A new formula for tax-efficient philanthropy

Client profile

Annabelle Bonheur*, 56, is a biochemist at a major pharmaceutical company and makes $325,000 a year. Her deceased parents left her a large inheritance, which includes shares in two private companies and a three-acre tract of land not far from her home in Oakville, Ont., that will likely be a future hotspot for residential development.

Financially secure and disinclined toward lavish spending, Annabelle plans to leave the private shares and land to charity. Current fair market value of the land is $3.2 million; the shares are worth about $1.6 million.

The rest of Annabelle’s assets will go to her 20-year-old daughter. These include $3 million she inherited, plus whatever is left of her retirement portfolio on death. Annabelle and her ex-husband, Chad, a securities lawyer, divorced 10 years ago. Their marriage contract says Annabelle’s inheritance is excluded from net family property in the event of a divorce, so he has no claim on the assets.

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Annabelle wants to ensure her charitable gifts are made in the most tax-efficient manner. So, three years ago, she had an estate plan drawn up. However, new rules from the Department of Finance mean she has to go back to the drawing board.

*This is a hypothetical scenario. Any resemblance to real persons is coincidental.

The expert

M. Elena Hoffstein

partner in Fasken Martineau’s Private Client Services group in Toronto

The situation

The rules for charitable giving on death got a major overhaul in Budget 2014. The government’s proposals were enacted into law in December of that year, but the new rules don’t apply until the beginning of 2016.

“It’s a sea change,” says M. Elena Hoffstein, a partner in Fasken Martineau’s Private Client Services group. All the planning people like Annabelle have done to pass on wealth will be “out the window” at the end of 2015.

Pre-2016 rules

The current rules start from a familiar premise: when someone dies, her assets are deemed sold immediately before death at fair market value. Capital gains and other taxes result from that deemed sale, and are reported by the estate on the deceased’s terminal tax return. “If you have a gift by will to charity, you can take the donation tax credit and offset the tax that arises in the year of death and the year prior,” Hoffstein explains. The gifted property doesn’t have to be transferred to the charity immediately for the credit to apply. The credit’s calculated based on the fair market value of the gift immediately before death.

The federal tax credit is 15% on the first $200 of donations claimed in a year, and 29% on donations above $200. In Ontario, it’s 5.05% and 11.16%, respectively.

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While the gift is deemed to be made by the deceased, it’s actually made by the estate, which is a separate taxpayer. So, under the current system, “you’re really taking the tax credit of another taxpayer—the estate—and applying it to the deceased.”

New rules

Rules that take effect in 2016 make two fundamental changes.

First, a charitable gift stipulated in a will is no longer deemed made by the deceased for tax purposes.

“Gifts to charity following death will be deemed to have been made by the estate,” notes Hoffstein.

Second, the value of the gift for the purposes of calculating the donation tax credit is determined at the time the property is actually transferred to the charity. The tax credit must then be applied to the estate return filed for the year of the transfer.

Problem: since the new rules say the credit must be claimed in the tax year the gift is actually transferred—which can be years after death for complex estates—how can a client use the credit to defray tax triggered by the deemed disposition on death and reported on the terminal return?

GREs

Hoffstein says Annabelle can solve this problem by setting up a Graduated Rate Estate (GRE), also introduced in Budget 2014, and available starting in 2016.

The GRE was devised as part of a major shakeup the Budget brought to the world of trusts. The government ended graduated tax rates for testamentary trusts, which are trusts established by will. These trusts will now get taxed at the highest marginal rate, just like trusts people set up during their lifetimes (inter vivos trusts). GREs are an exception. The GRE is a testamentary trust that begins at death and, when drafted properly, can last up to 36 months.

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During this period, graduated tax rates apply. The GRE is also structured to resolve the tax-credit timing issues the new charitable-giving rules cause. “What CRA has said is that, if you’re making a gift to charity, the only way you can carry the donation tax credit back to the year of death and the year before death is if [the gift is] done by a [GRE],” Hoffstein explains. With a GRE, Annabelle’s executor will be able to allocate the donation tax credit to:

the tax year of the GRE in which the donation is made;
an earlier tax year of the GRE;
the deceased’s terminal return; or
the year prior to death.

So, for a donation made in the third and final year of the GRE—let’s say it’s the year 2020 and the GRE started in 2018—Annabelle’s executor will have five tax years to choose from: 2020 (third 12-month estate return), 2019 (second 12-month estate return), 2018 (first 12-month estate return), 2017 (terminal return) and 2016 (year prior to death). Problem solved?

Degree of difficulty

9 out of 10.

The new rules give executors more tax years to choose from when deciding how to allocate the donation tax credit. But, that increased flexibility comes with a strict timeline that will make life difficult for executors overseeing complex estates with illiquid assets.

Not exactly. The new requirements present “a real challenge for executors of complex estates,” says Hoffstein, since these estates require a lot of administrative work. The problem is compounded in cases like Annabelle’s. “The estate’s assets are illiquid—real estate, private company shares—and difficult to monetize in order to accommodate charitable bequests within the 36-month window.”

The solution

Annabelle has to update her will with language establishing a GRE. “In drafting new wills, we now provide that [the estate] lasts up to 36 months,” notes Hoffstein. Her executor will have two options, depending on if he’s able to liquidate the land and shares within the 36-month window.

Option #1

If the executor can’t liquidate the land and shares in time, he’ll transfer them to the charities in kind (i.e., through a straight transfer of ownership) before the 36-month deadline. From CRA’s perspective, this is a taxable disposition based on fair market value, so Annabelle’s estate will be liable for 50% of the capital gain on the land and shares. The donation tax credit is then applied to the tax year of the transfer, prior years of the GRE or one of the deceased’s final two returns (terminal and the year prior to death).

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To avoid a potential dispute with CRA over fair market value, the executor will need an up-to-date, professional appraisal by an independent third party.

Option #2

Prior to Budget 2015, only public company shares were exempt from capital gains when donated. Budget 2015 applies this treatment to private company shares and real estate. “But there’s a twist,” notes Hoffstein. To be tax exempt, the donor must:

sell the shares to a buyer who deals at arm’s length with both the donor and the charity; and
donate the cash proceeds of the sale to a qualified charity within 30 days of the disposition.

So, unlike public shares, private shares and real estate must be sold for cash prior to the transfer to get the nil capital gains treatment. The legislation implementing this change is currently in draft form, and will have to be re-introduced by the new Parliament post-election. Option #2 is preferable, but it would only work if the estate can find a buyer within 36 months of Annabelle’s death. Nothing prevents the estate from selling the shares and land after 36 months, but, in that case, the donation tax credit can’t be carried back to offset the tax liability resulting from the deemed disposition of Annabelle’s assets on death. The credit would have to be used in the year of the donation or in any of the subsequent five years. Unfortunately, the credit would then go mostly unused, as the estate won’t have much tax to defray.

Client acceptance

7/10

Annabelle will update her estate plan immediately to provide for a GRE and Option #1. This is to cover the unlikely, but conceivable, scenario where she dies in January 2016, for instance—right after Budget 2014’s rules kick in.

If Budget 2015’s proposals go through, she’ll update the will again with instructions for the executor to liquidate the land and shares during the GRE’s 36-month window and donate the proceeds to her favourite charity. She accepts the fact that a less optimal, in-kind transfer may be her executor’s only choice if he can’t find a buyer.

Dean DiSpalatro is a Toronto-based financial writer.