Revisiting the “new” testamentary donation rules

December 15, 2022 | Darren Lund

The legal landscape for testamentary charitable gifts underwent a significant sea-change in 2015. In that year, amendments to the Income Tax Act (Canada), R.S.C. 1985, c.1 (5th Supp.) (“Tax Act”) were implemented that apply to deaths occurring on or after January 1, 2016.

Under what we now call the “old rules” – which applied to deaths occurring prior to January 1, 2016 – the Tax Act deemed a testamentary charitable gift made by will to have been made by the deceased taxpayer immediately before death, and the gift was valued as of the date of death. Since the gift was deemed to have been made immediately before death, the donation tax credits arising from the gift could be used to reduce or eliminate the deceased taxpayer’s tax liability on their terminal tax return. The Tax Act also permitted the donation tax credit to be applied to the year immediately preceding the year of death.

Out with the old and in with the new

With the implementation of the 2015 amendments, the landscape is quite different. If a deceased taxpayer makes a charitable gift in their will, subsection 118.1(5) now deems the gift to have been made by the estate, rather than by the taxpayer immediately before death. In addition, the gift is made at the time the property is transferred to the charity, such that the value of the gift is the value of the property at the time it is transferred, and not at the date of death.

One of the improvements in the new rules is that they have expanded the number of taxation years to which the donation tax credits can potentially be applied. To qualify, however, the gift in the will must be made: (a) by an estate that is a “graduated rate estate”[1]; (b) within 60 months of the deceased taxpayer’s death;[2] and (c) with property that the estate acquired on and as a consequence of the death of the taxpayer or property that is substituted for it.[3]

If the above requirements are met, the donation tax credits arising from the gift can be applied to: (i) the deceased taxpayer’s terminal year; (ii) the year immediately preceding the deceased taxpayer’s terminal year; (iii) the year of the estate in which the gift is made; or (iv) any prior year of the estate in which the estate was a graduated rate estate.[4]

The additional flexibility in applying the donation tax credits under the new rules was a welcome change. Of course, as is often the case with amendments to the Tax Act, they also introduced new complexities and considerations, two of which are considered below.

Substitute property

As noted above, to qualify for the flexible donation tax credit rules the property which is the subject matter of the charitable gift must be property that was acquired by the deceased taxpayer’s estate on and as a consequence of death or property that is substituted for it. In many cases this will not present a challenge. To take a simple example, assume an individual dies leaving a bank account with $50,000 and a home worth $950,000. The home is subsequently sold. The will provides for 5 charitable gifts of $50,000 which are paid from the net proceeds of sale of the home in the second year of the estate. The net proceeds of sale represent property substituted for the home, such that if the estate otherwise qualifies as a graduated rate estate, the donation tax credits arising when the legacies are paid qualify for the flexible donation tax credit rules.

Now consider an estate in which the deceased taxpayer’s wealth is held primarily in a corporate structure and their will makes provision for significant charitable bequests. Assume the estate does not have sufficient liquidity to fund the charitable gifts without accessing the value inside the corporate structure. If funds are paid to the estate in the form of a dividend on the shares, the dividend is not property substituted for the shares unless the dividend is paid on a redemption of the shares. It is therefore important for both the will-maker at the planning stage, and the executor at the implementation stage, to give due consideration to how the charitable gifts are or will be satisfied. There may be other options if properly planned, such as a donation by the corporation rather than the estate.

Partial charitable gifts of residue

An interesting complexity arises where an individual leaves a portion of the residue of their estate to one or more charities, and the balance of the residue to one or more individuals. Let’s assume that an individual makes a will that leaves 40% of the residue to each of their two surviving children and the remaining 20% to a named charity.

The executors determine to make in interim distribution of the residue in the second year of the estate. Under the new rules, the distribution to the charity of its 20% share of that interim distribution is a donation. Assuming the estate is a graduated rate estate, the resulting donation tax credits can be applied as described above under the flexible donation tax credit rules, including to the terminal year, which is likely to have the greatest taxable income and resulting tax liability. If a tax refund is generated, it is added to the residue, increasing the amount available for subsequent distributions. When the next distribution of residue occurs, the charity’s 20% share of the distribution represents a second donation under the new rules, and the same process repeats itself. If the flexible application of the donation tax credits results in another refund, it is added to the residue, increasing the amount available for distribution, and so on.

The loop created in these circumstances will not continue forever; the number of possible iterations is limited both by the amount of income in qualifying years and by the passage of time, since graduate rate estate donations must be made in the first 60 months of the estate. Practically, any refund generated will diminish with each iteration. Accordingly, to avoid unwanted delays in the estate administration, individuals may choose to “short-circuit” the loop by providing that any refunds generated accrue only to the individual beneficiaries, or providing executors with discretion as to the application or non-application of available tax credits based on a cost-benefit analysis.

The “new” rules introduced in 2015 provide both opportunities and challenges for structuring and implementing testamentary charitable gifts. Careful planning and advice at both the planning and implementation stages can assist in harnessing the opportunities while minimizing the challenges.

If you have any questions or concerns, please feel free to reach out to a member of Miller Thomson’s Social Impact group.

[1]     A “graduated rate estate” is the estate that arises on and as a consequence of the death of a taxpayer provided it qualifies as a testamentary trust, it is designated as a graduated rate estate in its first taxation year, and prescribed information is provided. The estate will be a graduated rate estate for up to 36 months from the date of death.

[2]     For this purpose, the definition of graduated rate estate is read without reference to the 36-month limitation, if the estate otherwise qualifies.

[3]     Tax Act, s. 118.1(5.1).

[4]     Tax Act, s. 118.1(1). As a result of this potential expanded application of the donation tax credits, the new rules are sometimes referred to as the “flexible donation tax credit rules”.

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