Ottawa overhauls trust rules

Ottawa has fast-tracked key technical amendments involving trust and estate planning, leaving Canadian estate professionals worried that the changes may adversely impact existing and future trust arrangements. The changes, first announced for consultation in the 2013 budget, relate to the elimination of graduated rates for certain trusts, including graduated-rate estates (GREs), qualified disability trusts (QDTs) and life interest trusts.

Despite concerns raised by industry groups, such as STEP Canada and CALU, the rules were confirmed in the 2014 budget and received royal asset in December 2014. Pamela Cross, regional leader of the tax group in the Ottawa office of Borden Ladner Gervais LLP, moderated a STEP webinar on the topic in Toronto in November 2014.

The new rules affect the 2016 taxation year and onward. And there is no grandfathering.

Qualified disability trusts

Changes have been made to qualified disability trusts (QDTs). They’ll be able to access graduated tax rates, provided they meet the following conditions:

• Trust is testamentary at the end of the year, and arose as a consequence of death (so insurance trusts are now included);
• Trust is resident in Canada for the full calendar year;
• Trust must elect to be a QDT, and the beneficiary, who must qualify for the Disability Tax Credit, must also elect to benefit from that trust.

All requirements must be met each year for the trust to remain a QDT. If any requirement is violated during the year, the trust will have to pay a penalty tax to CRA. Lisa Heddema, a tax lawyer at Smetheram & Company in Vancouver, notes that, under the new rules, only one QDT per electing beneficiary is permitted.

“Suppose you have a situation where a disabled individual has four grandparents, and each sets up a trust for the individual under their wills, which would not be unusual,” she says.

“Each of those trusts generates $20,000 in income, so you have $80,000 in total. Because of this rule that you can have only one QDT per elected beneficiary, only one can be taxed at graduated rates. The remaining $60,000 is taxed at the highest marginal rate.”

Another common situation is when a parent creates two types of trust for a disabled child: a will, and an insurance trust, where the child is the beneficiary of a life insurance policy. “Either of those testamentary trusts could qualify as a QDT,” says Heddema. “But, because of this rule, only one of them can. So, in that circumstance, it may be better to include the insurance in the estate so it forms part of the testamentary trust for the disabled beneficiary.”

In its submission to Finance Minister Joe Oliver, STEP Canada said it was concerned that allowing only one QDT per disabled beneficiary would result in widespread hardship, since many disabled people are beneficiaries of more than one testamentary trust.

Graduated rate estates

There are similar problems with GREs, says Angela Ross, principal in the high net worth tax group at PwC in Toronto. There too, you can only have one.

Yet if someone has multiple wills, each with different executors and beneficiaries, is there more than one estate? Most lawyers would say there’s only one. But since the legislation specifies you can only have one GRE, it’s possible, at least for tax purposes, for a client to have more than one estate, says Ross. That raises the question whether such an estate could file a single tax return.

“Even when there are multiple wills, we only file one tax return for the entirety of the estate,” she says. “But if you have an estate with different executors, can you file only a single tax return? If multiple estates file separate tax returns, which estate is the GRE and who decides? There are no provisions to correct a designation if a mistake is made,” and the designation has to occur in the first tax year.

Heddema gives an example to illustrate the difficulty of having only one GRE in a dual will situation. Jane’s main assets consist of $1 million in private company shares and $1 million in marketable securities, each with nominal cost bases. She’s told to have two wills with separate executors. One will deals with the private company shares, and the other deals with the public company shares. She wants to leave the public securities to charity and the value of the private company to her children.

“Under the ideal post-mortem plan, the securities gifted to charity create no capital gain in Jane’s terminal return under the rules relating to the donation of public securities,” Heddema says. “Then, double tax planning will be implemented to create a deemed dividend with respect to the private company shares held by the estate in that second will.” She can do that by using Section 164(6), or what’s known as the 50% solution (see “What’s the solution?” below).

Once that happens, “The donation tax credit under the will for the public securities donation should offset the deemed dividend arising on the private company redemption. So, [under the old rules] the result would be no tax payable on death,” Heddema says.

However, Ross explains that, under the new rules, only GREs are eligible for this type of planning. And, if there are two estates and two tax returns, only one can be designated the GRE.

“If the estate with the public securities is not the GRE, there’s no entitlement to the nil capital gains inclusion rate for the donated marketable securities,” Ross says. “So, Jane’s terminal return will include the gains on those securities.”

But, on the other hand, “if the estate with the private company is not the GRE, it’s not entitled to post-mortem double tax planning.” That means the estate and the deceased taxpayer will both pay tax on redeemed private company shares. The only way to avoid double tax is to use the Paragraph 88(1)(d) bump, which is complex and not appropriate for all clients (see “What to do when a taxpayer dies”). Advisors should determine which estate would incur more tax, and designate that one the GRE.

What’s the solution?

If your client owns private corporation shares and dies, she may be subject to double tax. Fortunately, there’s a way to eliminate this using Section 164(6) of the Income Tax Act (see “The importance of post-mortem planning” by Elaine Blades). If the deemed dividend is paid from a company’s capital dividend account, the dividend becomes tax-free. The CDA includes items such as the proceeds of life insurance policies on death.

If the dividend is elected to be a capital dividend, the loss realized by the estate is reduced by the amount of the capital dividend. If the capital dividend was $100, the estate’s capital loss would be reduced by $100 to $0. That would prevent carrying back the loss to the terminal return.

Fortunately, a provision in the Tax Act known as the 50% solution cuts the loss reduction by 50% when the taxpayer dies, recognizing the need for a loss carry-back. In this example, the capital loss would not be reduced by $100, but by $50. The net gain would be $50 ($100 minus $50).

Under the new rules, neither the 50% solution, nor the ability to eliminate the double tax, will be available to non-graduated-rate estates.

Life interest trusts

For life interest trusts, the proposed rules apply in 2016 and relate specifically to trusts where there’s a deemed disposition on the death of a person. These include:

• alter ego trusts;
• spousal or common-law partner trusts; and
• joint spousal and common-law partner trusts.

Again, there is no grandfathering, and these rules apply to all life interest trusts, regardless of when they’re created.

“These trusts are used all the time by many Canadian taxpayers,” Cross says.

The proposed subsection, 104(13.4), says that the trust will have a deemed year-end on the day the remaining life interest trust beneficiary dies, explains Ross. And the trust’s income for the shortened year (assuming the person didn’t die December 31), including any capital gains, is deemed payable in that year to the deceased beneficiary.

“Capital gains realized on the deemed disposition are included in the beneficiary’s terminal return, and not the trust return, which gets a deduction,” says Ross. “This is important because it taxes income in the hands of the taxpayer who doesn’t have—and isn’t likely to get—access to the assets subject to tax.”

Cross explains the implications: “In an alter ego trust, which an individual would set up for himself during his lifetime, the tax triggered on death is not in the trust where the assets are, but in that individual’s estate, where the assets aren’t.”

Estate question

Q. If someone died Jan. 1, 2014, when does her estate lose access to graduated rates? Jan. 1, 2017 (three years after the estate was created) or Jan. 1, 2019 (three years after the legislation comes into effect)?

A. Jan. 1, 2017.

And, “if you set up a spousal trust, and your spouse dies, the assets are in the trust, and the spouse’s estate pays the tax.”

This creates a tax-paying mismatch, says Ross. “The terms of virtually every life interest trust I’ve seen do not [distribute] property to the life interest beneficiary’s estate. Typically, once a spouse in a spousal trust dies, their interest in the trust ceases.”

Ross adds that trust terms rarely provide for the life beneficiary’s tax payment on death, even though another proposed rule says that the life interest beneficiary and the trust are both liable for any taxes owing as a result of 104(13.4). She says Finance’s intention is that “while the income of the trust is to be included in the terminal return of the deceased and subject to tax there, they want CRA to enforce payment of the tax bill against the trust.”

But CRA hasn’t yet stated how it will enforce these rules. It may try to collect unpaid taxes from the beneficiary, not just the trust. (Previously, if a trust was bankrupt, CRA had no other recourse to collect the taxes.)

This raises a host of issues as to who should pay the tax, when to pay it, how to calculate it, and what to do if a trust’s assets are illiquid but the estate’s assets are liquid. Cross says that the trustees should be told that the trust may be required to pay tax, and that they shouldn’t sue the beneficiary’s estate to recover the tax. (It may be possible to draft the trust to include statements to that effect.)

Cross adds that existing trusts may want to amend their terms, which can be difficult to do; for instance, if the settlor is incapacitated or has already died, amendments may not be possible. Concludes Heddema, “It’s difficult right now to advise life interest trust planning, and estate planning, before we get more guidance from Finance and CRA.”

by Doug Watt, an Ottawa-based financial writer, with files from Melissa Shin.