In our September 5, 2014, Tax Alert edition, we illustrated the lack of fairness in the recently proposed amendments to the taxation of trusts and estates with respect to disabled Canadians. As tax practitioners examine the details of the proposed amendments, more concerns are being raised and more inequities found.
Consider the impact the new rules will have on testamentary spousal trusts, along with certain other trusts, such as spousal/common law partner trusts, joint partner trusts, and alter ego trusts – collectively hereinafter referred to as special life interest trusts.
For example, a deceased individual may establish a special life interest trust for the benefit of their spouse pursuant to their will. Such testamentary spousal trusts are common today for many reasons. First, they permit the deferral of tax that would otherwise be payable from the disposition of assets beneficially owned by the deceased, deemed to occur immediately before death. In addition, a special life interest trust can preserve capital of the deceased – upon the death of the deceased's spouse, the assets of such trust will pass to the deceased's children. This type of planning is more common today as family dynamics have changed and more households have children from more than one marriage.
Under our current income tax rules, at the time of the death of a deceased's spouse, the special life interest trust is deemed to dispose of its assets at fair market value. As a result, capital gains relating to the trust's assets may be realized. Currently, the trust is liable for the tax resulting from such a notional sale. Accordingly, there is a matching of the tax liability to the taxpayer – in this case the special life interest trust that owns the property for which the capital gain was triggered.
Under the new proposed trust and estate rules, the special life interest trust will be deemed to have a year-end at the end of the day of death of the spouse, and all of the trust's income, including any resulting capital gains for that short year, will be deemed payable to the beneficiary spouse. As a result, any capital gains realized on the trust's assets from the notional sale must be reported on the beneficiary spouse's terminal return. Consequently, it will be the spouse's estate and not the special life interest trust that will bear the cost of the income tax liability that arises from the deemed disposition of the assets.
If the beneficiaries of the special life interest trust are the same as the beneficiaries of the spouse's estate, this new rule may be of little practical significance. However, as noted earlier, there are more and more individuals with children from past marriages who will want to leave property to those children. Difficulties will arise where the spouse's estate has no entitlement to the assets of the trust. Accordingly, there will be an enrichment of the beneficiaries of the trust since the tax liability will be borne by the spouse's estate.
Where the spouse's estate does not have the resources to settle the tax liability that is deemed payable to the spouse, the new rules propose to impose a joint and several liability on both the spouse's estate and the special life interest trust to ensure that the taxes will be paid. However, under the proposed new rules, the tax itself is not assessed to the special life interest trust. Furthermore, the new joint and several liability rule does not provide for the reimbursement by the trust to the estate for the tax liability relating to assets that the estate does not own. Hence, there is a mismatch with respect to the person paying the tax and the owner of the assets that gave rise to the tax. As such, an inequity results to the spouse's estate.
The special life interest trust could distribute property to the spouse's estate to make it whole, but in many instances the trustees of such a trust may not be in position to do so without breaching the terms of the trust.
The Joint Committee on Taxation of the Canadian Bar Association and the Chartered Professional Accountants of Canada has noted this inequity, along with other concerns with the proposed new rules, to the Department of Finance. The Joint Committee has recommended amendments to the new rules so that the taxes otherwise payable as a result of the deemed disposition will first be assessed to the special life interest trust, which allows the trust to use its assets to settle the tax liability. Furthermore, the Joint Committee has recommended rules that will allow for the spouse's estate to recover the taxes it is required to pay from the trust. Notwithstanding these recommendations, the Department of Finance has not yet amended the new rules. In addition, these new rules do not provide for any grandfathering provisions. As a result, the terms of existing special life interest trusts should be reviewed to consider the impact of the proposed amendments.
Despite some of the inequities that will arise if the new rules are passed into law, special life interest trusts will continue to provide benefits that merit consideration. Benefits include avoiding probate taxes, creditor protection, and the preservation of capital in the case of spendthrift beneficiaries and for children in blended families. Thus, taxpayers and their advisors still should consider these special life interest trusts when formulating estate plans.
Unless amendments are made to the new trust and estate rules, advisors should caution their clients. In situations where the spouse must include income realized by the trust, advisors should include provisions in the terms of special life interest trust agreements that will require the trustees to distribute property to a spouse's estate to make it whole. Moreover, advisors should consider the possibility of disposing of the assets held by the trust during the lifetime of the beneficiary spouse in order to minimize the capital gains that will be triggered at the time of the beneficiary's death.
While we wait for a response from the Department of Finance, taxpayers and their advisors will have one more thing to consider in the already complex estate planning world. Contact your Collins Barrow advisor for more information and guidance on these new trust and estate rules.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.