Trust – Page 4 – Doug Carroll

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

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.
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.
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.

Are Alberta trusts still worth it? – Mounting changes may make them uneconomical

There was a time when the creation of trusts in the province of Alberta was practically an industry unto itself. I can attest from personal experience when I was in private law practice a decade or so back that Alberta firms advertised directly to their Ontario colleagues.

From then up to last year, among the provinces Alberta clearly had the lowest top bracket tax rate at 39%, being 29% federal and 10% provincial. At times that has ranged from 5% to over 15% better than elsewhere in the country.

The expectation was that the trust’s residence for tax purposes would follow that of the trustee. This came under scrutiny in 2012 in Fundy Settlement with the Supreme Court of Canada ruling that residency is determined based on the location of the trust’s central management and control. In that case, that meant Canada rather than Barbados. The Newfoundland Supreme Court considered that case in Discovery Trust earlier this year, upholding a trust’s contention that it was resident in Alberta.

Still, even if a trust is properly established, managed and documented, is it still worth the effort to have it taxed in Alberta?

Changes to testamentary trusts

Inter vivos trusts have long been taxed at the highest combined federal-provincial tax rate, but testamentary trusts could take advantage of graduated brackets. Potentially this benefit could be multiplied for someone who was a beneficiary out of more than one Will.

After this year, with the exception of the first 36 months of an estate and trusts for qualified disabled beneficiaries, testamentary trusts will also be taxed at the highest bracket.

This obviously takes the shine off using testamentary trusts for tax purposes (let alone multiples), though where it is expected that a given beneficiary will be at top bracket in another province, a 39% tax rate may still seem useful — so long as the rate remains at that level.

Alberta rate changes

Even before the election of a majority NDP government in Alberta earlier this year, the incumbent Progressive Conservatives had proposed adding another tax bracket. This became moot once the election was called.

After winning a majority in May, the NDP moved swiftly to carry out a number of election promises before the summer. This included the addition of 4 provincial brackets, 3 of them above the federal bracket ($138,586 in 2015): 12% at $125,000, 13% at $150,000, 14% at $200,000 and 15% at $300,000. The rates are effective October 1, so there is a pro-rata calculation based on the addition applying for 1/4 of the year in 2015. For the top bracket, that means 11.25% for 2015, and then 15% hereafter.

Combined with the 29% federal bracket, that makes for a top combined rate of 44%, the same as Saskatchewan and slightly above the Newfoundland top rate of 43.3%. Alberta is no longer the obvious choice.

Liberals election platform

At time of writing, the Liberals have just won a majority in the federal election. A key plank in their tax platform was to reduce a middle federal bracket from 22% to 20.5%, and to add a top bracket for income over $200,000 at the rate of 33%.

With a majority mandate, it can be expected that these tax changes will be put in place, certainly for 2016. That will raise all provincial combined top rates by that same 4% increment. In Alberta’s case, that will take it to 48% in 2016.

This series of changes make for a significantly different tax proposition for testamentary trusts than would have been contemplated no more than three years ago, particularly for trusts resident in Alberta. Those who have drafted their Wills intending to take advantage of the tax differential should take another look and decide if their plans still make sense. For existing trusts, legal and tax advice is recommended if a variation of the trust is desirable or even possible.

Spousal trusts and blended families – A different mix in 2016

It can be challenging managing finances between spouses in second marriages.

Add two sets of children to the mix — and often some mutual children — and things can get very complicated. And it doesn’t necessarily get any easier as those children become adults, or even if they are already adults when the new relationship develops. It’s a delicate balance.

Beyond the day-to-day issues, attention will eventually turn to what happens when one of the spouses dies. While there are common interests between them as spouses, their parental desire to provide for their respective children adds a layer of complexity to the estate planning exercise.

How spousal trusts work

The spousal trust has been used for decades as a tool to address these concerns. Let’s assume the spouses are Jay and Pat.

Jay’s Will may make some immediate bequests, then a trust is set forth with Pat as lifetime income beneficiary. Pat may or may not be allowed to encroach on the capital to some extent, with Jay’s children being the ultimate capital beneficiaries on Pat’s death.

As an alternative, Jay could settle a joint-partner trust created during lifetime. In that case such an inter vivos trust would be a top bracket taxpayer, though income distributions would be taxed to Pat.

Either route would result in a spousal trust into which capital assets could be transferred at their cost base. This defers tax recognition of gains to that point, and allows for continuing deferral on future gains. Some gains could be triggered and taxed to Pat if there is an encroachment, but otherwise the gains will be deferred until Pat’s death.

Tax changes after 2015

A couple of wrenches were thrown into the machinery of this planning with changes to the rules for trust taxation passing into law in 2014. Let’s assume Jay dies, with the trust provisions having been established in Jay’s Will.

First, Jay would have contemplated that Pat’s income could be optimized by coordinating with the testamentary trust’s graduated tax brackets. But after 2015 (unless Pat is disabled at Jay’s death), such a testamentary trust will be subject top bracket taxation. Thus there will be less spendable income than the plan intended, possibly insufficient to sustain Pat based on Jay’s expectations when the Will was executed.

The second key change relates to the capital gains related tax on the deemed disposition of trust assets on Pat’s death. Under prevailing rules the trust is responsible for that tax, following which it distributes the net remainder to Jay’s children as capital beneficiaries.

Under the new rules for deaths occurring after 2015, the capital gain is deemed to be Pat’s. Pat’s estate is responsible to pay the tax, though if it is insolvent then the trust has the contingent liability. Subject to that proviso, Jay’s children will likely receive the trust capital, while Pat’s children bear the brunt of the taxes in the form of a depleted estate.

Even if an agreement is struck to have the trust pay the taxes, this will likely be considered a contribution to Pat’s estate that immediately disqualifies it from use of graduated tax rates (which otherwise would be available for three years under the new rules).

Any reprieve ahead?

These issues were acknowledged by the Canada Revenue Agency at this year’s annual conference of the Society of Trusts and Estates Practitioners. Not surprisingly, the loss of graduated brackets for testamentary spousal trusts did not seem to be a concern.

On the other hand, the mismatch problem on death of the spouse-beneficiary appears to have been unintended. It remains to be seen whether the government takes any action to address this.

Regardless, spouses in the planning stages may wish to reconsider, redraft or possibly completely unwind their plans — hopefully both spouses still have testamentary capacity. It’s likely not so easy for trusts that have already come into existence, potentially requiring a court application to vary trust terms.

[NOTE: Late in 2015, the federal Department of Finance issued a comfort letter acknowledging the issues discussed in this article, opening a dialogue with tax professionals intended to address the concerns.