- Published on Friday, 10 July 2015 21:10
Recently, I attended the Prairie Provinces Tax Conference hosted by the Canadian Tax Foundation. A common theme among the tax practitioners there was concern over the new rules established for "graduated rate estates", and how these new rules would impact a number of common estate planning techniques. The new rules take effect on January 1, 2016, and it is important to review your estate plan to ensure that the new rules do not have a negative affect.
In the 2014 Federal budget, the government introduced new rules for trusts created under a will, which were previously taxed at the same marginal tax rates as if they were individuals. According to the government, some planners were abusing this rule to multiply the savings available using low tax brackets, and it was creating an incentive to delay the distribution of estate assets.
One common technique in estate planning is the use of spousal trusts, particularly in blended family situations. Spousal trusts generally allocate all of the income of the trust to the spouse, but upon the death of the spouse, the assets will be transferred to a different party, typically children from a previous relationship. It is an effective method of providing both for your current spouse and former children, but it also carried certain tax benefits. Previously, the income could be taxed partially in the trust and partially in the spouse's hands, which would result in the use of two separate graduated rates.
Under the new rules, spousal trusts and any other separate trusts created under a will, including, for example, an insurance trust, are not considered graduated rate estates and therefore all of the undistributed income will be taxed at the maximum tax rate. This eliminates a primary tax benefit for using many of these structures, and may justify reevaluating the use of these trusts in your estate plan.
The biggest impact, however, isn't felt until the life beneficiary of the spousal trust also passes away. Previously, the trust was responsible for the tax liability of any assets that had a capital gain. However, the new rule reassigns the tax liability from the trust to the estate of the deceased life beneficiary, regardless of whether the estate is entitled to any of the income or assets that created the tax liability. The trust remains jointly and severally liable for the portion of the deceased's taxes that are a result of this reassigned income. There are not clearly defined restrictions on the CRA's ability to enforce this tax debt - they appear to be able to pursue the debt in the first instance through either the trust or the estate.
This tax situation creates potential disputes and conflicts of interest between the trustee of the spousal trust and the executor(s) or beneficiaries of the estate.
Consider the following example:
Alan married Beth. It was a second marriage for each of them. Alan had a child named Alice, and Beth had a child named Bob. Alan creates a will with a spousal trust assigning all income of the trust to Beth, and all remaining assets to Alice upon her death. Alan passes away first. Then Beth passes away.
If Beth dies in 2015, there will be no change, and the spousal trust will be responsible for the taxes, ultimately reducing Alice's inheritance.
If Beth dies in 2016, however, Beth's estate and the spousal trust will be jointly liable for the taxes, and it is not clear who the CRA will pursue first for the tax debt. If they pursue the spousal trust, it will reduce Alice's inheritance. If they pursue the estate, it will reduce Bob's inheritance. This introduces a potential for dispute and uncertainty between Bob and Alice into an area of law that is already rife with disputes.
The new rules may also affect several post-mortem tax planning techniques that can be used to reduce tax liability, particularly when shares of private corporations are involved.
Despite all the negatives associated with this change, there is a bright side - because the taxes should now be reported in the deceased's terminal return, the income can be sheltered by carry-over losses, charitable and medical tax credits, or other special tax provisions that apply to terminal returns.
While the Department of Finance is still accepting submissions regarding practitioner's issues with the new rules, it is unlikely they will be changed before coming into force on January 1, 2016. It is therefore important to ensure that your estate plan is reviewed by a tax or estate planning lawyer to reduce the potential for uncertainty or disputes, particularly if a spousal trust is involved.