CRA Rules on Family Trust Income Splitting

Introduction

Family trusts have long been used as a mechanism to allocate income among family members, defer tax, and facilitate intergenerational wealth planning. However, over the past several years, the Canada Revenue Agency has significantly tightened the rules governing income splitting through trusts. In 2025, the effectiveness of a family trust depends heavily on proper structuring, adherence to the Tax on Split Income regime, and careful documentation of beneficiary involvement.

High-income individuals and business owners frequently consider family trusts to reduce overall household tax liability by allocating income to lower-income family members. While income splitting remains legally permissible in certain circumstances, aggressive or poorly structured arrangements face substantial reassessment risk.

Understanding the interaction between trust taxation rules, attribution provisions, and the Tax on Split Income framework is essential.

Basic Taxation of Family Trusts

A family trust in Canada is typically structured as a discretionary inter vivos trust. For tax purposes, a trust is treated as a separate taxpayer. However, unlike individuals, trusts are generally taxed at the top marginal rate on retained income.

To avoid high trust-level taxation, trustees often allocate income to beneficiaries. When income is allocated and paid or made payable to beneficiaries in the year, the trust receives a deduction, and the income is taxed in the hands of the beneficiaries.

This mechanism historically enabled income splitting. For example, dividends received by a trust from a family corporation could be distributed to adult children in lower tax brackets.

However, this strategy is now significantly constrained by anti-avoidance rules.

The Tax on Split Income Regime

The most critical restriction is the Tax on Split Income, commonly referred to as TOSI. TOSI applies to certain types of income received by specified individuals from related businesses.

If TOSI applies, the income is taxed at the highest marginal rate regardless of the recipient’s actual income level. Personal tax credits are limited, and the benefit of income splitting is effectively eliminated.

Income potentially subject to TOSI includes:

Dividends from private corporations
Shareholder benefits
Income allocated from partnerships or trusts derived from related businesses
Capital gains from dispositions of certain private company shares

When a family trust receives income from a related business and allocates it to a beneficiary who is a specified individual, TOSI analysis is required.

A specified individual generally includes family members related to a person actively engaged in the business.

Excluded Amounts and Reasonableness Tests

TOSI does not apply if the income qualifies as an excluded amount. Determining whether income is excluded requires detailed factual analysis.

Common exclusions include:

Income received by individuals aged 65 or older in certain spousal contexts
Reasonable compensation for services provided
Returns on capital contributions
Excluded shares for individuals aged 25 or older meeting specific ownership criteria
Reasonable returns based on labour and capital contributions

The reasonableness test is central. The CRA evaluates the extent of labour contribution, capital invested, assumption of risk, and historical involvement in the business.

Passive beneficiaries with no involvement in the underlying business typically fail the reasonableness threshold.

Failure to properly document involvement or capital contributions increases reassessment exposure.

Attribution Rules

Separate from TOSI, attribution rules may apply when property is transferred or loaned to a trust for the benefit of related individuals.

If an individual transfers property to a trust and certain conditions are met, income generated from that property may be attributed back to the transferor and taxed at their marginal rate.

Common attribution triggers include:

Interest-free loans
Transfers of property to a trust for minor children
Certain spousal trust arrangements

Proper structuring often involves charging prescribed rate interest on loans to trusts and ensuring timely interest payments to avoid attribution.

In 2025, the prescribed interest rate environment materially affects the viability of loan-based planning structures.

Capital Gains and Trust Distributions

Capital gains realized within a family trust may be allocated to beneficiaries. However, TOSI can apply to certain capital gains derived from private company shares.

If the capital gain is recharacterized as split income under TOSI, the tax advantage of allocation disappears.

Moreover, the 21-year deemed disposition rule requires most inter vivos trusts to realize accrued capital gains every 21 years. Trustees must plan in advance to avoid unintended large tax liabilities.

Rollout strategies may involve distributing capital property to beneficiaries on a tax-deferred basis prior to the 21-year anniversary, subject to detailed compliance requirements.

Trust Reporting and Disclosure Requirements

In recent years, trust reporting requirements have expanded significantly. As of 2025, most express trusts are required to file annual T3 returns and disclose detailed beneficial ownership information.

Required disclosures include:

Settlor identity
Trustees
Beneficiaries
Protectors
Individuals with control or influence over trustee decisions

Failure to comply with reporting obligations may result in substantial penalties, even where no tax is payable.

Family trusts must maintain accurate records of distributions, resolutions, and beneficiary entitlements.

Minor Beneficiaries and Income Splitting Limitations

Income allocated to minor beneficiaries from private corporations through trusts is generally subject to TOSI at the highest marginal rate.

Historically, income splitting with minor children through trusts was widely used. Under current rules, this approach is largely ineffective for active business income and private corporation dividends.

Planning strategies must therefore focus on adult beneficiaries who can satisfy excluded amount tests.

Integration With Corporate Structures

Family trusts are frequently used to hold shares of private corporations as part of estate freezes and succession planning.

An estate freeze may involve exchanging growth shares for fixed-value preferred shares, with new common shares issued to a family trust. Future growth accrues to trust beneficiaries.

While this structure remains viable for estate planning, income allocations from the corporation to the trust must pass TOSI analysis to achieve income splitting benefits.

The primary advantage of the trust may now lie more in succession planning flexibility and creditor protection rather than pure tax rate arbitrage.

Common CRA Audit Focus Areas

The CRA commonly scrutinizes:

Lack of documentation supporting beneficiary involvement
Artificial allocations lacking commercial rationale
Improper loan arrangements triggering attribution
Failure to satisfy prescribed interest payments
Non-compliance with trust reporting rules
Incorrect application of excluded share rules

Family trusts that operate with formal governance, documented decision-making, and commercially reasonable allocation policies are more defensible.

Strategic Considerations in 2025

Income splitting through family trusts is no longer a simple marginal rate planning tool. It requires detailed analysis of:

Beneficiary age
Business involvement
Capital at risk
Ownership structure
Prescribed interest rate environment
Corporate dividend strategy

In many cases, the primary benefit of a family trust lies in estate planning flexibility, asset protection, and multigenerational capital management rather than short-term tax minimization.

Careful modeling is required before implementing or continuing income allocation strategies.

Conclusion

Family trusts remain a powerful planning vehicle, but income splitting through such trusts is tightly regulated under the Tax on Split Income regime and attribution rules. In 2025, dividends and certain capital gains allocated to related beneficiaries may be taxed at the highest marginal rate unless excluded amount tests are satisfied. Attribution rules can reallocate income back to the transferor if property transfers are improperly structured. Enhanced reporting requirements further increase compliance obligations. Proper documentation, reasonable allocation practices, and integrated corporate planning are essential to mitigate reassessment risk.

Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.

This article is written for educational purposes.

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