For 2023 and the following taxation years, trustees of the so-called “bare trusts” must file a T3 tax return in Canada or face penalties and/or other unfavourable tax implications. The deadline for the first tax returns prepared under the new rules is approaching fast (April 2, 2024).
Under the Income Tax Act (Canada), a “bare trust” is a relationship where a trustee “can reasonably be considered to act as agent for all the beneficiaries under the trust with respect to all dealings with the trust property.”
If you are confused by the paragraph you just read, you are not alone. Unlike contracts or other types of trusts, bare trusts may or may not be documented in writing. Thousands of Canadian taxpayers may act as bare trustees for their family members, corporations or business partners and not even know it. It takes some knowledge of trust law to identify a bare trust, but most taxpayers (and their accountants) never studied trust law.
In an effort to ease the confusion, we at Advotax Law came up with this Basic Guide and a simplified Four Steps Bare Trust Identification Test for Canadian taxpayers (and their advisors) who never studied trust law.
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What is a bare trust?
Very generally, a bare trust is a way to hold a property where one person appears on legal documents for the property, but a completely different person gets to enjoy the benefits (and risks) of owning the property, such as being entitled to income from the property, paying for its expenses, or keeping the proceeds when the property is sold. The legal owner's rights and responsibilities must be limited to merely holding the legal title to the property.
Why do people use bare trusts?
Bare trusts are more common than you think. Individuals and businesses separate legal and beneficial ownership for a variety of reasons including:
Creditor proofing: A beneficial owner may want to “limit the visibility” of their asset for potential creditors by putting the asset legally into a family member’s name;
Estate Planning: A common technique involves adding adult children to the legal title of parents' property for probate planning purposes while the parents retain all beneficial rights to the property;
Getting access to benefits that are available to legal owners but unavailable to beneficial owners, such as:
Financing: beneficial owner (usually, adult children) may not qualify for financing for the purchase of a real estate property whereas legal owners (usually, the children's parents) can help by obtaining mortgage and taking legal title in their name;
Account fees: beneficial owner (ex. corporation) may be subject to higher fees, whereas the legal owner (individual) can benefit from lower account fees;
Insurance rates: beneficial owner (ex. corporation) may be subject to higher insurance premiums for an asset whereas the legal owner (individual) is subject to lower premiums, etc.;
Business logistics: In joint ventures, it’s common for one joint venture partner to hold legal title for the benefit of all joint venture partners. The arrangement streamlines business dealings, where only one partner can enter into contracts on behalf of others.
When faced with an unusual ownership arrangement for any particular property, we recommend the following Four Steps Bare Trust Identification Test.
STEP 1 - Define Your Legal Owner(s)
Look at the legal documents for the property at issue and determine the owner of the property or the holder of the account. These person(s) are your legal owner(s).
Where do you look to identify legal owners?
For real property - see purchase agreements and land title records;
For equipment, machinery and other assets - see purchase agreement, title documents;
For accounts - see account holder agreements;
For private company shares - see share certificates.
As you are reviewing the legal documents, please note:
If someone simply has a signing authority on a bank account, the person is not necessarily a legal owner of the property;
If someone can manage/use the property under a legal power of attorney, the person is not the legal owner of the property.
STEP 2 - Define Your Beneficial Owner(s)
Imagine that one of the following scenarios happen to the asset/property:
The property needs repairs;
The property earns income (ex. rental income, interest, dividends);
Someone gets injured by the asset or on the property;
The asset is being sold/account is being closed and funds withdrawn.
With reference to the questions above, ask yourself:
Who would have to/agreed to pay for the repairs/maintenance?
Who pays the mortgage and property taxes out of their pocket?
Who is liable and pay damages to the injured person out of their pocket?
Who gets the rental income from the property?
Who will keep the proceeds of sale?
Who gets the funds once the account is closed?
Whose funds were used to purchase the property?
Who is claiming CCA on the asset?
Who is reporting the income on their tax return?
Who is reporting the sale on the tax return?
Also consider whose funds were used to purchase the property.
In most cases, you will use the same name or the same group of names to answer all the questions above (if not, speak to your lawyer). This person or this group of persons are your beneficial owner(s).
Who beneficially owns a matrimonial home?
Determining a beneficial owner(s) is harder when dealing with a married couple who share their finances. It is often hard to say whose savings were used to purchase the property, who gets the income or who keeps the proceeds of sale. Both spouses may have a claim to the matrimonial home or other property acquired during marriage on divorce. Does it mean that all matrimonial homes are beneficially owned by both spouses? Not necessarily.
It's common for only one spouse to be both legal and a beneficial owner of a matrimonial home. After all, this spouse would be solely responsible for mortgage, receive all the proceeds of sale, report the sale, pay tax, and be free to re-invest or even donate the proceeds if she wishes. The other spouse's separation/divorce rights to a matrimonial home only get triggered by a separation/divorce, and even then may be subject to a marriage or a separation contract.
When you are purchasing a property as a couple, discuss with your tax advisor the ways one or both spouses can report the related income/gain from the property for tax purposes. Do not forget to consider any attribution rules that may apply. Both spouses may agree to report income/gain from the property. If so, both spouses are probably the beneficial owners. If one spouse plans to report gain/income, that one spouse usually is the beneficial owner.
STEP 3 - Compare Your Legal Owner(s) (Step 1) and Your Beneficial Owner(s) (Step 2)
Compare your legal owner(s) established through STEP 1 and your beneficial owner(s) established through STEP 2. Do the names match?
If your legal owners match your beneficial owners, you likely don’t have any trust relationship. You are not subject to the new trust reporting rules.
If your legal owners do NOT match your beneficial owners, you likely have a trust relationship that may be subject to the new trust reporting rules.
STEP 4 - Do You Have a Bare Trust or a Regular Trust?
Where legal owners of a property are different from the beneficial owners, a trust relationship for the property may exist. This relationship may amount to a "regular" trust or a bare trust. To tell the difference, consider what rights and responsibilities the legal owner/trustee has.
If the legal owner/trustee has minimal rights and responsibilities other than to simply hold the title to the property and follow the instructions of the beneficiary, you are likely dealing with a bare trust, where:
The legal owners (STEP 1) are the bare trustees
The beneficial owners (STEP 2) are the beneficiaries
The name of the bare trust for tax reporting purposes is [First Name of Beneficiary] [Last Name of Beneficiary] Trust
If the trustee has a wide range of rights and responsibilities (such as to invest the trust funds, to hire advisors, to decide on the distribution of property subject to certain terms) you likely have a regular trust that is not a bare trust. The terms of these trusts must be documented in a trust deed. The reporting rules for these trusts also expanded recently. If you are a trustee or a beneficiary of a regular trust, make sure to provide the relevant details to your tax advisor.
How will the CRA enforce the bare trust rules?
Through audits and penalties. If the CRA audits you, they will likely follow the flow of funds. The proceeds of sale usually end up in the beneficial owner's pocket. The penalty for not complying with the rules can go up to $2,500/year or even higher.
In many cases, both bare trustees and beneficiaries will want to announce to the CRA their ownership status loud and clear through annual T3 filings.
A beneficial owner is sometimes entitled to certain tax benefits (ex. principal residence exemption, lower tax rate etc.) not otherwise available to the legal owners. Beneficial owners who hope to get these tax benefits in the future must ensure all T3 are filed annually with the CRA.
For example, an adult child who lives and pays for the property legally held by her parents, should report the arrangement on an annual T3 form. This is because when the property is sold, she (and not the parents) wants to report the gain and claim the principal residence exemption. If no T3s are filed, the CRA may apply penalties or ask the parents to pay tax, and they would not be eligible to the principal residence exemption.
Bare trustees will want to declare their status to the CRA on annual T3s or risk paying the beneficiary's tax bill.
We regularly see situations where an unsuspected person (usually, a new immigrant or a trusting senior) is put on a legal title for a residential house that is being built and sold by a savvy construction entrepreneur. As soon as the house is sold, the entrepreneur pockets all the sale proceeds and stops answering calls, while the bare trustee gets stuck paying massive income tax and HST bills from the sale of the property.
If a bare trust's T3 returns are properly filed, the bare trustees are protected from the beneficiary's tax liability.
We cation our readers that the rules are new and not a lot of guidance is currently available from the CRA or the courts. As more guidance becomes available, we may have to revise the views expressed in this article. Please subscribe to our blog to stay up to date on the newest developments on the new trust reporting rules.
Nothing in this article constitutes legal advice and no solicitor-client relationship is created. If you require legal advice pertaining to your specific situation, please contact our tax lawyer.
Please note that this post is only as current as its publishing date indicates, but the relevant rules - and guidance on their interpretation - change constantly.