As part of the 2014 federal budget, the Canadian government enacted significant changes to the taxation of estates and trusts, which come into force on January 1, 2016. The main effect of the amendments is to limit the ability of taxpayers to establish testamentary trusts as a form of income splitting for surviving spouses and children. The amendments also include a number of provisions that materially affect the taxation of spousal trusts, common-law partner trusts, alter ego trusts, joint spousal trusts and joint common-law partner trusts (collectively, "life interest trusts"). These provisions may have the effect of taxing the estate of the spouse, settlor, common-law partner or the last to die of the two (as the case may be) on any accrued gains in the trust at the time of his or her death, whereas this tax burden was historically borne by the trust, and ultimately the remainder beneficiaries of that trust. The tax community was hopeful that certain of these amendments would be revised before they came into force on January 1, 2016, but it is unclear if a revision will be made before such time. Accordingly, it is advisable for individuals to review their wills and estate plans more generally and determine whether changes are required in light of the amendments discussed below.
Under the current provisions of the Income Tax Act (Canada) (ITA), the estate and any other trust established as a consequence of a taxpayer's death is generally treated as a testamentary trust, provided that the trust or estate has not received certain contributions of property or certain loans. Testamentary trusts are currently taxed at the marginal tax rates applicable to other individuals. Subject to an anti-avoidance rule that allowed the Canada Revenue Agency to treat trusts established by the same person as a single trust, taxpayers could establish multiple testamentary trusts for different family members and realize tax savings through income splitting between the family member and the various trusts. The benefit of income splitting in this manner varies by province, but could result in tax savings of more than $20,000 per trust for individuals resident in Ontario or Québec.
On death, an individual is generally deemed to have disposed of his or her capital property (and certain other properties) for the fair market value of these properties, and to have realized any accrued capital gains or capital losses on such properties at that time. This deemed disposition does not apply to properties that vest indefeasibly in the deceased's spouse or a spousal trust within 36 months of the date of death. These properties are disposed of by the deceased and acquired by the spouse or spousal trust at the deceased's cost. The spouse or spousal trust has a deemed disposition of all capital property on the spouse's death, so this "roll-over" defers the taxation of these capital gains until the death of the last to die between the taxpayer and his or her spouse. If the property is held by the spouse, the spouse's estate must pay the tax on any capital gains realized on death. If property is held in a spousal trust, the spousal trust is responsible for any tax on capital gains realized on the trust property. Spousal trusts have been an often-used planning tool when the deceased had a second marriage. In such a plan, the second spouse would be named as an income beneficiary during his or her lifetime, and the deceased's children would have a residual interest in the capital of the trust (net of any taxes paid in the year of the spouse's death), so that they would inherit the remaining capital. The spouse's estate would generally devolve to his or her own children.
January 1, 2016 Amendments
The amendments enacted as part of the 2014 federal budget come into force on January 1, 2016. They include the concept of a graduated rate estate (GRE). GREs and certain testamentary trusts established for beneficiaries that are entitled to the disability tax credit (qualified disability trusts) are now the only testamentary trusts that continue to be taxed at marginal tax rates. All other testamentary trusts (including those in existence on January 1, 2016) will be taxed at the highest marginal rate applicable to individuals, eliminating any income splitting opportunities through testamentary trusts. A GRE is defined as an estate that arises as a consequence of death of an individual at a particular time if the following conditions apply:
- the time is not more than 36 months after the death of the decedent;
- the estate is a testamentary trust; and
- the estate is designated as the GRE of the decedent in the first tax return, no other estate is designated as the GRE and the estate provides the social insurance number of the decedent in the return.
In addition to graduated rates, GRE status is relevant for common estate planning transactions involving the carryback of capital losses realized in the first taxation year after death against the capital gains realized by the decedent in the terminal return, and the carryback to the terminal return or the immediately preceding taxation year of the decedent of tax credits in respect of gifts made to registered charities and other qualified donees under the deceased's will.
The January 1, 2016 amendments also affect how spousal trusts (and other life interest trusts) are taxed. Under the proposed amendments, the spousal trust will be deemed to have made an amount of income payable to the spouse on the date of his or her death equal to the amount of any income realized by the trust in its taxation year ending on the date of the spouse's death (including accrued taxable capital gains realized on the spouse's death). The deemed amount will now be included in the spouse's terminal return, not in the income of the spousal trust, as was previously the case. The spousal trust and the spouse's estate will be jointly and severally liable for the tax payable in respect of this deemed amount, and therefore the tax may be borne by the spouse's estate rather than the trust. If the beneficiaries of the spousal trust differ from the beneficiaries of the spouse's estate, these amendments can result in a material and unforeseen cost to the beneficiaries of the spouse's estate. In addition, the trustees of the spousal trust may not have the power to pay the spouse's tax or may be compelled to seek contribution from the spouse's estate if it does pay the tax. It is also unclear if the payment of tax by the spousal trust affects the GRE status of the spouse's estate, which can have implications for the spouse's estate planning.
The deemed payment to the spouse's estate will affect many common estate planning transactions involving spousal trusts. For example, the amendments can complicate planning to reduce the tax payable in connection with the deemed disposition arising on the spouse's death that involves the carryback of capital losses realized by the spousal trust after the spouse's death or making a charitable donation after death to obtain a charitable donation tax credit. Under current law, a spousal trust can make an election to have income made payable to the spouse taxed in the trust. This election is needed to achieve the income splitting opportunity described above. The amendments limit the availability of this election so that it is now available only if the spousal trust has losses.
Individuals whose estate planning includes testamentary trusts may wish to review their planning in light of the foregoing.
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.