On January 15, 2016, the Department of Finance released legislative proposals to amend certain new rules in the Income Tax Act (ITA) that govern the income tax treatment of testamentary trusts, as well as spousal and similar trusts, which apply for the 2016 and subsequent taxation years. It is understood that these legislative proposals were put forward by Finance partly in response to concerns raised by practitioners and other persons and organizations working in the Canadian tax, charities, and private client services industries regarding the new rules. Finance had previously indicated in a letter dated November 16, 2015 (in reply to a submission made by the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada, as well as other industry leaders) that it was seeking to understand the concerns raised by industry groups in respect of the new rules and the options they identified for addressing them.
Notably, as part of the legislative proposals, Finance is proposing to amend the ITA’s rules regarding the use of charitable donation tax credits (CDTCs) by testamentary trusts. The legislative proposals also contain amendments to the ITA’s rules relating to trusts and “loss restrictions events” (LREs), which should come as a relief to certain investment trusts.
Finance’s January 15, 2016 legislative proposals are summarized below.
New Election to Tax Capital Gain in Estate
The rules that applied before January 1, 2016 provided that if a trust established for a spouse or common law partner permitted the deemed disposition of capital property on death to be deferred, this deferral would come to an end upon the death of the surviving spouse or common law partner. At that time, the trust was required to pay tax on the resulting capital gain.
The new rules (which are currently in effect and which apply after January 1, 2016) provide that the capital gains arising from the deemed disposition on the death of a surviving spouse beneficiary of a spousal or similar trust are to be taxed in the surviving spouse’s estate, and not in the trust. The new rules were released in draft form following the 2014 Federal Budget and received royal asset on December 16, 2014.
In general, new paragraph 104(13.4)(b) of the ITA provides that the capital gains arising from the deemed disposition upon a surviving spouse’s death are to be taxed in the surviving spouse’s estate, and not in the trust. Many industry leaders raised concerns regarding the fairness of this provision. Industry leaders were particularly concerned that the provision resulted in considerable inequity when the beneficiaries of a surviving spouse’s estate were different from the residuary beneficiaries of the trust which was established for the surviving spouse during his or her lifetime. In blended family situations, for example, the capital gains tax liability arising as a result of a surviving spouse’s death was to be borne by his or her estate (thereby diminishing the overall property available for distribution to the beneficiaries of the estate), while the capital property of the trust was available to be distributed to the residuary beneficiaries of the trust with a cost base equal to its fair market value.
The amendments to the ITA proposed by Finance on January 15, 2016 are aimed at remedying the apparent inequity caused by new paragraph 104(13.4)(b), in particular. In this regard, the proposed amendments introduce a new paragraph (104(13.4)(b.1)) to the ITA which limits the application of paragraph 104(13.4)(b) to circumstances involving a surviving spouse who:
- immediately prior to his or her death, was resident in Canada; and
- was a beneficiary of a post-1971 spousal or common law testamentary trust, which was created by a Will of a taxpayer who died before 2017.
If these circumstances are met, then the trustee or administrator of the surviving spouse’s estate may jointly elect with the trustee of the spousal or common law partner testamentary trust to have paragraph 104(13.4)(b) of the ITA apply, with the result that the capital gains arising as a result of the surviving spouse’s death will be taxed in his or her estate and not in the spousal or common law partner trust.
There may be compelling tax reasons to make this election for deaths occurring before 2017. It may, for example, be beneficial to make use of the election if there is a capital gain in a spousal trust and, at the time of a surviving spouse’s death, he or she had personal capital losses which otherwise could not be used.
The joint election in proposed paragraph 104(13.4)(b.1) of the ITA will only be available for spousal or common law partner trusts created by the Will of a taxpayer who died before 2017. Otherwise, as was the case before the introduction of the new rules on January 1, 2016, the capital gains tax deemed to be recognized in a spousal or similar trust upon the death of a surviving spouse will continue to be taxed in the trust (at the highest applicable marginal tax rate to the trust) and not in the estate of the surviving spouse.
More Time for Trusts to Use Charitable Donation Tax Credits
Under the rules currently in place and that apply for the 2016 and later taxation years, an estate that is a graduated rate estate (GRE) for the purposes of the ITA (generally, an estate is treated as a GRE for the 36-month period following the particular individual’s death), is permitted to allocate CDTCs in any of the following taxation years:
- the taxation year of the estate in which the donation was made;
- an earlier taxation year of the estate; or
- the last two taxation years of the individual before the individual’s death.
In general, publicly listed securities and units of mutual funds are exempt from capital gains tax arising on an individual’s death if they are donated to charity by the individual’s estate following his or her passing. The capital gains tax exemption is only applicable to the taxation year in which the individual is deceased.
Finance’s proposed amendments extend the time in which testamentary trusts may take advantage of their ability to allocate CDTCs. While the existing legislation only allows for the allocation to be made within a 36 month period following an individual’s death (during which time the individual’s estate is a GRE), the proposed changes would extend this period to 60 months. According to Finance’s release regarding the proposed amendments, it appears that any CDTCs arising from donations made after the estate ceased to be a GRE would be allocable among either:
- the taxation year in which the donation was made; or
- the last two taxation years of the individual.
Trust Loss Restriction Events
Currently, when certain commercial or investments trusts are subject to a significant change in ownership (typically when a beneficiary or group of beneficiaries acquires more than 50% of the beneficial interest in the trust), the loss restriction rules in the ITA limit the ability of those trusts to carry losses forwards or backwards. One exception to these LRE rules is a trust which is considered to be an “investment fund,” as defined in subsection 251.2(1) of the ITA.
The proposed amendments will revise the ITA’s definition of an “investment fund” to allow trusts that are investment funds to more readily establish whether they are in keeping with the definition. More particularly, as a result of the proposed amendments, investment funds should no longer have to consistently track the valuations of the entities in which they invest in order to ensure that they are in compliance with the ITA’s requirements. The proposed amendments to the ITA also provide that an “investment fund” will not be subject to a LRE based only on the fact that certain of its issued and outstanding units have been redeemed. Further, the proposed amendments include certain anti-avoidance rules which are intended to ensure that trusts carrying on a business cannot inappropriately claim to be “investment funds” for the purposes of the ITA. On account of proposed amendments to several interrelated subsections of the ITA, there should also be increased options for deferred filing when a trust is subject to a loss restriction event.
In general, Finance proposes that the amendments to the ITA released on January 15, 2016 apply to the 2016 and subsequent taxation years. If implemented in the form proposed, the amendments will be a welcome relief to many individuals, families and industry members. As drafted, the proposals provide more flexibility with respect to the taxation of capital gains, as well as the timing for claiming CDTCs. They also restore a perceived sense of fairness to the taxation of spousal and similar trusts.
In the coming months, individuals whose estate plans were developed in contemplation of the new rules currently in effect (and that apply to the 2016 and subsequent taxation years) should contact their advisors to discuss how the amendments could apply to the them and their estate planning. Individuals are also encouraged to contact their tax and estate planning advisors with questions relating to how Finance’s proposed amendments to the ITA could apply to them and their estate planning, including to planning relating to charitable giving.
The authors wish to thank Toronto, Student-At-Law, Benjamin Mann for his assistance with the preparation of this article.