21-Year Rule

The 21-year-rule is a tax rule that affects both testamentary and inter vivos trusts.  It provides that the trust will be deemed to have disposed of its capital property at fair market value every 21 years.  The effect of this rule is that assets, such as real estate or shares in public and private  companies, that have increased in value since the creation of the trust, will be subject to capital gains tax at the end of 21 years from the date of creating the trust.  This tax will be payable by the trust and levied at the top marginal tax rate applicable in the province where the trust resides.

One of the main goals in any tax planning is to eliminate, defer and reduce tax liabilities. As such, prior to the 21st year of the trust, the trustees should consider distributing the property (for example, shares in the family business) to all or some of the named beneficiaries.  This transfer can be done on a roll-over basis (i.e. tax-free) to Canadian resident beneficiaries.  However, the result is that each beneficiary who has received property will inherit the (lower) cost base of the trust, which will result in a larger capital gains tax liability when they sell the shares.  If those shares are held until death, the capital gains tax liability will arise at that time, as the beneficiary will be deemed to have disposed of the shares (and other capital property) at fair market value (subject to a possible rollover to a spouse).

It is important to note that the 21-year deemed disposition does not apply to life interest trusts (including inter vivos and testamentary spousal trusts).  In this case the first deemed disposition for the trust takes place upon the death of the “life interest beneficiary” (i.e. the surviving spouse) and thereafter every 21 years.  Again, it is possible to avoid the deemed disposition in the trust by transferring the property on a rollover basis to the life interest beneficiary.