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Giving money -- the smart way

Parents or relatives looking to give assets to their children, maybe to help them save for an education or buy a home, need to be careful how they go about it. Otherwise, they could fall afoul of the Canada Revenue Agency's attribution rules and find themselves on the hook for taxes owed on the income generated by their gift.

"The kiddie tax rules prohibit you from income-splitting with minors," explains Jeff Llewellyn, a partner at the accounting firm Meyers Norris Penny LLP, in Calgary. So, certain types of income earned by the gift are attributed to the person who gave it.

That doesn't mean an aunt can't set up a college fund for her favourite niece or that grandpa can't help his grandson build a down payment for a home. It simply means there are administrative hurdles to such good intentions and some decisions to make at the outset.

First, you have to decide what type of account will hold the asset. You can use an informal in-trust account or a formal legal trust. "They are really two different things," says Karen Wilkinson, a chartered accountant at Deloitte & Touche LLP, in Burlington, Ont., and there are pros and cons to each.

In-trust accounts
Jamie Golombek, vice-president of taxation and estate planning, at AIM Trimark Investments, in Toronto, says in-trust accounts can be set up at most financial institutions and usually have four components: a donor, a beneficiary, an asset and a trustee. The donor is the person who makes the gift, while the beneficiary is the person who receives it. The gifted asset could be cash, a piece of property or shares in corporation. The trustee is the person who manages the assets on behalf of the beneficiary until she reaches the age of majority.

From a legal perspective, a child can't own the account if she is a minor. However, once she reaches the age of majority, which is 18 or 19, depending on where you live, the child has the right to spend the money on what she wants, despite the donor's objections.

The problem, says Wilkinson, is that many people set up an in-trust account but continue to treat it as if it's their own and don't appreciate the ramification of their actions.

Golombek says there can't be any terms or conditions on such an account. "The child can come knocking and ask for it." He says there is at least one instance in Canada where a beneficiary has successfully sued to get access to money in an in-trust account.

That doesn't mean you should dismiss them out of hand. As Golombek says, they can be a good way to help a child build a nest egg. However, he says the person making the gift has to be careful he doesn't run afoul of the Income Tax Act.

The taxing consequences
The tax impact of such an account depends on the nature of the payments the gift generates. For example, if a parent takes the monthly child tax benefit payment, or baby bonus, and contributes it to the account, any income generated is taxed in the hands of the child. The same is true if the gifted money comes from an inheritance made to the child.

However, if the gift comes from a parent or relative, any income it generates must be claimed by the donor and is taxed in his or her hands. "If the investments generate interest or dividends, then there is a series of rules that effectively transfers that income back to the (donor)," explains Wilkinson.

The only exception is a capital gain, adds Golombek, which is taxed in the hands of the child beneficiary. "Equities and mutual funds and things that generally produce capital gains are perhaps the ideal investment when gifting to minors," he says. The trade off is that such investments are riskier than a GIC or bond.

Of course, the donor is deemed to have disposed of the gifted asset at fair market value and will have to pay tax on any gains prior to giving it away. The informal trust then acquires the asset at fair market value.

The government is lenient when it comes to second generation income or income on income, says Wilkinson. Such money is taxed in the hands of the beneficiary. For example, if a donor provides $1,000, which earns $100 of first-generation income, that is taxed in the donor's hands. However, the next year that $100 will earn second-generation income, which is taxed in the hands of the child.

That's why proper records must be kept in tracking the income. "The record keeping is not that onerous and most people can handle it," says Wilkinson. Golombek says the easiest way to track second-generation income is to move the first-generation income to a separate account and let it build.

Formal trusts
A formal trust is a legal structure created by a trust deed. The deed identifies the donor, the trustee, the beneficiary and the assets. The deed sets out how the assets are to be managed and the conditions under which they may be distributed, unlike an in-trust account. A trust can be set up and administered while the donor is alive -- known as an inter vivos trust -- or kick in after the donor dies -- known as a testamentary trust.

A trust is a legal entity that files a tax return and pays taxes. An inter vivos trust pays taxes at the top federal and provincial rates, but income can be allocated to the beneficiaries and taxed in their hands, which can lower the tax impact, though you still have to watch out for the attribution rules. A testamentary trust pays tax based on how much it earns using the graduated marginal tax rate structure.

The challenge with a formal trust is the cost. There are legal, accounting and administrative fees. "It's expensive," says Wilkinson, suggesting it isn't worth using one for a small amount of money.

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to the National Post, Investment Executive and Wall Street & Technology.

-- Posted: Dec. 14, 2005
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