Editor’s note: The following case study uses fictional characters. Any resemblance to real people is coincidental.
Ling, a middle-aged widow, has a serious problem: her daughter Kai is poor money manager. Ling thought that as Kai grew older, she would become more responsible with money, but since Kai is already over 30, Ling fears that her daughter’s extravagance will haunt her for the rest of her life.
That’s why Ling wants to make sure Kai’s legacy is protected.
For Ling and thousands of other Canadians with similar concerns, the most common options for inheritance protection are to purchase an annuity or create a trust.
Annuity option
An annuity provides a fixed amount, usually paid monthly or annually. Ling may include a direction in her will that part of Kai’s inheritance be used to purchase an annuity, which would provide Kai with a steady stream of income.
Typically, the annuity purchase direction is used in more modest estate plans where the cost of a trust is prohibitive. Ling could also invest in a segregated fund with an annuity option for Kai after Ling’s death.
Beneficiary protection annuities can be complex. Choosing the right option may depend on a number of factors, including the size of the estate and where the beneficiary lives.
Trust option
Trusts allow Canadians to ensure that the needs of specific family members, such as disabled beneficiaries, minor children, spouses and spendthrift beneficiaries, are protected.
Before deciding whether a trust is the right vehicle to protect Kai, there are several factors to consider, including the choice of trustee. The selection of a family member as trustee may have a detrimental effect on Kaia’s relationship with her family and may make it difficult for the trustee to make prudent decisions regarding Kaia’s access to funds.
Ling should also consider including investment clauses in her will, which will provide an action plan for investing the funds in the trust. Some clauses to consider are:
Hiring an investment advisor
Various provincial trustee statutes allow a trustee to employ an investment advisor on a discretionary basis. Ling could include a clause specifying which investment advisor the trustee wants to hire.
Although the trustee is not bound by Ling’s election, this clause provides guidance and is the best way for Ling to ensure that her management team will be available to Kaia. This clause also ensures that fees charged by the investment advisor will be considered fiduciary expenses.
Haslam clause
Investment advisors often want to use mutual funds. In trusts, investment funds provide professional management and diversification. However, the question arises whether an advisor employed by a fiduciary can use mutual funds.
Haslam v. Haslama 1994 Ontario decision held that a fiduciary’s delegation of tasks to an investment adviser did not entitle the adviser to further delegate tasks to anyone else.
To remove any uncertainty and ensure the availability of investment funds to the trust, Ling should consider a Haslam clause expressly allowing their use.
Definition of income
Typically, a trust has two different beneficiaries: a life tenant and a residual beneficiary. The life tenant is usually entitled to the “net income” earned by the trust, while the residual beneficiary is entitled to the residue remaining in the trust upon termination of the trust. You can also create a trust that allows the life tenant to have access to the trust’s capital.
The Trust Funds Act defines income differently than the Income Tax Act. For example, in the case of a trust, a cash dividend (including a capital dividend) is income, while a stock dividend or proceeds from the redemption of shares is capital. For income tax purposes, all dividends (other than capital dividends) are included in income.
Depending on the investment tools used, divergent definitions of income can lead to investment confusion and administrative burdens.
Ling should therefore consider whether she wants to include a clause that redefines income to be consistent with tax and investment law rather than trust law.
Possibility to enter the capital
One issue Ling must resolve is whether Kai, as life tenant, will have access to the trust’s capital and, if so, on what basis. If Ling wants Kai to have this access, he needs to decide how liberal or conservative to allow it.
Even if Ling decides not to allow Kai access to the capital, Ling should discuss with her investment advisor the types of investment vehicles that should be used when investing on behalf of the trust. For example, if an investment advisor wants to use mutual funds, he or she can get a return of capital when a small portion of the capital is distributed as income. If this happens, Ling may want to include this issue in his will so that a return of capital can be paid to Kai rather than a recapitalization of him.
The principle of equality
One of the fundamental principles of trust law is that a trustee must consider the needs of both the life tenant and the ultimate beneficiary when making decisions. In Ling’s case, her main goal is to keep Kai. Ling should consider including a clause stating that the trustee is not bound by the equal arm rule to ensure that Kai’s primary concern is when investing the trust funds and managing the trust.
Ling has a lot to consider. Once she decides whether an annuity or trust is the right solution for her, she should talk to her investment professionals and attorneys to make sure her will includes the appropriate provisions to protect Kaia in the future.
Keith Masterman, LLB, TEP, is vice president of tax, retirement and estate planning at CI Investments. He can be reached at kmasterm@ci.com.
