What is a Bare Trust Agreement?
Bare trust agreements are relatively basic structures. A bare trust is a form of trust in which the trustee is only tasked with carrying out directions by the settlor and creditors can only pursue the bare trustee personally without recourse to the trust property or assets. Bare trusts are sometimes referred to as simple trusts as a reference to the limited powers given to a bare trustee.
For the purpose of clarifying our understanding let’s consider the following example: A settlor founds a bare trust with ABC Inc. as trustee. The beneficiaries of the trust may be unrelated to the settlor and not known to the trustee . The beneficiary or beneficiaries may have some claim to trust property under the trust terms. The bare trustee would hold legal title to the trust property. The beneficiaries would hold equitable rights with respect to that trust property. There are generally no discretionary powers granted to a bare trustee, the trustee’s obligations are limited to administration of the trust property or assets under a set of predetermined instructions. The basic idea is that a bare trustee performs no role other than to hold title or manage an asset on behalf of another party. The administrative obligations of the trustee are restricted to that which has been predetermined in the underlying trust documents.
Bare Trust Agreements and How They Work in Canada
Bare trust agreements in Canada involve a grantor who transfers property to a trustee to hold for a beneficiary. Bare trust arrangements typically entail the trustee acting under the sole direction and control of the beneficiary.
On an ongoing basis, the beneficiary may direct the trustee to act, engage, dispose of, or do anything that the beneficiary may act, engage, dispose of, or do as if the beneficiary were the trustee, except for merging of any trusts. The trustee is not to manage or have any responsibility for the management of the trust, which is solely retained by the beneficiary.
The trustee will only be liable for its express acts done in bad faith or gross negligence and will be indemnified from the principal and/or income of the trust property against any loss, damage, costs, claims, demands, expenses, actions or other proceedings arising out of the exercise or performance or purported exercise or performance of any of its powers or duties.
In the absence of direction from the beneficiary, a bare trustee will only act on the object of the trust, register any transaction or expend any moneys pursuant to its discretion.
Instead of the beneficiary being responsible for the obligations, the trustee retains the right to enforce the obligations against and compel compliance by a party that has legal obligations to the trustee.
A bare trust agreement often involves the establishment of a bank account by the trustee to hold title of the financial assets and proceeds of the trust property by the trustee, which is typically one of the following models:
A bank account established in the name of the trustee will be structured with two signatories required to authorize a transaction on the bank account.
On the death of the beneficiary, a bare trust agreement will continue to exist for the benefit of the estate of the beneficiary (rather than the beneficiary’s heirs). A conditional trust can also be considered a bare trust with any conditional limitations stated therein.
Benefits and Drawbacks of Bare Trusts
The primary benefits of using a bare trust are estate freeze planning, estate management or preserving and investing assets, using up the settlor’s tax credits and avoiding probate.
Estate Freeze Planning
A strategy known as an estate freeze is often used in tax and estate planning. An estate freeze is a plan to "freeze" the value of an individual’s estate – if done properly, it serves to eliminate his or her potential tax liability on capital gains that accrue on the value of the assets that are "frozen".
An estate freeze is typically achieved by selling the capital property to a family trust or a holding company controlled by the settlor (the individual seeking to freeze the value of their estate). The trust or corporation then issues units or shares designated as "growth units" or "growth shares" to the settlor or his/her family members (either directly or indirectly). These units or shares achieve the freeze by designating all future capital appreciation in the underlying property as belonging to the family members who hold the growth units or shares. The freeze has been made when the amount of the frozen capital property equals the aggregate amount of the debt owing to the settlor by the trust or corporation (the ‘swap amount’) and the recipient family members now have the option to receive gifts or trusts from the settlor.
An important tax consequence of an estate freeze is that the capital gains accrued during the period prior to the freeze become taxable on the tax return of the settlor but the capital gains accrued after the freeze are taxable on the tax return of the trust/holding corporate or its beneficiaries.
Example:
Mary purchased a rental property in Toronto in 1984 for $200,000 with a mortgage of $100,000. When she sold it in 2017, it had increased in value by $400,000, resulting in a capital gain of $400,000 (i.e. $600,000 sale price less $200,000 purchase price) or $200,000 taxable capital gain. Because she owned the property for more than 30 years, she qualifies for and elects to use the $500,000 lifetime capital gains exemption.
Maria then transfers the property to her child, Samuel, at its current fair market value of $600,000, with the following consequences:
Samuel decides to keep the property and do nothing with it and, 5 years later, he sells it for $750,000. However, for the purposes of this example, let’s assume that the property does not appreciate in value over the next 5 years.
In this example we see the importance of the timing of the transfer, given that savings in capital gains taxes can result from the proper timing of the transfer. It is often beneficial to implement the transfer strategy in the year in which a capital gain is realized by the settlor.
An estate freeze done through a family trust is advantageous because a trust is not a legal entity such as an individual or corporation but is deemed to be for tax reasons. Consequently, the trust will typically not be subject to capital gains tax (at the top rate of 50%) on the portion of capital gains in the underlying capital property that has been allocated to its beneficiaries. As a result, the trust beneficiaries can achieve tax savings by being taxed at their lower rates on their share of the capital gains accrued after the freeze.
Whether the taxation of the property should be achieved through a family trust depends on the needs of the family and the desired tax outcome. Use of a family trust is generally advisable when there are more than two settlors (particularly if they are not spouses), if minors who are unable to legally hold property are involved and in situations where the beneficiaries reside in more than one province or country.
Estate Management
A bare trust can also be used to hold title to property for the benefit of another person without transferring the property legally into that other person’s name. This can sometimes be desirable to preserve public assistance or benefits or for other estate management purposes. Bare trustees are not required to file tax returns for the trust (unless an election is made to treat it as a corporation subject to tax), to distribute any income to the beneficiaries or to prepare formal accounts. A bare trust is an excellent means to manage a minor’s property until adulthood, as it permits the trustee to manage the property without interference while simultaneously shielding it from the minor’s potential creditors. Similarly, a bare trust can be used to transfer property from a parent to a child while remaining the legal owner and economic beneficiary of the property.
The use of a bare trust for the benefit of a minor is often preferable to making a direct gift of the property to the minor. If an outright gift is made to a minor, that gift may not be used to pay expenses for the minor’s benefit (e.g. medical or dental expenses or to pay for education) or might be improperly seized by creditors of the minor if not held by an unrelated adult trustee. A bare trust avoids these issues by placing the property under the legal control of a person who is ultimately reliant on the minor to decide whether or not to benefit from the property.
Preserving or Investing Assets
A bare trust is also an appropriate means to assist a minor child with his or her savings. Separate ownership of the money in a regular bank account is for the benefit of the minor child. However, if that bank account is in trust with instructions to pay the money to the minor child, or to allow him or her to access or withdraw money from that account, it will be vulnerable to creditors and to be seized by civil proceedings concerning the trustee. The principal may be protected if it is placed in a separate bare trust account to hold the money, while the taxable income may be taxed at the minor’s lower, preferential tax rate. In such case, the minor child is the sole beneficial owner of the funds.
Legal Mandates and Obligations
When establishing a bare trust agreement in Canada, specific legal requirements must be met for it to be considered valid and enforceable. It is essential to comply with relevant provincial and federal laws, particularly the Income Tax Act (RSC 1985, c 1 (5th Supp)), Insolvency Act (RSC 1970, c I-23), and provincial trustee legislation. Failing to adhere to these regulations can result in serious financial and legal consequences for the individuals involved.
A bare trust agreement in Canada does not require formal registration or notarization. However, having a written document is highly advisable. The agreement should clearly outline the terms and conditions of the trust, including the identities of the settlor, trustee, and beneficiaries, as well as the assets held in the trust and any specific instructions regarding the management and distribution of those assets. For tax purposes, both the settlor and the trustee must maintain accurate records to report trust income on their respective tax returns.
It is important to note that the Income Tax Act treats bare trusts and other types of trusts as separate taxpayers. The income earned by the bare trust is subject to taxation at the highest marginal tax rate, meaning that funds held in a bare trust may not be an effective strategy for long-term tax deferral. In addition, beneficiaries of a bare trust are generally not entitled to any distribution until they reach age 18, though there are exceptions for special needs beneficiaries and those who have been in care.
Another compliance requirement for bare trusts in Canada is the filing of Form T3 – Trust Information Return. The trustee is responsible for preparing and submitting this annual information return to Canada Revenue Agency (CRA). The T3 return must include information regarding the trust’s income, expenses, and distributions to beneficiaries. Penalties apply for failure to file the T3 on time or for filing it incorrectly.
Such a failure to comply with the legal formalities required for a bare trust may render the trust invalid and subject to exposure to creditors for the debts of the settlor. This is particularly relevant in the context of corporate groups, bankruptcy, or insolvency, where arrangements between related parties may be scrutinized by the CRA, especially with respect to the Reporting Requirements for Certain Trusts (RC4023); "Information Sheet – Trusts: How Do They Work?". The primary purpose of a bare trust should be to simplify ownership of property, rather than to avoid taxes or creditors.
Applications and Uses of Bare Trusts
In Canada, bare trust agreements are commonly used in a variety of industries for good reason. Bare trusts are used in estate planning, family law and business law.
Estate Planning:
One of the most common uses of a bare trust agreement is in the realm of estate planning. Wealthy individuals often utilize bare trust agreements for real estate and other assets in order to reduce exposure to creditors and protect their wealth for future generations.
Family Law:
In the family law context, it is common for individuals to create a bare trust agreement that places cash in a bare trust that is not subject to division by a court. This is particularly common in high net worth divorces where division of assets is otherwise difficult.
Business:
Also quite common, is the use of a bare trust agreement in the context of business reorganization strategies. Parties often utilize a bare trust agreement to ensure that a preferred spouse or child receives certain tax benefits or capital gains exemptions under the Income Tax Act of Canada. For example, a holding company exists to own shares in another company. If there is a tax benefit in having an arm’s length party own shares of the holding company, a bare trust agreement can be an effective tool.
Bare Trusts vs Other Types of Trusts
Bare trust agreements are one type of trust used in Canada, but there are several other types of trusts with different functions and features. Understanding how bare trusts compare to these other types of trusts can help determine whether a bare trust is the right type of trust for an individual’s specific situation.
Trusts can be broadly classified into "express trusts" and "implied trusts." Express trusts are explicitly set up by the trust agreement, while implied trusts are trusts that arise because the law imposes or implies a trust relationship. Bare trusts fall within the category of express trusts.
For example, the following are some examples of implied trusts:
• resulting or constructive trusts, which may arise when the legal titleholder of property acts in a way that is contrary to the best interests of the beneficial owner of the property;
• "equitable mortgages," which arise when the parties to a secured transaction intend to create a mortgage even though all of the formalities required by law have not been met; and
• "institutional constructive trusts," which are trusts imposed primarily by the courts to prevent unjust enrichment at the expense of another party.
In terms of other express trusts, the clearest differentiation between a bare trust agreement and other types of trusts is that bare trusts do not engage with the extensive legal and statutory formalities which apply to other express trusts, such as wills and estate planning trusts. The following are brief descriptions of some of the more prevalent types of express trusts:
• testamentary trusts are trusts created in a will and come into operation once the benefactor has passed away, governing the transfer of assets to the name of the executor or trustee of the estate of the deceased;
• charitable trusts are trusts created for the advancement of education, religion, medicine , or other purposes beneficial to the public and may be enforced by the Attorney General;
• inter vivos trusts are established while the settlor is living, as opposed to testamentary trusts, which only come into existence upon death. Inter vivos trusts may be established for a variety of reasons, including asset protection, income splitting, transfer of wealth, and succession planning.
The distinctions between the types of trusts noted above and bare trusts also extend to their tax consequences. Bare trusts are generally not regarded as separate persons for tax purposes, and the income and capital gains earned within the trust are attributed to the beneficiary. However, bare trusts can still play an important role in tax planning, as the use of a bare trust may avoid some taxes that might otherwise apply when an individual holds particular types of properties directly.
Bare trusts can also be contrasted with "fixed" and "discretionary" trusts. Clients often confuse "discretionary" trusts with "bare" trusts because both result in the same outcome – the legal owners are obliged to follow the directions of the beneficiaries in regard to the management of the trust. However, bare trusts differ from discretionary trusts in that the trustee of a discretionary trust typically retains discretionary powers to manage the properties of the trust.
Discretionary powers are very common in Canadian trust law, giving the trustee the ability to exercise choices on how to manage and dispose of assets. In contrast, the bare trustee has no discretion with respect to management or alienation of trust assets.
To state the matter succinctly, the difference, in effect, is that while the discretionary trustee has the power of a car owner driving a car down the street, the trustee of a bare trust is essentially the passenger sitting in the backseat reading the roadmap provided by the beneficiary.
Use Cases and Practical Examples
To understand the practical application of bare trust agreements in Canada, consider the following real-life situation. A non-resident investor was seeking to invest in Canadian real estate without being subject to Canadian taxes. On the non-resident’s behalf, a Canadian lawyer set up a Canadian family trust. The investment was structured in such a way that the Canadian trust would never actually become beneficially entitled to the investment. The trust held title to the property but lent funds obtained from a Canadian bank to a borrower interest-only at an attractive rate of return. In turn, the borrower redeployed the funds in a high-yield investment. Because legally the Canadian trust was still only a nominee for the non-resident, all the profits flowed out of Canada. The trust merely held the funds.
In another scenario entirely, the Lawyer made various life insurance policies irrevocable and named the Canadian trust as the beneficiary. He also set up a bare trust that would be kept confidential from the life insurance company. The result was that the life insurance benefit paid to the Canadian trust would not be subject to taxes as long as the trust never became beneficially entitled to the funds. Because the contrary is true, if instead the life insurance policy named the ultimate beneficiary, any funds paid would be taxed as part of the deceased’s estate. Under the former scenario, the trust never had to distribute the funds in any particular way. The trust merely named the deceased’s friend, who also happened to be his landlord as the bare trustee. Because he was a mere havenotary, the friend incurred no additional taxes.
There are other tax reasons for setting up a bare trust agreement with Canada Revenue Agency. Solely as an example of what is possible, a Canadian bank was unwilling to provide a loan to purchase a piece of Canadian art. The bilateral tax treaty with the non-resident’s country, however, did not require non-resident withholding taxes. The art was purchased by the non-resident without any taxes. The art was then immediately given by way of a gift to a Canadian bare trust established for his children. Because the fund did not establish a relationship with the bank, the bank did not have to provide withholding taxes on the loan plus interest obtained against the art. As a result, additional taxes on the art also remain relatively low.
It should be noted that the specific facts of each situation will determine how effective the use of bare trust agreements will be. Bare trust agreements have evolved over time. Ultimately, their application may change. With the number of new tax laws and regulations that come out every year, it is very important to work with lawyers and accountants who specialize in this type of trust law.
A Step-by-Step Guide for Establishing a Bare Trust
Setting up a bare trust agreement may seem like a long and complicated process. Nevertheless, by following some basic steps, individuals can ensure that their agreement is proper and enforceable.
Firstly, an individual (the settlor) wishing to create a trust must appoint another person (the trustee) to whom the settlor will transfer all or some of his or her assets. The trustee can be a family member, trustworthy friend or professional organization who will hold the assets independent from the settlor. Once the trustee has consented, the settlor may draft the trust deed that outlines the settlor’s intentions and the general operation of the trust.
The terms of the trust will govern the obligations of the trustee in managing the trust and the benefit of the beneficiaries. In a bare trust agreement, there are no complicated conditions required for the trust to operate. Bare trusts enable the trustee to hold assets for the benefit of the beneficiaries without having any responsibility to do anything with those assets except transferring them to the beneficiary or to a new trustee. However, the trustee does not have the conversations or enforce the accounts on behalf of the settlor and the beneficiary must request these actions.
Further, the rights and responsibilities of the settlor and the trustee must be clearly expressed and agreed upon. The settlor has the right to demand the assets held in the bare trust at any time but does not have the right to issue directions to the trustee in how to manage the assets. The settlor is not liable for the actions of the trustee, unless the settlor issued specific directions for a course of action that would otherwise be against the law.
Consider having a lawyer prepare the bare trust deed to ensure it follows the applicable laws in Canada, which may vary by province. For example, a bare trust agreement in British Columbia, where the laws may differ from Ontario or Saskatchewan, may look different than a bare trust deed in those provinces and can have very different tax implications. To be enforceable, the settlor and the trustee must carefully consider the terms of the agreement and both parties should sign and date the deed.
When creating a bare trust, keep in mind the following: When a settlor establishes a bare trust, it is imperative that they are aware of their obligations and those of the trustee to avoid any breach of the bare trust deed. Also, it is important for the settlor to be specific and precise in their intentions to avoid unintentional consequences. For example, if a settlor requires his or her children to leave their trust funds in a bank until a certain age for educational purposes but does not indicate what occurs in such event that the funds are used for any other purpose, the fair market value of the funds may be used to determine income taxes owed instead of assuming the capital gains tax.
Typical Downsides and Pitfalls
While bare trust agreements may provide a simple and effective solution in many cases, there are a number of potential risks and limitations that you should carefully consider:
1. Liability of the bare trustee
A bare trustee will be liable for its own actions and any default. This raises the possibility that a bare trustee may be held liable for the actions or defaults of any investment manager or adviser that is delegated investment authority for the assets held in the bare trust. Therefore, it is essential to consider the degree to which the bare trustee may be exposed to liability for the actions of others and whether it would be appropriate to indemnify the bare trustee for such liability.
2. Impossibility of compliance with asset requirements
In order for the assets held in a bare trust to constitute qualified investments for registered plans (such as RRSPs and RRIFs), the assets must be, among other things, an interest in a property (other than real estate) that is registered in the name of the trustee of the registered plan. Real estate could still be acceptable if it meets the requirements for qualified investments for tax-free savings accounts.
However, if the intention is to qualify assets for an employee benefit plan, registered pension plan or another type of investment vehicle, it is not possible to have an interest in property registered in the name of the trustee because these properties cannot be registered in this manner. As such, the objectives of these types of plans would need to be achieved in ways other than with the use of a bare trust.
3. Cost and administration
If the goal of the bare trust is to have the assets pass directly to a beneficiary, the cost and administration of the bare trust may be unnecessary and burdensome. Legal, accounting and tax compliance costs may be incurred at the time the trust is established and throughout the term of the trust. Filing of the trust’s annual income tax returns will always be required.
4. Other tax implications
A bare trust does not avoid all tax problems. The income or gains on the assets in a bare trust are included in the income of the beneficiary who is deemed to have disposed of them. If the beneficiary is first generation, the income or gains are taxed at his or her marginal rate. If the beneficiary is a trust or is not related to the settlor of the trust, the income or gains are taxed at the highest marginal rate.
Further, if the assets held in a bare trust are foreign property, the bare trust will need to file a foreign income tax return in Canada, as well as a foreign country income tax return, if applicable. Once again, the bare trust must also file Canadian annual income tax returns. This will increase the administration and costs of the bare trust.
The Future of Bare Trusts
The evolving landscape of international finance and asset management will likely continue to drive the future demand for bare trust agreements in Canada. As cross-border transactions increase, though the CRA currently adopts a fairly restrictive view in relation to the application of the GAAR, Canada’s exemptions under the Income Tax Act (Canada) may be very appealing to international institutional banks and financial entities looking to invest in Canada.
The real estate sector in Alberta continues to expand. While the local new Hilton hotel has attracted local and international attention, other Calgary real estate developments also show promise. As new condos and office towers rise, even as the Alberta economy continues to dig itself out of the downturn experienced a couple of years ago, international investors continue to see promise and opportunity in Alberta. Bare trust agreements allow non-resident investors to comply with the underlying Income Tax Act (Canada) regulations and psychologically limit the risks of the non-resident investors in the eyes of their kiwi accountants , while allowing such investors to otherwise maintain a low profile.
International businesses and broker-dealers also continue to recognize the benefits of using bare trust agreements to avoid having foreign accounts trigger special taxes and reporting requirements under US securities tax laws. This emerging trend of proactively structuring private and limited partner investment through Canada and establishing qualification of limited partner status under the applicable US securities laws may mean increased use of Canadian bare trust agreements.
The evolution of e-commerce and public demand for international shopping opportunities may similarly mean increased use of Canadian bare trust agreements. Canadian bare trust agreements may provide a mechanism for disregarded entities, that are wholly-foreign owned for US federal income tax purposes, to hold US stocks and bonds that are foreign and not otherwise portfolio debt.