs can be lower for legal owners compared to beneficial owners, making bare trusts a financially advantageous setup.
Simplifying Business Operations: In joint ventures, having one partner hold legal title simplifies contractual and operational processes, allowing a singular entity to act on behalf of the collective.
Given the complexity and potential unfamiliarity of property ownership arrangements, the Four Steps Bare Trust Identification Test is recommended as a straightforward method to clarify and navigate the nuances of bare trusts.
Step 1: Identifying the Legal Owner(s)
Begin with a thorough examination of the legal documents associated with the asset in question to ascertain the legal owner(s). This critical step involves consulting specific documents based on the nature of the property or asset:
For Real Estate: Consult the purchase agreements and land title records to identify the individual(s) or entity listed as the owner(s).
For Equipment, Machinery, and Other Tangible Assets: Review the purchase agreements and any title documents that specify ownership.
For Financial Accounts: Look into the account holder agreements that delineate who holds the legal right to the account.
For Shares in Private Companies: Examine the share certificates which indicate ownership of the company shares.
It's crucial to discern that legal ownership goes beyond mere control or access:
Signing Authority: Possessing the ability to sign for a bank account does not equate to owning the asset contained within it.
Power of Attorney: Managing or utilizing property under a legal power of attorney does not confer legal ownership to the individual.
This step lays the foundational groundwork in the process of distinguishing between the legal and beneficial ownership of assets, setting the stage for further analysis in the identification of bare trusts.
Step 2: Identifying the Beneficial Owner(s)
To determine who the beneficial owner(s) of an asset or property are, envision the following scenarios unfolding:
The asset requires maintenance or repairs.
The property generates income (e.g., rent, interest, dividends).
An injury occurs due to the asset or on the property.
The asset is sold, or an account is being closed with funds withdrawn.
Reflect on these scenarios to answer critical questions:
Who is responsible for or agrees to cover repair and maintenance costs?
Who directly pays for the mortgage and property taxes?
Who would be liable for injuries occurring on the property or because of the asset?
Who receives the income generated by the property?
Who retains the sales proceeds?
Who is entitled to the funds upon account closure?
Whose initial investment purchased the property?
Who claims Capital Cost Allowance (CCA) on the asset?
Who declares the income on their tax returns?
Who reports the sale on their tax return?
These considerations are pivotal in pinpointing the true beneficial owner(s), typically identifiable by consistent names across these questions. If there's ambiguity, legal advice might be necessary.
Considerations for Matrimonial Homes:
Identifying beneficial ownership can be complex within marriages, especially when finances are intertwined. It's challenging to ascertain whose funds purchased the property, who benefits from its income, or who retains sale proceeds. Matrimonial homes, acquired during the marriage, might be perceived as jointly owned, yet this isn't always the case legally.
Commonly, one spouse may hold both legal and beneficial ownership, solely managing financial responsibilities like the mortgage, and retaining the right to the sale proceeds, taxes, and reinvestment. The other spouse's claim typically arises only upon separation or divorce, potentially modified by prenuptial or separation agreements.
For couples purchasing property, it's advisable to consult a tax advisor to determine how best to report income or gains for tax purposes, taking into consideration any relevant attribution rules. Agreement between spouses to report income or gains could imply joint beneficial ownership; however, if only one spouse is designated to report, they are likely the sole beneficial owner.
Step 3: Comparing Legal and Beneficial Ownership
This pivotal step involves scrutinizing the identities of the legal and beneficial owners you've identified in Steps 1 and 2. Do the entities listed as legal owners on official documents mirror those benefiting from the asset's income and bearing its liabilities, as determined in Step 2?
Alignment of Ownership: If the names of the legal and beneficial owners coincide, indicating no disparity between who holds title and who enjoys the benefits, then the arrangement likely falls outside the purview of a trust structure. Consequently, such scenarios are exempt from the newly implemented trust reporting obligations.
Discrepancy in Ownership: Conversely, if there's a mismatch between the legal owners and the beneficial owners, it signifies the presence of a trust arrangement. This discrepancy is a clear indicator that the relationship is subject to the new trust reporting guidelines set forth by the regulatory authorities.
This comparative analysis is crucial for determining the necessity and scope of compliance with the latest trust reporting mandates, ensuring that all legal obligations are met in accordance with the updated regulations.
Step 4: Distinguishing Between Bare Trusts and Regular Trusts
Upon establishing a divergence between legal and beneficial ownership, it becomes essential to classify the trust relationship accurately. This distinction hinges on the scope of rights and duties bestowed upon the legal owner or trustee:
Characteristics of a Bare Trust: In instances where the legal owner's (or trustee's) role is confined to holding the property title and acting on the beneficiary's directives without further discretionary powers, the arrangement aligns with that of a bare trust. In such setups:
The individuals identified as legal owners in Step 1 serve as bare trustees.
The parties pinpointed as beneficial owners in Step 2 are recognized as the beneficiaries.
For tax reporting, the trust is typically named after the beneficiary ([First Name of Beneficiary] [Last Name of Beneficiary] Trust), simplifying its identification in tax documents.
Identifying a Regular Trust: Conversely, when a trustee possesses extensive powers, including the authority to make investment decisions, appoint advisors, or dictate the distribution of the trust's assets based on specific conditions, the structure likely constitutes a regular trust. These trusts are characterized by detailed trust deeds outlining the terms and obligations. Given the recent expansion in reporting requirements, trustees and beneficiaries of regular trusts must ensure they communicate all pertinent information to their tax advisors for accurate compliance.
This final step is crucial for trustees and beneficiaries to understand their obligations under the new tax reporting guidelines, ensuring proper classification and compliance with the Canadian Revenue Agency's requirements.
The Canada Revenue Agency (CRA) will implement the bare trust rules rigorously, utilizing audits and penalties to ensure compliance. During an audit, the CRA will closely examine the flow of funds, particularly noting that the proceeds from sales typically benefit the beneficial owner. Failure to adhere to these rules could result in penalties exceeding $2,500 annually.
To mitigate risks and ensure transparency, both bare trustees and beneficiaries are advised to proactively declare their ownership status to the CRA through annual T3 filings. This approach is crucial not only for compliance but also for beneficiaries to secure specific tax advantages, such as the principal residence exemption or reduced tax rates, which are not accessible to legal owners.
For instance, an adult child responsible for the financial upkeep of a property owned legally by their parents should file this arrangement via a T3 form annually. This ensures that upon the property's sale, the adult child can report the gain and avail themselves of the principal residence exemption. Without such filings, the CRA might impose penalties or levy taxes on the parents, denying them eligibility for the exemption.
Bare trustees, to avoid assuming the tax liabilities of the beneficiaries, must also diligently file T3 returns, declaring their trusteeship status. Instances where unsuspecting individuals, like new immigrants or elderly persons, find themselves liable for significant taxes following the sale of a property they legally own but do not benefit from, underscore the importance of these filings. Properly submitted T3 returns for bare trusts safeguard trustees from bearing the tax burdens intended for beneficiaries, emphasizing the critical nature of compliance and accurate reporting in the management of bare trust arrangements.