Insurance premiums could retroactively disqualify rollover to spousal trust

At issue

Life insurance is a regularly-used estate planning tool, often quantified in part to satisfy a capital gains tax liability on death.  As capital property can transfer – or ‘rollover’ – between spouses at adjusted cost base (ACB), insurance proceeds for this purpose would not be required until the second death of the two, and the insurance may be structured with that in mind.  (In this article, the term spouse includes a common-law partner.)  

Trusts are also central tools in wealth and estate planning.  A transfer of capital property to a spousal trust can (but does not have to) occur on a rollover basis.  As long as the trust does not dispose of that property during the spouse-beneficiary’s lifetime, capital gains recognition will be deferred until that person’s death.

But where life insurance and a spousal trust are married together (pun intended), it could lead to a retroactive negative tax result.

Income Tax Act (ITA) Canada – Sections 70(6) and 73(1.01)

The main rules enabling a rollover to a spousal trust are in ITA s.73(1.01) for inter vivos (lifetime) transfers, and ITA s.70(6) for testamentary transfers.  For present purposes, the requirements are essentially the same either way.  The result of the successful application of the rules is that the transferor has deemed proceeds equal to his or her ACB, and the trust is deemed to have acquired the assets at that same amount.

In addition to both the parties having to be Canadian residents at the time of the transfer, the trust must comply with ongoing rules regarding income entitlement and access to capital.  Specifically, 

  • The spouse-beneficiary must be entitled to all income of the trust during his/her lifetime; and 
  • No-one but the spouse-beneficiary may receive or otherwise obtain the use of any of the income or capital of the trust before that person’s death.

Carefully reading the second proviso, the spouse-beneficiary does not have to be entitled to the capital in order for the rollover to apply.  A typical application might be a second-marriage spouse-beneficiary having use of a house, cottage or other capital for life, with the capital to be distributed to the first-marriage children upon the beneficiary’s death.

2014-0529361E5 (E) – Spousal trust & life insurance, November 16, 2015

This CRA letter deals with the use of trust assets to pay life insurance premiums, where the proceeds of the insurance will be paid to a policy beneficiary.

At issue is the constraint on access to the capital of the trust.  Though the contents of the taxpayer’s letter are not quoted directly, the CRA letter begins with an acknowledgement of common ground “that the relevant legislation does not contain a requirement that the spouse “benefit” from the trust while alive.”  However, it goes on to raise the concern whether someone other than the spouse-beneficiary may be obtaining the use of the trust capital or income.  

The taxpayer’s argument appears to have been that as nothing is received before the spouse’s death, the premium payments should not be considered as property used by the residual beneficiaries.  This position is rejected, and instead characterized by the CRA as the use of trust property to establish the residual beneficiaries’ rights to the funds from the policy, the realization of which will simply occur after the death of the spouse.

The upshot is that payment of such insurance premiums would disqualify the trust from ever being a spousal trust eligible for a capital property rollover.

Notably, it took the CRA a year-and-a-half to respond to this letter, which is a bit longer than usual.  The opening states that the “submission received careful consideration”, an unnecessary but arguably telling indication that extended time was required to grapple with the merits of the arguments.  As well, the closing advises that the submission was also forwarded to the Department of Finance, the responsible legislative department (as compared to the CRA being an administrative body).  

Practice points

  1. Life insurance remains a useful tool for dealing with tax liabilities, but its ownership, funding source and beneficiary designations must be carefully considered in light of CRA’s position in this letter.  Any contemplated workaround (for example a parallel trust for the insurance alone) should be reviewed by legal and tax advisors to be sure the problem is adequately addressed without causing other undesirable consequences.  
  2. Some insurance-based concepts, for example an insured annuity, may be positioned as a means to improve investment returns.  Though they may be shown not to harm a spouse-beneficiary – and possibly even to increase lifetime income – such concepts would appear to be problematic for spousal trusts.
  3. CRA’s open notice that it was sharing the submission with the Department of Finance may be a ray of hope that this may not be the final word on the issue. 

Wills and public policy

Can an alleged racially-motivated bequest stand?

At issue

Courts are loath to interfere with the final wishes expressed in a person’s duly executed Will, except in the most egregious circumstances.  

One time when it can occur is when a Will includes a provision that offends public policy, such as a bequest that has a racist element.  For example, a bequest may be impugned if it is contingent on a beneficiary entering or ending a relationship based on racial criteria. 

But can a bequest be assailed on the basis that it is racist-motivated, but where the Will says nothing to that effect on its face?

Tataryn v. Tataryn Estate (SCC), [1994] 2 S.C.R. 807 

The Supreme Court of Canada instructs courts to be cautious in dealing with testamentary freedom:  “In the absence of other evidence a will should be seen as reflecting the means chosen by the testator to meet his legitimate concerns and provide for an ordered administration and distribution of his estate in the best interests of the persons and institutions closest to him.”

Against this backdrop, the SCC upheld the British Columbia legislation in issue, which constrained a testator’s testamentary freedom by requiring first that adequate provision be made for a surviving spouse and children.

Canada Trust Co. v. Ontario (Human Rights Commission) (1990), 74 O.R. (2d) 481

This is not a case of testamentary capacity, but sheds light on the interpretation of discriminatory provisions in a trust.

Canada Trust was trustee over a public charitable trust that had been settled in 1923 to provide student scholarships.  The trust had overt discriminatory conditions, including that it was only available to white, Protestant, British subjects, and that no more than 25% of annual funds could go to female students.

The court ruled that the explicit discriminatory provisions be deleted, but that otherwise the trust could continue.

McCorkill v. McCorkill Estate, 2014 NBQB 148, aff’d 2015 NBCA 50

The deceased named as beneficiary of his estate the National Alliance, an anti-semitic white supremacist group in the United States.  The evidence showed that the purpose and activities of the National Alliance – notably the dissemination of hate propaganda – were illegal under the laws of Canada and New Brunswick.   

While there was nothing in the wording of the Will that was against public policy, the bequest was voided because the “the beneficiary’s raison d’être is contrary to public policy.”

Spence v. BMO Trust Company, 2016 ONCA 196

The deceased intentionally left his adult daughter VS out of his Will, stating briefly in it that “she has had no communication with me for several years and has shown no interest in me as her father.”  

VS alleged she was excluded for racist reasons.  In addition to her own evidence, a long-time family friend swore that the deceased had told her on several occasions that he disinherited VS and her son because the son’s father was white.  The deceased was a black man.

The initial ruling went in favour of VS.

In overturning the application judge, the Ontario Court of Appeal found that:

  • Unlike Tataryn, the deceased had no statutory duty to VS under Ontario law,
  • Unlike Canada Trust, the Will had no provisions that offended public policy, and
  • Unlike McCorkill where the executor would effectively be carrying out an illegal act, the named residual beneficiaries were not unworthy heirs so as to warrant disinheriting them.

As to the evidence of VS and the family friend, the court ruled that “extrinsic evidence of a testator’s intentions is not admissible when the testator’s will is clear and unambiguous on its face.”  Allowing such an attack “would significantly erode and arguably displace meaningful testamentary freedom.”

Practice points

  1. Testamentary freedom is a central tenet in estate law, allowing testators the expectation that their wishes will generally be upheld. 
  2. Express racist provisions in a Will or bequests to organizations with illegal racist purposes will not be allowed to stand.
  3. An allegation of a particular motive behind a testator’s choices will not be allowed to supplant an unambiguous motive expressly stated on the face of a Will.
  4. At time of writing, an application for leave to appeal Spence is pending before the Supreme Court of Canada. [UPDATE: The SCC denied leave on both Spence and McCorkill in June 2016.]

Bringing a foreign pension to Canada – A two-step technique

Our nation was born through immigration, and it continues to welcome new arrivals in a steady stream. While some newcomers will be at the start of their careers, many will be arriving in the midst of their working lives.

Frequently, immigrants have significant tax-sheltered savings in foreign pension plans, and may wish to bring those funds over to their new home in Canada. They may be surprised, however, to learn that our system does not allow tax-free transfer of foreign pensions to Canadian registered retirement or pension plans. However, all is not lost.

If appropriate steps are taken – on a timely basis – the net result can be continued tax-sheltering of their retirement savings.

No direct transfers

While it may seem harsh to not allow direct tax-free transfers, it’s simply not practical for our tax system to be so intimately intertwined with foreign tax systems.

Instead, our system makes allowance within the domestic tax rules once the person has collapsed the foreign pension. As this “deregistration” of the foreign pension is likely irreversible, at minimum the person will want to be certain:

  • what gross and net-of-tax amounts are involved,
  • that the particular plan and transactions qualify, and
  • whether the actions can be completed in the required time frame.

Step 1 – Foreign tax procedure

Generally, the foreign pension administrator will be required to withhold taxes according to that jurisdiction’s laws. This may include the administrator evaluating the nature of the transaction to determine whether it has a withholding obligation at all and, if so, for what amount. The amount of withholding tax may in turn be reduced if there is an applicable provision in the tax treaty Canada has entered into with the foreign state.

Some jurisdictions also impose penalties on some withdrawals when taken below a specified age. In the past, the Canada Revenue Agency had not allowed credit for that type of penalty imposed on individual retirement plans from the United States.  However, it reversed its position a few years ago.  It would be advisable to verify CRA position on plans originating from other countries to be sure what to expect.

The Canadian resident will receive a payment denominated in the foreign jurisdiction’s currency, net of all withheld amounts. Unless there is a continuing connection, this withholding will usually satisfy the person’s final tax obligation on the pension to the foreign jurisdiction.

Step 2 – Canadian tax calculation

Income inclusion

Canadian residents are taxable on worldwide income. Accordingly, the gross amount received from the foreign pension, converted to Canadian dollars, must initially be included in calculating Canadian tax liability.

The withheld foreign taxes entitle the person to claim a foreign tax credit when calculating this initial Canadian tax due. Depending on the circumstances, however, the credit may be less than the withheld amounts (see provisos below).

Special RRSP/RPP deduction

A special deduction will be allowed if the pension satisfies the Canadian definition of superannuation, pension benefit or foreign retirement arrangement. Additionally, the payment must be a lump sum and specifically not be part of a series of periodic payments.

The deduction is in the form of an allocation of contribution room toward either a registered pension plan (RPP) or registered retirement savings plan (RRSP). Though not obligated, the person may make an RPP or RRSP contribution up to the amount taken as income as a result of collapsing the foreign pension. This does not require or affect existing contribution room.

The special deduction must be used in the same taxation year as the income inclusion or within the first 60 days of the following year. To be clear, any unused room from this allocation cannot be carried forward.

Some practical provisos

Bear in mind that the actual payment received from the foreign plan will be net of withheld amounts. If the person wishes to take advantage of the full contribution/deduction, other cash will be required for that top-up. On the other hand, if the amount is not topped up, then Canadian tax will still be due on the difference between the gross income amount and the chosen contribution.

The foreign tax credit is limited to the lesser of the actual foreign tax paid/withheld (up to a maximum of 15%) and the Canadian tax due on the foreign-sourced income. The credit may thus be less than the withheld amount. Furthermore, this type of credit cannot be carried forward for use in future years.

As you’ve likely come to realize, determining how to deal with a foreign pension can be a complicated matter. As a starting point, the person should obtain a clear statement from the pension administrator as to the procedure and amounts from that end. The statement can then be analyzed with the person’s Canadian tax advisor to determine how best to proceed.