Usufructs: What Are They & How Are They Taxed in Canada?

Usufructs: What Are They & How Are They Taxed in Canada?—A Canadian Tax Lawyer’s Analysis

Introduction – Usufructs

A usufruct is a legal arrangement that separates the interests in the various legal rights that—when combined—constitutes ownership.

The usufruct concept comes from civilian law. With the exception of Quebec, which uses civilian law, Canada has adopted the common-law system. The difference between civilian law and common law is primarily theoretical. Civilian law relies predominantly on enacted civil codes, and it subordinates the authority of case law. Common law, however, finds at its root the doctrine of stare decisis, which demands judges to decide similar cases in a similar manner. In other words, in principal, case law has less significance in civilian-law systems than it does in common-law systems.

For instance, under common law,a decision of a higher court will bind a lower court in the same jurisdiction; the lower court must decide in a consistent manner. In civilian law, on the other hand, the precedents of higher courts do not bind a lower court’s decision. In practice, however, civilian-law courts generally defer to decisions of higher courts.

This article explores both the nature of the usufruct arrangement and the Canadian income-tax implications stemming from a usufruct arrangement.

The Nature of a Usufruct

The three attributes of ownership in civil law: uses, fructus, abuses

In civilian legal systems, ownership of a thing consists of three components:

• usus, the right to use the thing;
• fructus, the right to receive the fruits or income produced by the thing; and
• abusus, the right to abandon or destroy the thing.

In addition, besides the right to abandon or destroy the thing, the right of abusus carries two important prerogatives: the right to alienate the thing gratuitously or for consideration, and the right to preserve the thing in one’s estate.

Moreover, since its Roman law roots, civil law permitted arrangements “dismembering” these three ownership rights. For instance, as discussed in more detail below, a testator might give land to his child, but give to his widow a usufruct for life—thus dismembering usus and fructus from abusus. This meant that, during her life, the widow had the enjoyment of the land and the right to all its fruits. The child owned the land, but as a bare or naked owner while the usufruct remained outstanding. On the widow’s death, the usufruct would end, reuniting the three components of ownership in the child.

To be clear, dismembering the components of ownership does not dismember the right of ownership itself. Another’s receipt of a dismembered component of ownership does not thereby render the recipient an owner of the underlying property; it renders the recipient an owner of the dismembered right. Civil law views ownership of a thing as unitary or indivisible. Unlike the common-law trust, which recognizes that one person may beneficially own a thing while another holds legal title, civil law recognizes only one ownership right to a thing. Granted, a thing may have multiple owners or co-owners, but these owners all share in a single right of ownership. So, while a usufruct may confer extensive rights over a thing, it does not transfer ownership of the thing itself.

The usufruct arrangement: the naked owner owns the property itself, while the usufructuary owns the usufruct rights The usufruct arrangement consists of the usufructuary, who owns the usufruct rights, and the naked owner, who owns the property subject to the usufruct. As mentioned above, the usufructuary does not gain any ownership interest in the underlying property; he or she owns the usufruct rights in the underlying property. In other words, the naked owner owns the property itself, while the usufructuary owns merely the usufruct rights:

• In modern civil law, the owner of the usufruct is similar to a life tenant, and the owner of the property burdened is known as the naked owner.
• In civil law, one person may be the bare owner (“nu-propriétaire”) of the property but another person, called the usufructary, may use and enjoy the property and the usufructary is the owner of the usufruct in his or her own right, subject to the obligation of preserving the substance of the property. … The usufructary receives the income from the property as owner of the income. He or she is not accountable to the bare owner for any income. That person is similar to the “beneficial owner” in common law of the income. When a property is held by a nominee, agent or trustee in a civil law jurisdiction and a common law jurisdiction, that person acknowledges the relationship that he or she is not actually the owner of the property.

In addition, various civil-law jurisdictions differentiate the owner of the property from the owner of the usufruct rights in that property. For instance, the Civil Code of Quebec says that a usufruct “is the right of use and enjoyment, for a certain time, of property owned by another…”. And the provisions concerning usufructs in Title VI of Brazil’s Civil Code describe the usufructuary as someone distinct from the property’s “owner”:

• The civil fruits, due on the date of the usufruct, belong to the owner, and to the usufructuary those due on the date on which the usufruct ceases.
• The usufructuary may enjoy in person, or through lease, the building, but not change the economic destination, without express authorization of the owner.

Traditionally, the common law viewed the usufruct as similar to a life interest

The common law has long conceived of the usufructuary as holding a life interest and the naked owner as holding a remainder interest:

• In modern civil law, the owner of the usufruct is similar to a life tenant.
• Usufruct is a [real right] of limited duration on the property of another. It is similar to the common law’s life estate, although the usufruct need not last for life. …The owner of the usufruct, or usufructuary, is similar to a life tenant. …The ownership of a [thing] burdened with a usufruct is the naked ownership, which is owned by the naked owner. Naked ownership is similar to a reversion or estate in reversion, the residue of a life estate.
• In Roman terms, the holder of a life estate has the usus and fructus—the right to possess the land and enjoy its current income—but not the full right of abusus.

More recently, in Provost Car Inc v The Queen, the Tax Court of Canada was asked to identify the “beneficial owner” of dividends. In its decision, the Tax Court continued the common-law tradition of comparing a usufruct to a life interest:

• In civil law, one person may be the bare owner (“nu-propriétaire”) of the property but another person, called the usufructary, may use and enjoy the property and the usufructary is the owner of the usufruct in his or her own right, subject to the obligation of preserving the substance of the property. … The usufructary receives the income from the property as owner of the income. He or she is not accountable to the bare owner for any income. That person is similar to the “beneficial owner” in common law of the income. When a property is held by a nominee, agent or trustee in a civil law jurisdiction and a common law jurisdiction, that person acknowledges the relationship that he or she is not actually the owner of the property. …
• [I]n common law, one person may have a life interest in property and another may have a remainder interest in the same property. The owner of the life interest receives income from the property and owns the income; the owner of the remainder interest owns the capital of the property. There is no division of property in common law as there is in civil law. …
• In both the common law and the civil law, the persons who ultimately receive the income are the owners of the income property.

Since the common-law jurisprudence already insists that a usufruct is similar to a life estate, it seems likely that this characterization will hold up for tax purposes. On this view, the usufructuary—characterized as a life tenant—holds an income interest, while the naked owner—characterized as a remainder person—holds a capital interest.

Usufructs in Quebec are Trusts for Canadian-Tax Purposes

Still, one might argue that usufructs should be characterized as a trust for tax purposes. Subsection 248(3) of Canada’s Income Tax Act deems certain Quebec legal arrangements—including the usufruct—to be a trust. Since Quebec’s civil-code provisions on usufructs fundamentally repeat the rules found in other civilian jurisdictions, subsection 248(3) may hint at Parliament’s attempt to recognize usufructs as trusts for tax purposes.

But, while this reasoning clearly demonstrates that Quebec usufructs are trusts for Canadian-tax purposes, it does not warrant concluding that all usufructs are trusts for Canadian-tax purposes. The deeming rule in subsection 248(3) was not Parliament’s attempt to influence the characterization of arrangements governed by foreign law. Instead, it signifies Parliament’s attempt to harmonize the two legal systems that Canada embraces—the civil law of Quebec and the common law of all other Canadian jurisdictions.

Canadian Income-Tax Implications of Usufruct Arrangements

Tax implications flow from the nature of the underlying transaction or arrangement. As discussed, Canada’s Income Tax Act deems usufructs under Quebec law to be trusts for tax purposes. In contrast, Canadian common law generally characterizes a foreign usufruct as a life interest. As a result, depending on whether the foreign law or Quebec law governs the usufruct, the arrangement may trigger income-tax rules relating to either life estates or trusts.

Sections 104 through 108 of the Income Tax Act govern the taxation of trusts and their beneficiaries. These provisions therefore apply to usufructs stemming from Quebec lawon the basis of Income Tax Act subsection 248(3), which deems Quebec usufructs to be trusts.

On the other hand, should the usufruct be construed as a life interest, section 43.1 of Canada’s Income Tax Act may prove relevant. This subsection applies where a taxpayer disposes of the remainder interest in a real property while retaining for him or herself the life interest in that property. If so, section 43.1 contains two deeming rules. First, the taxpayer is deemed to have disposed of his or her entire interest—life and remainder—for fair market value. Second, the taxpayer then is deemed to reacquire his or her life interest at a cost equal to its fair market value at the time that the taxpayer disposed of the remainder interest. These two deeming rules, in turn, produce two tax consequences. First, the taxpayer realizes either a taxable capital gain or allowable capital loss on the same basis as if the taxpayer had disposed of his or her full interest in the land for fair market value. Second, the taxpayer’s life interest will not be subject to any further capital-gains tax upon the taxpayer’s death.

In addition to the rules relating to trusts or life estates, a usufruct may trigger foreign-reporting obligations. For instance, section 233.3 requires a Canadian-resident individual, who owns specified foreign property with a total cost exceeding $100,000, to file a T1135 reporting the existence of the foreign property. The Income Tax Act offers a broad definition of “specified foreign property,” which captures life, remainder, and usufruct interests.In particular, the definition includes “an interest in, or for civil law a right in, or a right—under a contract in equity or otherwise either immediately or in the future and either absolutely or contingently—to any property.” So, a Canadian resident with an interest in a foreign usufruct may need to file a T1135 or risk incurring steep financial penalties.

Tax Tips – Usufructs

As you have probably guessed, your Canadian tax obligations in relation to your interest in a usufruct are not entirely straightforward. Not only is it uncertain as how Canadian law will characterize the usufruct for tax purposes, but also the various characterizations themselves may invoke complex income-tax rules.

If you have an interest in a usufruct, consult one of our expert Canadian tax lawyers with respect to any of the following:

• the appropriate characterization of your usufruct interest for tax purposes,
• the tax consequences of transactions involving usufructs,
• your foreign reporting obligations in relation to your interest in offshore usufructs, and
• tax planning opportunities involving usufructs.

In addition, consult one of our Canadian tax lawyers if you were required but failed to report your income from a usufruct or your interest in a usufruct. The Voluntary Disclosure Program may be a viable option to avoid penalty or prosecution.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch