Spousal & Joint Partner Trusts – A Case Study Highlighting Benefits and Important Tax Considerations

Note to readers: The Department of Finance released draft legislation on August 29, 2014, that proposes to make changes to inter vivos and testamentary trusts, including eliminating marginal tax rates for testamentary trusts and amending the rules relating to the deemed disposition of a spousal or joint partner (JP) trust’s property on death. At the time of this writing, it is unknown to what extent the final legislation will be implemented as drafted. This article does not address the proposed changes.

Spousal and joint spousal trusts, also known as joint partner trusts, are typically used in estate planning for high-net-worth spouses, including owner-managers, both as an alternative to wills and for probate savings. Whereas a spousal trust is established for the benefit of a settlor’s spouse, a JP trust is settled for the benefit of a settlor and the settlor’s spouse or common-law partner.[1] This article discusses the use of inter vivos spousal and JP trusts, or trusts created during the settlor’s lifetime.

The basics

A spousal trust may be created by a settlor at any age. By comparison, only settlors who are 65 years of age or older may create a JP trust. In the case of the former, only the settlor’s spouse is entitled to receive all of the trust’s income and receive/otherwise use its capital while said spouse is alive. In the case of the latter, only the settlor or the settlor’s spouse are, separately or together, entitled to receive all of the trust’s income and access its capital until the latter of the pair dies. Where these conditions are met, property is contributed to the spousal or JP trust at cost (i.e. on a rollover basis).[2]

A spousal trust has a deemed disposition of its property on the death of the beneficiary spouse at the fair market value (FMV) of the property,[3] whereas a JP trust has a deemed disposition on the death of the last remaining spouse. In contrast, an inter vivos trust has a deemed disposition on its 21st anniversary. Spousal and JP trusts may have any beneficiaries other than the spouses, but these beneficiaries will not be entitled to income or capital until after the death of the settlor, or of the last remaining spouse.

A case study

Consider the following hypothetical couple: John and Jane Doe. John and Jane each own 50% of the common shares of their business, Opco, and both are approaching retirement. They have three children, one of whom will eventually take over the business as part of an estate freeze. Opco has a FMV of $10 million. In addition, John and Jane each have non-registered investments with a FMV of $5 million, plus registered investments, and they own a principal residence and a vacation home in BC. To fund their retirement, John and Jane intend to draw on their non-registered and registered investments, and on the preferred shares of Opco, which they will receive as part of the estate freeze. They expect to be subject to the highest marginal tax rates in their retirement years, and they have not yet used their lifetime capital gains deduction (CGD).

In this situation, John and Jane may consider using a spousal trust or a JP trust as part of their estate plan. Step one would be to undertake an estate freeze by exchanging their common shares of Opco for preferred shares with an aggregate redemption value equal to $10 million. Then they could contribute their preferred shares and non-registered portfolios to separate spousal trusts for each other’s benefit. Alternatively, if at least one of them has reached age 65, they could contribute their assets to a JP trust for their shared benefit.[4]

The benefits

First, since the spousal or JP trust—not John and Jane personally—will own the property contributed, such property will not be subject to probate on the couple’s deaths; this means a savings of approximately $280,000 (assuming there’s a 1.4% probate rate on assets with an FMV of $20 million).[5] Second, unlike the deeds of a will, the deeds of a spousal or JP trust are not subject to public disclosure. Third, John and/or Jane can designate anyone as a beneficiary of their spousal or JP trust, and such beneficiaries might not be challengeable under the Wills Estates and Succession Act (formerly the Wills Variation Act). This may be a favourable option if John and Jane wish to leave property of the spousal or JP trust disproportionately to their heirs, including if they have children from previous marriages.

Trust income and attribution

The spousal or JP trust will earn portfolio income and deemed dividends on redemptions of the preferred shares and will allocate such income to the respective spouse beneficiary. However, income allocated to the beneficiary spouse can attribute back to the settlor spouse, under either the reversionary trust rules[6] or the spousal attribution rules[7]; therefore, careful tracking and reporting of income on trust and personal tax returns would be required.

The spousal or JP trust may be drafted to avoid attribution under reversionary trust rules. Further, John and Jane could avoid the spousal attribution rules by electing to have income taxed in the trusts,[8] where it would be taxed at the highest marginal tax rate. Such after-tax income would then be allocated to the respective spouse as a tax-free capital distribution. Assuming John and Jane will be taxable at the highest marginal rate due to other sources of income, there should be no difference between taxing the trust income in the trusts or taxing it to the individuals.

Deemed disposition on death[9]

The deemed disposition of property on death must be managed carefully. Where preferred shares are held personally, there is a deemed disposition of the shares on death, resulting in a capital gain on the deceased’s terminal return. The preferred shares then transfer to the estate with a high adjusted cost base (ACB) equal to FMV. The preferred shares are typically redeemed in the estate, resulting in deemed dividends and a significant capital loss. The estate’s executor then files an election to carry back the capital loss to offset the capital gain in the terminal return.[10]

Where the preferred shares are owned by a spousal or JP trust, the same deemed disposition will take place on death, resulting in a capital gain in the spousal or JP trust. However, when the shares are later redeemed by a spousal or JP trust, the capital loss may be denied under affiliate stop-loss rules,[11] potentially resulting in double tax in the spousal or JP trust. Careful planning must be undertaken to mitigate such double tax.

The capital gains deduction

A spousal trust may claim the CGD in the taxation year in which the spouse dies,[12] whereas a JP trust cannot. As an alternative to claiming the CGD through a spousal trust, John and Jane could elect out of the rollover to the spousal trust and could contribute enough common shares at FMV to claim their CGD. In either case, the preferred shares in the spousal trust would have an ACB equal to the CGD claimed. On redemption of the preferred shares, the resulting capital loss would be denied, as discussed above, and such outcomes would have to be managed carefully.

As a further alternative, John and Jane could retain sufficient preferred shares personally to use the CGD on death. The resulting preferred shares would have high ACB and FMV, and—again—care would need to be taken to manage the high ACB when the preferred shares are redeemed.

Charitable donations

Charitable donation planning is often used to offset the large tax bill on death. In the case of a spousal or JP trust, charitable donations must be made in the trust to offset the tax on the deemed disposition on death. A spousal or JP trust may only claim a donation made to a qualified donee in the same year as the deemed disposition, and it may only claim an amount up to 75% of its income. In addition, the donation cannot be carried back, but can be carried forward five years. Further complication arises where trustees have the discretion to make a donation, as it is not always clear whether the recipient charity is considered to be a qualified donee, or a beneficiary of the spousal or JP trust. If the charity is considered a beneficiary, then the contribution is denied as a donation and treated a distribution to a beneficiary.

On the other hand, a donation made in a settlor’s will is deemed to be made by the individual immediately before death.[13] In the year of death, a donation can be claimed for up to 100% of the individual’s income, and this donation can be carried back to the year immediately prior. Accordingly, John and Jane should consider their charitable intentions carefully when using a spousal or JP trust.

Contributions of real estate

In addition to their preferred shares and portfolio, John and Jane may want to consider contributing their principal residence and/or vacation property to a spousal or JP trust. If that’s the case, land transfer tax would need to be considered where the property changes title from John and/or Jane to a trust, and when the property is eventually distributed by the trust to a beneficiary.[14] Something else to consider: A trust may claim the principal residence exemption, but the normal principal residence exemption rules apply.

Tax debts and property transfers

It is important to consider the implication of tax debts when transferring assets between spouses. In the case of John and Jane, suppose John has a tax debt of $10,000 and transfers property to Jane—either directly, indirectly, or by means of a trust. The Income Tax Act will impose joint and several liability to Jane for John’s tax debt, up to the lesser of the tax debt and the FMV of the property transferred, net of consideration given by Jane.[15]

Closing thoughts

Spousal and JP trusts can be effective estate-planning tools, but due care must be taken in managing the income tax consequences.

Faizal Valli is a senior manager in tax services with Ernst & Young LLP in Vancouver specializing in tax and estate planning for private clients.

Footnotes

1. Throughout this article, the term “spouse” refers to a spouse or common-law partner, and includes same-sex partners.
2. Subsection 73(1) and (1.01) of Canada’s Income Tax Act (the Act). All references herein are to the Act.
3. Clause 104(4)(a)(iv)(A).
4. Practically speaking, a JP trust may have more than one spouse as the settlor (see CRA Document No. 2001-0099055, “Joint spousal trust,” January 23, 2002). Contributed property must be carefully tracked for attribution purposes, as discussed in this article.
5. The probate savings will decrease as the value of assets decreases in the spousal or JP trust.
6. Subsection 75(2).
7. Section 74.1, 74.2, or 74.3.
8. Subsection 104(13.1).
9. Spousal or JP trusts cannot benefit from the marginal tax rates currently available to testamentary trusts. As mentioned in the note to readers, however, the Department of Finance has proposed that these marginal tax rates should be effectively eliminated.
10. Pursuant to subsection 164(6).
11. Subsection 40(3.6). Subsection 40(3.61) is a relieving provision that applies to testamentary trusts only. It does not apply to inter vivos trusts (including spousal and JP trusts).
12. Subsection 110.6(12).
13. Subsection 118.1(5).
14. There may be an exemption or mitigation strategy.
15. Subsection 160(1).