Will new trust rules impact you?

Recent headlines warn Canadian tax rules taking effect in 2016 may disrupt estate plans that use spousal, alter ego or joint-partner trusts. But how might they impact planning for U.S. citizens living in Canada?

An alter ego trust (AET) can be useful for Canadian residents 65 or older who want to avoid probate tax on transfer of assets. The trust can essentially be used as a substitute for a will.

Other key benefits include:

• privacy, since AETs aren’t subject to probate;
• protection against litigation, since they’re more difficult to challenge than wills;
• provisions for incapacity, since they act as substitutes for powers of attorney and continue after the settlors die; and
• in some cases, creditor protection.

There’s a cost to establishing an AET, plus ongoing administration fees; like annual tax filings since the trust classifies as a separate taxpayer in Canada.

Right now, testamentary trusts have a tax advantage over AETs, but new rules will change that in 2016. For people in Ontario and British Columbia, where probate rates are high, more people will likely give AETs consideration.

The changes also complicate matters for Americans in Canada, because the IRS requires U.S. citizens to report and pay tax on income earned worldwide. And, when they die, they’re subject to U.S. estate tax, provided the estate is worth more than $5.43 million (2015’s total).

Generally, under the Canada-U.S. Tax Treaty, a U.S. citizen is entitled to foreign tax credits if he pays tax to the IRS. He can apply those FTCs to his Canadian tax return to avoid double taxation (any Canadian tax owing reduces the amount of U.S. tax paid).

But, right now, a mismatch between Canadian and U.S. tax rules can leave clients with no foreign tax credits and expose them to double tax. The 2016 changes fix that, and will make it more viable for U.S. citizens living in Canada to use alter ego trusts as part of their estate plans.

Right now, in Canada, an AET is classified as a separate taxpayer from the settlor, but income distributed to the AET’s settlor is taxed in her hands. Since the U.S. disregards the AET, the settlor has to report and pay taxes on the income to the IRS, subject to available foreign tax credits.

If the AET includes a right to access capital, the Income Tax Act requires all capital gains and losses be attributed back to the individual. The settlor must report those gains and losses in both Canada and the U.S.

But, if there’s no right to encroach on capital, the AET will report capital gains and losses in Canada, but the individual is required to report to the U.S. This creates a mismatch for the foreign tax credits and, again, can expose someone to double tax.

And, in Canada, the death of an AET settlor triggers a deemed disposition of remaining assets (provided the settlor hasn’t elected otherwise). But since AETs are taxed at the highest marginal rates, the trust can be taxed at a higher rate than would otherwise apply to the person who created the trust.

The new rules fix this: beginning in 2016, the deemed income inclusion goes to the deceased individual, rather than the AET. This matches up rules between Canada and the U.S.

And this change makes alter ego trusts more appealing for wealthy U.S. citizens living in Canada, since these trusts shouldn’t affect the settlor’s ability to use U.S. estate tax exemptions at death.

But, make sure there’s enough liquidity on hand to pay the taxes. The new rules say the settlor and the trustees of the AET will be jointly and severally liable for the tax bill.