On December 16, 2014 amendments were made to the Income Tax Act which have a critical impact on will and trust planning. Two of those changes, which are highlighted in this bulletin, are substantive and may require your immediate attention, since both amendments are effective on January 1, 2016.
Statutory Shifting Of Tax Liabilities Between Spouses
The Income Tax Act deems all individuals to have disposed of their capital assets on death. This deemed disposition often results in a capital gains tax liability. In many instances this tax presents a funding problem for an estate, particularly where the estate's major assets are relatively illiquid, such as shares of a family business corporation. A common will planning technique to alleviate the problem and to enable the estate to properly manage its cash flow obligations, is for a will to direct the transfer of capital assets into a trust or fund for the exclusive benefit of the surviving spouse during his or her lifetime. This type of trust is known as a spousal trust, and when used, as specified in the Income Tax Act, capital gains taxes that would otherwise be payable on death, may be deferred until the surviving spouse passes away. Under the tax rules that are in effect until December 31, 2015, that tax liability is a burden of the estate of the first spouse to die, which is logical as the relevant capital assets remain as property of that spouse's estate to be disposed of in accordance with the provisions of such spouse's will. The new rules shift the tax obligation to the estate of the second spouse to die.
This change is dramatic as the ownership of the capital assets remain in the first estate. Essentially a tax liability in respect of the appreciation in the value of particular assets is imposed on a person who does not own those assets. A number of excellent technical submissions have been made to the Federal Government on the inherent unfairness of this new rule, and the many odd and perverse situations that may occur, dependent on family relationships, and family composition.
We had hoped that the 2015 Federal budget, which was tabled in the House of Commons on April 21, 2015, together with those technical submissions, would have remediated the problems with these provisions. No changes were, however, contained in the budget. Recently, however, the Department of Finance has responded to those technical submissions acknowledging the concerns raised and considering a potential option to address those concerns. Unfortunately, until alleviating provisions been implemented, the new legislation may still have an impact on your planning come 2016.
As a result, we consider it necessary that we advise you of the changes now, so to provide you with a reasonable amount of time to review your will and to make changes if necessary. If your will does contain a spousal trust please contact us to discuss the implications of the new tax rules in more detail and if necessary the implementation of will changes or other potential planning tools to avoid an undesirable and unexpected result.
Existing Joint Partner Trusts
You may have created a joint partner trust. This is a trust created by an individual during his or her lifetime, which in some respects is a will substitute. A joint partner trust is an inter vivos trust that essentially mirrors a spousal trust in a will, following the death of the first of the spouses. The commentary above regarding the new rules impacting spousal trusts similarly impacts joint partner trusts. If you have created a joint partner trust please contact us on potential requisite changes consequent on the new tax rules.
There are many existing estates in which capital assets form part of a spousal trust. The new rules will apply to those estates if the spouse dies after 2015. If you are an executor or trustee of such an estate or the surviving spouse, please contact us to discuss the nature and depth of the potential problem, and whether there are reasonable planning mechanisms available to appropriately and prudently deal with and resolve the problem.
Existing Alter Ego Trusts
In the case of an Alter Ego Trust, on the death of the settlor of the trust, the new tax rules shift the tax liability from the trust to the settlor's estate. Although in many instances this change will be inconsequential, in some cases a negative consequence will result. If you have established an Alter Ego Trust please discuss with us whether the tax changes impact your plan.
Graduated Rate Estate And Charitable Gifts
Under current tax rules, trusts or funds established by wills are taxed on accumulated or designated income in the same manner as individuals; that is, at graduated marginal rates depending on the amount of taxable income in the year. By contrast taxable income accumulated or designated in inter vivos trusts is taxed at the top marginal rate regardless of amount or size.
New tax rules, commencing with the 2016 tax year will limit the ability of estates, or trusts or funds established under wills to benefit from graduated marginal rates for a maximum period of three years from the date of death, following which all future accumulated or designated income will be taxed, as is now the case with inter vivos trusts, at the top marginal rate. This three year period is called a 'graduated rate estate'. Several technical rules apply to the creation and maintenance of a graduated rate estate. One of the more important consequences of those rules pertain to the availability of charitable tax credits.
Under existing tax law, charitable gifts made by will result in tax credits that are applicable to taxable income in the year of death and in the year immediately preceding the year of death. Similarly with careful planning charitable tax credits are available in a spousal trust following the death of the surviving spouse. The new tax rules in some respects are more flexible and beneficial to estates and in other respects are more restrictive. Charitable gifts by will must be made within a graduated rate estate and consequently must be perfected within three years of death.
In many circumstances the three year period will be incidental and present no hardship to estates. In other instances, particularly where the charitable gifts require the winding up or reorganization of family business corporations, or where the charitable gifts are delayed until the death of the second of the spouses to die, significant difficulties could arise, resulting in the loss of otherwise valuable charitable tax credits.
This already complex situation becomes more confounded when combined with the problems described above relating to shifting income tax liabilities involving spousal trusts. In such instances the tax liability may arise in the estate of the second spouse to die, while the charitable gifts are made and the assets to make those gifts reside in the estate of the first spouse to die. That mismatch could result in the loss of the charitable tax credit.
If there are charitable gifts in your will please contact us to determine whether any changes are required to ensure that anticipated charitable tax credits are available and that the tax credits arise in the right estate.
It is always a good idea to review your will at regular intervals, particularly if you have not done so for a number of years. Now with the significant income tax changes that have recently been enacted it is essential that you do so. We will be pleased to guide you through these complex tax changes and to assist you in properly adjusting your will and trusts to deal appropriately with them, should you determine to proceed to do so.