Expiring Clients, Expiring Tax Opportunities
The November/December 2014 issue of CPABC in Focus included a tax article entitled “Spousal and Joint Partner Trusts – A Case Study Highlighting Benefits and Important Tax Considerations,” which reviewed the benefits and tax considerations of spousal and joint partner (JP) trusts. On December 16, just a few weeks after that issue was published, Bill C-43, the Economic Action Plan 2014 Act, No. 2, received royal assent. The tax changes Bill C-43 has introduced are significant enough to warrant a second look at spousal and JP trust planning. These changes may herald unanticipated tax consequences for established trusts, and practitioners need to consider how to mitigate the coming impacts.
Changes and additions
As discussed in the November/December 2014 article, a settlor of any age may create a spousal trust for the benefit of their spouse, while a settlor aged 65 or older may create a JP trust for the benefit of either partner. Any number and types of residual beneficiaries are permitted under either trust vehicle, although they do not become entitled to trust income or capital until the (last surviving) spousal beneficiary has died.
The 2014 article presented a case study in which spousal or JP trusts were considered for a John and Jane Doe. Some of the tax considerations reviewed in that article have changed materially as a result of Bill C-43’s passing—notably:
- Deemed dispositions on the death of the (last surviving) spousal beneficiary;
- Charitable donations made on death; and
- Capital gains deduction claims by a spousal trust.
In addition, the following new tax concepts warrant special attention:
- The introduction of graduated rate estates (GREs) and
- The mismatching of tax liability between trust and estate.
The spousal and JP trust benefits of probate savings and the avoidance of wills variation still apply notwithstanding the changes introduced by Bill C-43. However, for taxpayers who are in a position to alter their current or proposed trust arrangements, careful reflection is required.
Graduated rate estates introduced
Bill C-43 has restricted the availability of marginal tax rates to testamentary trusts by introducing the concept of GREs. As mentioned in the July/August 2015 issue of CPABC in Focus, a GRE is a testamentary trust arising on, or as a consequence of, an individual’s death, and this testamentary trust must be designated as a GRE on its first tax return.
All testamentary trusts are currently subject to marginal (graduated) tax rates. Beginning in 2016, however, only GREs will be subject to these rates. The benefits afforded to GREs will include:
- Taxation at marginal tax rates on income earned within the GRE for its first 36 months;
- New charitable donation rules (discussed below) for donations made by will or in the GRE; and
- A capital gains exemption on share donations.
While the challenges created by the new GRE rules are complex and numerous, it is particularly important to reiterate that only one testamentary trust will be afforded GRE status under the new rules. Under the existing rules, clever will-planning can cause multiple estates to arise on a testator’s death as long as the terms are sufficiently varied to avoid duplication, and each of these separate testamentary trusts will be subject to graduated tax rates. Under Bill C-43, however, since only one GRE will be subject to graduated tax rates, inter-vivos and non-GRE testamentary trusts will find themselves on an even keel.
Changes made to rules for deemed disposition on death
As discussed in the 2014 article, under the existing rules, the death of the (last surviving) beneficiary spouse results in a deemed disposition within the spousal or JP trust. Under the new rules, however, there will be a deemed year-end on the day of death of a spousal trust’s beneficiary (or on the date of death of a JP trust’s last surviving spouse). Any income for that year, up to the date of death, and any capital gains resulting from the deemed disposition of the spousal or JP trust property, will be taxed on the individual’s terminal return.
Consider the example of John and Jane Doe from the 2014 article, in which preferred shares are owned by a spousal trust. Under the new rules, the deemed disposition of such shares will be reported on the terminal return of the deceased spouse, rather than in the spousal trust. Where preferred shares are owned by a JP trust, the deemed disposition will now be reported on the terminal return of the last surviving spouse, rather than in the JP trust.
The estate loss carry-back rule also warrants further review in light of Bill C-43. A detailed discussion is beyond the scope of this article, but one important change, using the example of John and Jane Doe, arises where preferred shares are held personally: Under the existing rules, the capital gain from the deemed disposition of these shares on death can be offset by the trust’s capital loss on the subsequent redemption of said shares. Beginning in 2016, however, the estate loss carry-back will only be available to GREs.
If the preferred shares are owned by a spousal or JP trust, although the deemed disposition and capital gain will be reported on John or Jane’s terminal return under the new rules, any capital losses subsequently triggered on redemptions by the spousal or JP trust will continue to be denied, potentially resulting in double-taxation. Therefore, careful planning is required.
Moreover, with deemed dispositions occurring on the deceased individual’s terminal tax return effective January 1, 2016, it will no longer be possible for a spousal trust to claim the capital gains deduction. Accordingly, subsection 110.6(12) of the Income Tax Act will be repealed effective 2016.
Mismatched tax liability between trust and estate now a possibility
Under the existing rules, the tax liability on deemed disposition is attached to the spousal or JP trust. Effective 2016, however, the deceased’s estate will face the tax liability for the spousal or JP trust property. Unfortunately, at the time of death, the spousal or JP trust will still hold all the relevant assets; this could give rise to situations wherein estates face taxes payable on a spousal or JP trust’s formerly unrealized capital gains, without having sufficient capital to cover these taxes.
Additionally, beneficiaries of an estate may find their own residual interests eroded by a tax liability that arises from the spousal or JP trust’s deemed disposition. The fact that each trust may have different beneficiaries means that beneficiaries of a spousal or JP trust could potentially see the tax consequences of deemed disposition absorbed by an unrelated group.
To avoid these scenarios, the Department of Finance has stated its intention for the CRA to enforce the tax liability “…. as though the [inter-vivos] trust were liable in the first instance for that amount.” This could create a precarious situation—if the tax liability relating to the spousal or JP trust remains unpaid, the beneficiaries of the estate would have to rely on the CRA enforcing this tax liability against the spousal or JP trust rather than the estate. Furthermore, spousal or JP trusts likely will not contain provisions that allow them to distribute property to the estate. In addition, the CRA might only be swayed by the Department of Finance directive when collecting a tax liability. The time lag between when the tax liability arises and when the CRA begins collection is also a cause for concern, because if an estate does not pay at the time of filing (and it may not be able to afford to do so), interest and penalties could ensue from that date.
Spousal and JP trust deeds will need to be amended to address how the mismatch in tax liability will be handled and funded. Careful planning will be required to avoid tainting the spousal or JP trust, or the GRE status of an estate.
New charitable donation rules created
Currently, donations made by will are deemed to be made immediately before an individual’s death, and the resulting donation tax credit may be used in the terminal return or carried back to the preceding tax year. Donations made by a spousal or JP trust are not afforded the same flexibility.
Effective 2016, however, donations made by will or by any estate will be deemed to be made at the time the property is transferred to the charity, and it will be possible to carry unused donations forward for up to five years, matching the carry-forward period currently allowed for individuals. For GREs, it will be possible to claim such donations on the deceased individual’s terminal or prior-year tax return, or on the GRE’s tax return. There are no changes to donations made by a spousal or JP trust.
Using the practical example of John and Jane Doe once again, it will no longer be necessary for a spousal or JP trust to plan charitable donations, since there will be neither deemed disposition nor tax liability in either trust. Under the new rules, donations should be made in John’s and/or Jane’s will(s). Therefore, if current spousal or JP trusts contain charitable intentions, careful planning is in order.
The impact will be far-reaching
Bill C-43 has introduced significant changes to the trust and estate-planning landscape, and not just in terms of the examples discussed in this article. The changes will apply to all taxpayers, with no grandfathering provided for existing trusts. Practitioners will need to fully understand these changes and consider their implications for existing plans—even if those plans involve individuals who have already passed away. In addition, new trust and estate plans will require very careful drafting.
Faizal Valli is a senior manager in tax services with Ernst & Young LLP in Vancouver, specializing in tax and estate planning for private clients.
Brendan L’Heureux is a tax senior at Ernst & Young LLP in Vancouver.
- Throughout this article, the term “spouse” refers to a spouse or common-law partner, and includes same-sex partners.
- Stephanie Yu, CPA, CA, “Post-Mortem Donations – Legislative Changes and Their Impact,” CPABC in Focus, July/August 2015 (26-28).
- As noted in the July/August 2015 article.
- See new paragraph 104(13.4)(a) and (b) of Canada’s Income Tax Act (ITA).
- ITA subsection 164(6).
- ITA subsection 40(3.6).
- See clause 57, “Joint Liability – Spousal and Similar Trusts,” Explanatory Notes Relating to the Income Tax Act, Excise Tax Act, Excise Act, 2001 and Related Legislation, October 2014. (www.fin.gc.ca/drleg-apl/2014/bia-leb-oct20-1014-n-eng.asp)