Alter-Ego Trusts – An Effective Estate-Planning Tool

Estimates show that nearly one in six Canadians is at least 65 years of age, and according to population projections, 20% of the population will be 65 years or older by 2024[1]. As the population of Canada continues to age, it becomes ever more important for Canadian taxpayers to plan for their passing.

A key step to executing an estate plan is the effective and efficient distribution of the deceased’s assets to their intended beneficiaries. Traditionally, this step has been performed through an individual’s will. In some circumstances, however, the distribution of assets through a will may not be efficient from a tax perspective, as it can also expose an individual’s estate to other risks. Accordingly, there are a number of alternative methods for transferring property that do not include the use of a will. These methods, commonly referred to as “will substitutes,” may involve transferring assets via a living (or inter-vivos) trust (such as an alter-ego, spousal, or joint-partner trust) in order to gift assets during the individual’s lifetime, or using joint tenancy arrangements (among others). This article focuses on the selected benefits of using an alter-ego trust (AET) to distribute assets as part of a comprehensive estate-planning strategy.

The basic rules of AETs

As mentioned above, an AET is a type of inter-vivos trust (as opposed to a testamentary trust, which is created on the death of an individual). In order to qualify as an AET and function properly under the rules in the Income Tax Act [3] (the Act), the terms of the trust and the facts concerning the settlor must meet the following criteria[2]:

• The trust must be settled by an individual who is at least 65 years of age at the time the trust is created;
• The individual settling the trust and the trust itself must be resident in Canada, meaning that the trustee(s) and/or other legal representative(s) who exercise management and control over the trust[4] must be resident in Canada;
• The settlor must be entitled to receive all of the income generated by the trust during their lifetime; and
• No one but the settlor is entitled to receive or otherwise use any of the trust’s income or capital during the settlor’s lifetime.

With regard to the final bullet above, it is important to note that while no other person is allowed to receive any of the trust’s income or capital, there is no requirement for the settlor to be a capital beneficiary.

AETs in estate planning

Rollover rules

Generally, gifting or transferring property with accrued gains to a personal trust can result in a taxable event to the transferor. However, property can be transferred to an AET on a rollover basis for Canadian tax purposes, thereby providing an opportunity for the transferor to avoid being forced to recognize accrued gains. Accordingly, on transfer to an AET, the property is deemed to be disposed of at the individual’s adjusted cost base (ACB) and, subsequently, is deemed to be acquired by the AET at that same ACB[5]. Note that the individual can elect out of the tax-free rollover if they would prefer to realize any accrued gains or losses at the time of transfer.

On the death of the settlor

The legislation surrounding AETs and similar trusts provides that such trusts are not subject to the 21-year deemed-disposition rule during the settlor’s lifetime[6]. Instead, on the death of the settlor, there will be a deemed disposition of the assets in the trust at fair market value. Additionally, the trust’s tax year will be deemed to have ended on the date of death, and a new taxation year will commence immediately after that day[7]. The trust will then be required to file a T3 return within 90 days of the deemed year-end.

Under the current legislation, any income earned by the trust in the year of death and/or any capital gains or losses arising from the deemed disposition are to be reported in the T1 terminal return of the deceased primary beneficiary[8]. However, new rules have been proposed to tax the income of the trust, along with any deemed gains recognized by the trust in the year of death, in the trust itself[9]. Once enacted, this amendment will apply to the 2016 taxation year and subsequent taxation years. Accordingly, the trust will be subject to tax at the top marginal tax rate in the year of the primary beneficiary’s death. Following the primary beneficiary’s death, if the trust is to carry on as an inter-vivos trust, the trust property will be subject to the 21-year deemed disposition rule thereafter.

Probate fee planning

When an individual dies, the executor or administrator of an estate may prefer, or may be required, to obtain a grant of probate from a court in order to establish their authority to deal with assets under the will. Prior to the grant being issued, probate fees will have to be paid on the gross value of the deceased individual’s tangible assets that are situated in British Columbia and pass through the deceased’s estate (and, if the individual was ordinarily resident in BC, probate fees will have to be paid on the gross value of the deceased individual’s intangible property, wherever it is situated, that passes through the deceased’s estate)[10]. Probate fees in British Columbia are among the highest in the country—essentially 1.4% of the gross value of the estate.

Over the years, a number of techniques have been used to minimize or eliminate probate fee tax. These techniques include beneficiary designations, the use of nominee corporations to hold property, multiple wills, etc. When property is transferred to an AET, legal title to the property resides with the trustee in trust for the desired beneficiary. This reduces the value of the transferor’s estate and minimizes probate taxes on death, since the assets of the AET do not form part of the deceased's estate for the purposes of the probate fee legislation.

Confidentiality

The probate application lists the fair market value of the deceased’s assets (owned) and liabilities (owing) at death, and these assets and liabilities pass through the estate. Any person willing to pay a small fee can access a copy of the will and the accompanying probate documents. This can be troubling for many individuals due to concerns about family security and privacy. By contrast, assets transferred to an AET are subject to the terms of the trust and do not pass through the deceased’s estate; accordingly, it is usually the case that the trust’s assets can be kept confidential prior to and after death.

Protection from claims against the estate

An AET (or a trust in general) can be an effective tool to protect an estate from claims by family members. The wills variation provisions in the Wills, Estates and Succession Act (WESA) provide a regime wherein a spouse or child of a deceased individual can claim support from the deceased’s estate, where the provisions for support of such spouse or child in the deceased’s will are inadequate. The legislation limits an individual’s testamentary freedom when crafting their will, as any limitations of entitlement they may wish to impose under their will could be set aside or varied under WESA. When used correctly, however, AETs can be an effective way to reduce and/or eliminate the possibility of a claim under WESA.

To sum up

AETs provide a number of benefits that can make them an effective piece of the estate-planning puzzle. Any person considering the use of an AET should consult both legal counsel and a tax advisor with respect to their specific situation.

Kam Nat is a senior manager in taxation services for BDO Canada LLP (Vancouver).

Footnotes

1. Statistics Canada, “Canada’s Population Estimates: Age and Sex,” The Daily (accessed September 2015).
2. Income Tax Act, R.S.C. 1985, c.1 (5th Supp.), as amended, herein referred to as the Act. All section references that follow refer to the Act unless otherwise noted.
3. Subsections 73(1), 73(1.01), and 73(1.02).
4. St. Michael Trust Corp., [2012] 2012 SCC 14.
5. Subsection 73(1).
6. Subparagraph 104(4)(a)(iv).
7. Paragraph 104(13.4)(a).
8. Paragraph 104(13.4)(b).
9. Department of Finance Canada, “Legislative Proposals Relating to Income Taxation of Certain Trusts and Estates and Explanatory Notes,” January 2016. See proposed addition of paragraph 104(13.4)(b.1). (www.fin.gc.ca)
10. Probate Fee Act, S.B.C. 1999, c. 4, s.1.