This Advisory provides an overview of some of the key rules regarding the Canadian taxation of estates and testamentary and inter vivos trusts, including spouse, alter ego, joint partner and other life interest trusts in domestic estate planning and trust and estate administration.
TYPES OF TRUSTS
Definition and Creation of a Trust and Other General Trust Principles
A trust is considered a separate entity and is a taxpayer under the Income Tax Act (Canada) (the "ITA"). Please refer to our Advisory "Using a Trust in Your Estate Plan" to learn more about general trust principles, such as the legal nature of a trust, how a trust is created, dual ownership under a trust, and key provisions of a trust agreement.
Inter Vivos and Testamentary Trusts
A trust may be established during a settlor's lifetime (an "inter vivos trust") or it may be established under a will and, as a result, it will only take effect on death (a "testamentary trust"). The estate of a deceased individual is deemed to be a trust under the ITA and is taxed as a trust. The person who settles or creates an inter vivos trust is called the "settlor". If the trust is testamentary, the person who made the will under which the trust is created is called the "testator"
Life Interest Trusts
Qualified spouse trusts and alter ego and joint partner trusts (collectively referred to in this Advisory as "life interest trusts") are taxed on the deemed disposition of the assets in the trust on the death of the income beneficiary (or the death of the surviving income beneficiary in the case of a joint partner trust), unless the assets are disposed of at an earlier date. This allows for a deferral of tax on any unrealized capital gains in the trust until the death of the income beneficiary (or last surviving income beneficiary in the case of a joint partner trust), at the latest. All accumulated capital gains in the trust are taxed at that time.
Qualified Spouse Trusts
Qualified spouse trusts under the ITA can be either inter vivos or testamentary. The spouse must be entitled to all of the annual net income of the trust for his or her lifetime and no person except the spouse may receive or otherwise obtain the use of any of the income or capital of the trust during the spouse's lifetime. Other requirements under the ITA include that the settlor or testator must be a Canadian resident for income tax purposes at the time of the settlement of the trust or immediately before his or her death (as the case may be) and the trust must be Canadian resident for tax purposes immediately after the time the property vested indefeasibly in the trust (which essentially means when all possible steps to legally transfer ownership of the property to the trustees have been taken).
Assets may be transferred to the trust on a tax-deferred, rollover basis, although an election can be made to transfer certain assets at fair market value (which may be desirable in certain circumstances, for example if there are capital losses which can offset capital gains). In the case of testamentary qualified spouse trusts, the assets must vest indefeasibly in the trust within 36 months of the testator's death to qualify for the rollover (although the period can be extended if an application for an extension is made within the 36-month period). Also, spouse trusts are not subject to the 21-year deemed disposition rules, whereby capital property is deemed to be disposed of and subsequently reacquired (thereby giving rise to capital gains or losses in the trust) every 21 years (discussed later in this Advisory), which apply to most other types of trusts.
Because the tax rules must be strictly followed to ensure the benefits of using a qualified spouse trust are obtained, it is important to ensure that a spouse trust which is intended to qualify for such treatment does not include provisions which disqualify it. For example, loans at a rate which is less than a commercial rate of interest to anyone other than the beneficiary spouse, or even the power to make such a loan, could taint the spouse trust. Also, the Canada Revenue Agency ("CRA") has taken the position that the ability of the trustees to purchase and pay the premiums of a life insurance policy on the life of the spouse taints the trust. This is due to the fact that the trust fund is being used for a purpose which will not benefit the spouse but rather other beneficiaries, since the insurance proceeds will not be paid to the trust until after the spouse's death.
Alter Ego and Joint Partner Trusts
An alter ego trust is created by a person for his or her sole benefit during his or her lifetime. A joint partner trust is created by a person for the benefit of the person and his or her spouse (including a common law spouse) until the death of the survivor of them. Alter ego trusts and joint partner trusts are entitled to special treatment under the ITA. Persons age 65 or older may establish an alter ego or joint partner trust and transfer assets to it on a tax-deferred basis, whereas normally a transfer of property to a trust, with certain exceptions, results in a disposition, which may result in tax on any resulting capital gains.
BASIC TAX RULES
Inter Vivos and Testamentary Trusts
Rates of Tax on Inter Vivos and Testamentary Trusts
Under the current rules, the top marginal rate of tax applies on income earned by, and taxed in, both inter vivos trusts and testamentary trusts, which includes estates, with certain exceptions for Graduated Rate Estates and Qualified Disability Trusts, as discussed below.
21-Year Deemed Disposition of Trust Capital
Both inter vivos and testamentary trusts, with certain exceptions for life interest trusts (discussed above), are subject to the 21-year deemed disposition rule. This rule provides that a trust will be deemed to have disposed of all of its capital property on the 21st anniversary of the date the trust is established, and every 21 years after that. The trust is taxed on the net capital gain on the capital assets held in the trust on that date.
Certain planning steps may be available to minimize the tax consequences on the 21-year deemed disposition of the trust's assets, such as making a capital distribution and "rolling out" assets from the trust to beneficiaries prior to the 21-year anniversary. However, the terms of the trust may restrict what planning the trustees can do in this regard.
Other Tax Rules Which Affect Trusts
Estates (other than Graduated Rate Estates, discussed below), testamentary (other than Qualified Disability Trusts, discussed below) and inter vivos trusts are subject to a number of other rules (with certain exceptions) under the ITA, including that they:
- Have a calendar tax year-end;
- Pay tax instalments, if applicable;
- Pay alternative minimum tax, if applicable;
- Are unable to allocate investment tax credits to beneficiaries; and,
- Are unable to elect to tax income paid to a beneficiary in the trust unless the trust has losses to offset the tax.
Taxation on Death and Taxation of Estates
Taxation in the Year of Death
In the year of death, a deceased individual will be taxed on three main types of income:
- Income earned to the date of death (including, for example, employment, investment or business income);
- Income deemed to be realized at the date of death (such as the value of Registered Retirement Savings Plans ("RRSPs") and Registered Retirement Income Funds ("RRIFs") held by the individual at death, discussed further below); and
- Income arising from the actual or deemed disposition of capital property, such as non-registered investments or real property, , based on the increase in value of the property above its cost base, as discussed further below. Pursuant to the ITA, a disposition of capital property is deemed to occur immediately prior to the owner's death.
Taxation of Registered Retirement Accounts in the Year of Death
Registered retirement accounts such as RRSPs and RRIFs are treated differently in the year of death than other investment assets. Not only are payments received by the deceased individual from such plans to the date of the individual's death included in income, but any balance in such plans held by the individual at his or her date of death will be deemed to be income arising at the date of death. The full value of the plans held at date of death will therefore be taxable as income subject to tax at the individual's marginal tax rate.
An exemption from the application of this rule is available if the plan is paid to a spouse (married or common law) of the deceased account holder. The spouse may then roll the proceeds into his or her own RRSP or RRIF, and the proceeds will be not be taxed in the deceased's final tax return if the transfer is completed within the required period (the time limit is 60 days after the end of the year of death, subject to extension by the Minister of Finance). The spouse will then be taxed on any withdrawals from the funds he or she makes in the future. If the spouse is the designated beneficiary of the plan, the deceased's estate may still elect to tax some of the RRSP or RRIF proceeds in the estate, which may be beneficial in some circumstances. It should be noted that the spouse is not obligated to roll over the plan proceeds to his or her own registered plan, in which case the deceased account holder's estate will become liable for income tax on the plan proceeds, as described above.
Limited exemptions from the application of this rule are also available for dependent children and grandchildren (whose income must be below a certain threshold to qualify as a dependent), typically involving a limited-term annuity being purchased for the child or grandchild from the proceeds unless the dependent child or grandchild is also mentally or physically infirm, in which case the dependent child or grandchild can also roll over the proceeds to an RRSP or RRIF (and in certain circumstances a Registered Retirement Disability Plan).
It should be noted that the exemptions set out above are available even if the plan is payable to the estate and not designated directly to the beneficiary in question, as the estate and beneficiary can jointly elect to apply the rollover in such circumstances, subject to certain terms and conditions.
Deemed Disposition of Capital Property
Capital assets such as investments (non-registered), shares in a private company or real estate are deemed to be disposed of as a result of the death of the individual owner and any gain or loss arising on the deemed disposition is included in the individual's income in his or her year of death.
The individual's principal residence (which can be any residence the individual designates as his or her principal residence, subject to certain restrictions) is exempt from capital gains tax. Qualified small business shares and farm or fishing property may also be eligible for the lifetime capital gains tax exemption up to a maximum amount (if the individual has not previously claimed the exemption amount).
Property transferred to a spouse (married or common law) outright or to a qualified spouse trust on death can be rolled over at its cost base and the gain or loss will be included in the spouse's or spouse trust's income at the earlier of (i) when the asset is disposed of by the surviving spouse or the trustees of the spouse trust, as the case may be, or (ii) on the surviving spouse's death. A family farm or shares in a family farm corporation may also be eligible for a tax-free rollover to a child or grandchild in certain circumstances.
Foreign Assets Held on Death
The deemed disposition of capital property on death will include foreign capital property held by a deceased Canadian resident at death, as Canadian residents are taxed on their income. The foreign jurisdiction may also impose tax on the same assets which could potentially lead to double taxation on such assets. Canada has entered into tax treaties with certain countries which may mitigate the double tax concern. For example, Canada has tax treaties with the U.S. and France which reduce or eliminate double taxation on death by in general allowing a credit for the foreign taxes paid against Canadian capital gains tax on the same assets. Cross-border income tax and other professional advice is critical when dealing with such situations.
Income Arising After Death
As noted above, the estate of a deceased individual is taxed on income arising after death in the same manner as a trust is taxed, as it is considered to be a trust for the purposes of the ITA. The exception to this is if and while the estate qualifies as a Graduated Rate Estate.
Graduated Rate Estate ("GRE")
An estate can qualify as a GRE for up to 36 months following a person's death and must:
- Qualify as a testamentary trust under the ITA (i.e. a trust that does not come into being until the person's death and does not receive any contributions from another person, subject to certain restrictions regarding debt payments and loans);
- Designate itself as a GRE in its first tax return;
- Be the sole estate designated as a GRE for a deceased person; and
- Provide the deceased's Social Insurance Number on all tax returns filed while a GRE (i.e. not a new trust tax identification number).
According to CRA commentary, only the "general" estate will qualify as a GRE. Ongoing testamentary trusts and insurance trusts provided for in a will or pursuant to a beneficiary designation do not qualify as GREs under the rules. If an executor has the discretion under the will to do so, it is possible to continue the estate administration for the full 36-month period in order to obtain the benefit of graduated tax rates, even if the estate is immediately distributable.
An estate will cease to be a GRE on the earliest of the following dates: 36 months after the deceased person's date of death; the date the estate no longer meets the requirements set out above; and, the date the general estate administration is complete and ongoing trusts, if any, are set up. On this date, the estate will be deemed to have a tax year end and will thereafter be taxed as a regular trust, paying tax at the top marginal tax rate and being subject to the other rules applicable to trusts.
Under the rules, there is no discretion given to the Minister of Finance to extend the time for an estate to be a GRE after the initial 36-month period, even if, for example, there is ongoing estate litigation or unforeseen problems arise which prevent the estate from being fully administered within that time frame.
Issues Arising from the GRE Rules
Many issues involving trust planning and tax planning for trusts and estates arise from the GRE rules, although some initial concerns were alleviated by the CRA after the rules came into effect in 2016. For example, CRA has confirmed that where a person has executed multiple wills, such as a "primary will" and a "secondary will" commonly used in Ontario to minimize exposure to Ontario Estate Administration Tax (often referred to as "probate fees"), it will consider there to be only one estate.
The implementation of certain tax planning techniques after death can now only be accomplished successfully as long as the estate qualifies as a GRE. For example, if a person owns shares in a private corporation, his or her executor can only engage in certain postmortem tax planning to avoid double-taxation on the value of those shares if his or her estate is a GRE at the time the planning is completed.
Executors will have to be very careful not to disqualify an estate from being a GRE where certain tax planning depends on this status and to complete such tax planning within 36 months of the deceased's date of death. For example, one requirement to qualify as a GRE is that no person other than the deceased can contribute to the estate, therefore an estate can be disqualified from being a GRE if someone else contributes to the estate. This could happen if a beneficiary borrows from the estate and then recontributes the borrowed funds to the estate, or if a related person pays the deceased's debts and is not reimbursed as required within the necessary timeframe.
Another issue to bear in mind is that GRE designations cannot be late-filed by executors, and an estate may therefore miss the opportunity of a GRE designation if the executors fail to make the necessary designation on the first estate tax filing or if they make the first estate tax filing late.
Where such post-mortem tax planning is expected or potentially beneficial, qualified advisors should review a person's estate planning to ensure the executors have the necessary powers and flexibility to allow them to complete tax planning after death and maintain an estate's GRE status for as long as it may be necessary and possible to do so.
Charitable Donations by a Trust or Estate
This Advisory does not examine the impact of the 2016 changes to the charitable donation rules applicable to trusts and estates, as these rules are intricate and complex. For a discussion of these rules, please see our Advisory "Charitable Giving". However, it should be noted that it is important to maintain an estate's GRE status in order to claim charitable donation credits against 100% of net income in the year of death and the year immediately preceding death (as opposed to the 75% of net income limit which applies during a person's lifetime) and to maximize donation tax credits for the estate.
Exemptions from Top Marginal Tax Rates
Unlike an inter vivos trust, for which there is no exemption from the application of the top marginal tax rate on its income, there are exemptions available for two types of testamentary trusts: Graduated Rate Estates (discussed above) and Qualified Disability Trusts (discussed below). These types of trusts are also exempted from certain other rules to which trusts are generally subject, such as the requirement to have a calendar year-end.
Qualified Disability Trusts
The second exemption is for a "qualified disability trust" ("QDT"). Trusts that qualify as QDTs will be taxed at graduated tax rates. QDTs are for the benefit of certain disabled beneficiaries, and with the inclusion of appropriate terms can allow such disabled beneficiaries to benefit from trust distributions while still being eligible for government disability benefits (e.g. Ontario Disability Support Payments or "ODSP").
To qualify as a QDT, a trust must:
- Have at least one beneficiary who qualifies for the federal disability tax credit (the "qualifying beneficiary") who is specifically named in the trust;
- File a joint annual election with one or more qualifying beneficiaries (the "electing beneficiary" or "electing beneficiaries");
- Be resident in Canada for the elected year(s); and
- Be a testamentary trust (see above under GREs for further information on this requirement).
A qualifying beneficiary can jointly elect with only one trust for the QDT qualification. Only one qualifying beneficiary is required to be an electing beneficiary for each QDT, although a QDT can have multiple qualifying beneficiaries.
Problems may arise in making the joint election to be treated as a QDT if the qualifying beneficiary is not legally capable of making an election and has no legal representative who can make the election on his or her behalf. If this is the case, it will be necessary to obtain a court appointment of a guardian of property for the qualifying beneficiary in order to be able to make the joint election. Such appointments, however, come with an extensive range of legal responsibilities, often require onerous compliance, and are subject to court supervision.
Also, there is a tax recovery mechanism in the rules which will be triggered in any year in which the trust stops qualifying as a QDT or a capital distribution is made from the trust to a non-electing beneficiary.
For further information and a more detailed discussion of planning for special needs beneficiaries, see our Advisory "Estate Planning to Benefit Family Members with Special Needs".
To view the full article, click here.
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.
