On October 3, 2016, the Department of Finance unveiled a Notice of Ways and Means Motion to amend the Income Tax Act (the “Motion”) with the stated purpose of “improv[ing] tax fairness by closing loopholes surrounding the capital gains exemption on the sale of a principal residence.” If passed, the Motion will limit or eliminate the ability of certain trusts and non-resident individuals to use the principal residence exemption.
Before providing an overview of the proposed amendments, it is important to note that the proposed amendments will have a significant impact on families and individuals holding property in trust. Specifically, they could have the effect of defeating carefully arranged tax and estate plans. If the amendments are enacted, then individuals and families holding real property in trust (if it could be a principal residence) should review their trust terms and consider transferring the property out of the trust.
Of particular concern are situations in which the trust property cannot be transferred to a beneficiary, or beneficiaries of the trust. One such situation involves trusts holding property for disabled individuals incapable of managing property. Under the proposed amendments, these trusts may not be able to claim the principal residence exemption going forward or to take advantage of a tax-deferred transfer to the trust’s beneficiary or beneficiaries.
As the amendments, if enacted, would take effect in 2017, affected individuals are encouraged to retain competent advisors at their earliest convenience in order to develop appropriate strategies for mitigating or avoiding their impact.
Overview of the Principal Residence Exemption
Unless stated otherwise, all references in this article to statutory provisions, or proposed statutory provisions, are references to the Income Tax Act (Canada) (the “ITA”).
The formula for calculating the principal residence exemption is set out in paragraph 40(2)(b). Generally, it allows individuals, including personal trusts, to dispose of a principal residence at a reduced or nil capital gain. An individual, or that individual’s family unit (e.g. the individual’s spouse and minor children), may only designate one property as a principal residence in respect of each taxation year. If, in the year of its disposition, a residence can be designated as a principal residence for all of the years during which it was owned by the taxpayer, then the principal residence exemption will reduce any capital gain to nil. The ITA sets out detailed rules for how and when the principal residence exemption is applied.
In connection with the formulas set out in paragraph 40(2)(b), section 54 includes three primary requirements for a property to be designated as a principal residence:
- the property, including the surrounding land, must be a housing unit owned by the taxpayer.
- the property must have been ordinarily inhabited in the taxation year for which the principal residence exemption is being claimed by either the taxpayer or his or her spouse, common law partner or child (it may be a second home or cottage if one or more of these individuals ordinarily inhabited the property); and
- the taxpayer must designate the property as the taxpayer’s principal residence for the taxation year.
Currently, for a personal trust to qualify for the principal residence exemption, the requirements under paragraph 54(c.1) must be met. Accordingly, there must be an individual who is beneficially interested in the trust and who ordinarily inhabits the property in the taxation year for which the principal residence exemption is being claimed. That individual’s spouse, common-law partner, former spouse or former common law partner or child may also have inhabited the residence for the purpose of claiming the principal residence exemption. When filing its returns for the year, a trust must also designate, in prescribed form, each individual beneficially interested in the trust for the calendar year who inhabits the residence for that taxation year.
The Proposed Amendments
Limiting the Types of Trusts Able to Claim the Principal Residence Exemption
These proposed amendments severely restrict the types of trusts which are able to claim the principal residence exemption for any taxation years after the 2016 taxation year. By operation of proposed subparagraph 54(c.1)(iii.1), trusts will only be able to claim the principal residence exemption if they meet one or more of the following criteria:
- the trust is a spousal or common law partner trust, joint spousal or common law partner trust, alter ego trust or trust for the exclusive benefit of the settlor during the settlor’s lifetime (as those trusts are described in subsection 104(4)); and the beneficiary in respect of whom the principal residence exemption is claimed must be, depending on the type of trust, the settlor or the spouse or common law partner of the settlor;
- the trust is both a testamentary trust, and a qualified disability trust for which the beneficiary is a spouse, common law partner, former spouse or common law partner or child of the settlor; or
- the settlor of the trust died before the start of the year for which the principal residence exemption is being claimed, and the beneficiary of the trust is a minor child of the settlor whose parents are deceased before the start of the year for which the principal residence exemption is being claimed.
In all cases, the beneficiary in respect of whom the principal residence exemption is being claimed must be a resident of Canada during the year for which the principal residence exemption is claimed. That beneficiary must also have a right under the terms of the trust to the use and enjoyment of the property as a residence.
Proposed new subsection 40(6.1) establishes a calculation for trusts which do not meet the above criteria but intend to claim the principal residence exemption in respect of a taxation year after the 2016 taxation year. Under this formula, there will be two capital gains calculated: (i) one for those years prior to 2017, for which such a trust could claim the principal residence exemption; and (ii) one for those years after 2016, for which it could not.
For example, if a trust disposes of property in 2020, and this disposition qualified for the principal residence exemption for some or all of the trust’s taxation years prior to 2017, the trust may claim the principal residence exemption in respect of any taxation years up to, and including, 2016 (during which it owned the residence). The trust may not do so for its 2017, 2018, 2019 and 2020 taxation years, regardless of whether it would have qualified for the principal residence exemption but for the Motion’s proposed amendments. This is the case regardless of when the trust was settled or when the trust acquired the property at issue.
Limiting the “One-Plus” Factor to Canadian Residents
Generally, when the aforementioned criteria are met, a taxpayer may claim the principal residence exemption for all years in which the taxpayer owned a property, including the year of the disposition, plus one extra year. The purpose of this extra year is to allow the taxpayer to claim the principal residence exemption in respect of the year in which the residence was purchased, but during which the taxpayer may also have claimed the principle residence exemption on another principle residence disposed of in that year.
Pursuant to the Motion’s proposed amendments, this “one plus” factor will only apply when the taxpayer claiming the principal residence exemption was resident in Canada during the year in which the principal residence was purchased.
Limiting the Application of Subsection 107(4.1)
Subsection 107(2) allows personal trusts to distribute assets to capital beneficiaries in satisfaction of all or part of their capital interest in the trust on a tax-deferred basis. Whereas pursuant to subsection 107(2.1), if subsection 107(2) (and certain other provisions which are not relevant here) does not apply, then the distribution is deemed to occur at fair market value.
Currently, subsection 107(4.1) requires that subsection 107(2.1), and not subsection 107(2), apply to a distribution from a trust to a beneficiary in satisfaction of that beneficiary’s capital interest when, at any time during the trust’s existence, the attribution rule in subsection 75(2) has applied to that trust.
While the language in proposed paragraph 107(4.1)(a.1) is highly technical, its effect appears to be to allow the tax-deferred distribution of a principal residence to a beneficiary or beneficiaries under subsection 107(2), notwithstanding the potential application of subsection 75(2) to the trust, in certain circumstances.
Under the terms of the new paragraph, subsection 107(4.1) will not apply to a distribution from a trust when:
- the trust owned the property distributed at the end of 2016;
- in the trust’s first taxation year beginning after 2016, the trust is not a trust described in new subparagraph 54(c.1)(iii.1) (e.g. an alter ego trust, a joint spousal trust, a testamentary qualifying disability trust, etc.); and
- the trust would have been able to designate the property distributed as its personal residence but for the introduction of proposed subparagraph 54(c.1)(iii.1).
The stated purpose of this new paragraph is to ensure the application of subsection 40(7) to a principal residence distributed from a trust. Subsection 40(7) provides that when a trust distributes property to a beneficiary pursuant to subsection 107(2), that beneficiary is deemed to have owned that property since the trust last acquired it, for the purpose of the definition of a principal residence in section 54.
Eliminating the Normal Reassessment Period for Distributions of Real Property
Subject to certain exceptions, the Minister of National Revenue (the “Minister”) is only permitted to reassess a taxpayer within the “normal reassessment period.” Generally, the normal reassessment period is three years for individuals and four years for corporations.
The Motion introduced proposed paragraph 152(4)(b.3) to allow the Minister to reassess taxpayers beyond the normal reassessment period when the taxpayer disposes of real or immovable property in the year and that disposition is not reported. This provision will also apply when an individual owned property indirectly through a partnership, and the partnership failed to report the disposition of real or immovable property. If the disposition is by a corporation, then that corporation may only be reassessed outside the normal reassessment period when the property is capital property to the corporation.
If the taxpayer does file a return but does not report the disposition, then the taxpayer may amend the return to report the disposition. A proposed amendment to subsection 220(3.21) specifically permits the Minister to accept this amendment. The normal reassessment period then begins from the time the amendment is filed.
Additional Reporting Requirements for Individuals
While the Canada Revenue Agency has not previously required individuals other than personal trusts to report the disposition of a principal residence in prescribed form (notwithstanding that it is a requirement under section 54), it appears that it will be an enforced requirement going forward (based on the proposed amendments to section 152 and subsection 220(3.21)). Personal trusts have always been required to report the disposition in prescribed form, and those trusts still able to claim the principal residence exemption will continue to be required to do so.