On December 16, 2014, Bill C-43 received Royal Assent. The new rules introduced by the Bill affect the manner in which testamentary trusts are taxed, and in addition, change significantly the manner in which testamentary charitable gifts will be dealt with under the Income Tax Act RSC 1985, c.1 (5th Supp.) ("ITA").
In order to better appreciate the significance of the changes, it is important to review briefly the law as it was prior to 2016.
In the past, income and capital gains retained in inter vivos trusts were taxed at a different rate than testamentary trusts. Inter vivos trusts have always been taxed at the top marginal rates of tax. On the other hand testamentary trusts and certain pre 1971 inter vivos trusts have enjoyed access to progressive rates of tax and other benefits not available to inter vivos trusts. Bill C-43 has eliminated the various differences between inter vivos and testamentary trusts commencing in 2016. There are two exceptions to these new rules. Firstly, the progressive tax rates will continue to apply to the first thirty-six (36) months of an estate that arises as a consequence of the death of an individual and that is a testamentary trust. This type of trust has been given a new name…the graduated rate estate or GRE as it is now affectionately named. The second exception is for trusts that qualify as qualified disability trusts or QDTs for disabled individuals. It is not intended to discuss QDTs in this Bulletin.
GRE: What is it?
A GRE is defined as an estate that arose on and as a consequence of the death of an individual if the estate is at that time a testamentary trust as that term is defined in the ITA, the estate designates itself as a GRE in its tax return for the first taxation year ending after 2015, no other estate has designated itself as a GRE of the deceased individual and the deceased's social insurance number is provided. In addition it is provided that a GRE can only last as such for up to thirty-six (36) months after the date of death of the individual. Thus, it is important to note that if there is planning that relies on GRE status it must occur within this time period.
What are the benefits of being a GRE?
The benefits that are available for a GRE and not for other testamentary trusts include the following. As noted above, the graduated tax rates apply to income retained in the GRE during the term of an estate qualifying as a GRE. A GRE can continue to have an off calendar year end (or fiscal period) unlike other trusts that must have a calendar year end which allows for some deferral of tax. A GRE will be exempt from remitting tax instalments and is exempt from having to pay alternative minimum tax. In addition it will be able to allocate investment tax credits to beneficiaries. And, as will be discussed in more detail below, there are significant advantages for testamentary charitable gifting that are available for gifts by a GRE versus gifts by an estate that is not a GRE, such as access to new flexible rules for donations by will and exemption from tax on capital gains on donations of publicly traded securities.
There is no grandfathering for existing trusts which will have a deemed year end on December 31, 2015. Thus, for those testamentary trusts which have had a fiscal period or off calendar year end, this will result in two year ends in 2015. An exception is provided in ss. 249(4.1) if the particular trust is an estate which exists at the end of 2015 and that is a GRE of the individual for the first 2016 taxation year. In this case and in the case where the particular trust is an estate that arose on a death after 2015 and that is a GRE for its first taxation year that deemed taxation year end is deferred until the last time at which the estate is a GRE.
A number of preliminary questions have arisen with respect to the GRE. One of the pre requisites for a GRE, as noted above, is that only one estate can qualify as a GRE. In situations where multiple wills are used to avoid probate tax, the question has arisen as to whether this creates two estates or just one. It would appear that the profession has approached this issue in two ways. There are those who see multiple wills as creating two estates. Others believe that there is only one estate even in cases where there may be different executors of the two estates. CRA has indicated that, in its view, there is only one estate and that, therefore, a combined tax return should be filed and joint election made to designate the estates as a GRE.
It is also important to note that only an estate can qualify as a GRE. What then is an estate? An estate arises on the death of an individual and continues until the executors are in a position to distribute the assets to beneficiaries outright or to on-going trusts which may continue for some time. Testamentary trusts established under a deceased person's will do not qualify for GRE status nor do life insurance testamentary trusts even if established under the will of a deceased individual.
As noted in the Explanatory Notes to Bill C-43 (October 23, 2014 and October 30, 2014)
In the case where an individual's will provides for the creation of a trust from all or part of the property of the individual's estate, the property may be considered property of the estate until the estate transfers or distributes the property to the trust or the duties of the personal representative in administering the estate are complete. In some cases, however, property in separate trusts created under the terms of an instrument, such as a will, will not form part of an individual's estate for income tax purposes. For example, a particular individual's estate does not include a trust created under the terms of another individual's will, such as, for example, a spouse or common-law partner trust described in paragraph 70(6)(b) of the Act for the benefit of the particular individual.
As noted above, in order to continue to qualify as a GRE, the estate must meet the requirements of a testamentary trust. Therefore it cannot receive contributions from an individual other than from an individual on his or her death, or receive loans from or incur indebtedness to a beneficiary or a person dealing at non-arm's length with a beneficiary.
Okay, so now we know what a GRE is. How does this affect testamentary charitable gifting?
In order to understand the significance of the changes that Bill C-43 brought about the testamentary gifting on death rules, it is important to know what the rules were pre-2016.
For pre-2016 deaths, the ITA provided that a charitable gift made by will (often referred to as a "Gift by Will") was deemed to have been made by the donor immediately prior to death. This was advantageous because it ensured that the donation tax credits arising from the gift could be used in the deceased's terminal return to offset tax liability arising from the deemed disposition of his or her capital assets immediately prior to death. To the extent that these donation tax credits were not exhausted in the donor's terminal return, a one-year carry-back of the credits to the year preceding the year of death was permitted. In addition the credits could be applied against 100% of the income in these years (not 75% as is the usual rule).
Canada Revenue Agency has issued many publications outlining its position as to what constitutes a "Gift by Will", and in general, requires that: (i) the terms of the Will provide for a donation of a specific property, a specific amount or a specific percentage of the residue of the estate; (ii) it is clear from the terms of the Will that the executors are required to make the donation; (iii) the estate is in a position to make the donation after the payment of debts; and (iv) the donation is actually made.
Under these rules, the value of a Gift by Will for charitable receipting purposes was to be determined on the date of the individual's death regardless of when the charity actually received property from the estate.
If a gift did not qualify as a "Gift by Will", it could qualify as a charitable gift made by an estate or testamentary trust. In other cases, a distribution made to a charity from a testamentary trust would not be considered a charitable gift eligible for a donation tax credit but instead would be considered a distribution made in satisfaction of the charity's capital interest in the testamentary trust and no donation tax credit would be available.
Donation tax credits were also available when a charity was designated as beneficiary under a life insurance policy, registered retirement savings plan (RRSP), registered retirement income fund (RRIF) or tax free savings account (TFSA).
The New Regime
The new legislation introduces significant changes to this testamentary charitable gift regime for the 2016 and subsequent taxation years both as to timing and recognition of charitable gifts for tax purposes.
Donations made by will and designated donations (RRSP, RRIF, TFSA and life insurance) will be deemed to be made by the estate at the time when the property is transferred to a charity and no longer will be considered to have been made immediately before the donor's death.
As well, the fair market value ("FMV") of the gift for tax receipting purposes is to be determined at the time of the transfer of property rather than the FMV at the date of death.
The legislation builds some new flexibility into the ability to use of the donation tax credits in respect of estate gifts by will and designated donations by permitting the executors or trustees of a GRE to allocate the tax credits among:
- the terminal or last taxation year of the donor;
- the taxation year preceding the taxation year of death; and
- the taxation year of the Estate in which the donation is made and up to two (2) prior years of the estate.
It is only a GRE however, that enjoys the benefits of the flexibility to allocate the donation tax credit among different tax years and most importantly to carry-back the donation tax credit to the year of death and one year prior to death which in many cases is where the largest tax liability arises (because of the deemed disposition on death rules). Thus, if an estate is to benefit from this flexibility, it is important that the estate attains and maintains GRE status and that the property must be transferred to charity within thirty-six (36) months after death.
An additional requirement is that the property to be transferred to the charity by the GRE must be property held by the deceased at date of death or property substituted therefor. This rule is important to keep in mind when contemplating post mortem reorganizations in circumstances where charitable gifting is also involved as the property to be gifted after such a reorganization may not be property owned by the deceased at the date of death or property substituted therefor. In addition it is important to note that a borrowing of funds by an estate to effect a charitable gift within the thirty-six (36) months will also not qualify for the flexible rules allowing use of the donation tax credit in the year of death or the year before the year of death.
Current annual charitable donation limits of 100% of net income for the donor's last taxation year or for the taxation year preceding the taxation year of death will continue to apply.
An estate other than a GRE will continue to be able to claim the charitable donation tax credit in respect of other donations in the year in which the donations are made or in any of the five following years.
It is also noted that the rules relating to the tax free transfer of publicly traded securities to charity will now be limited to gifts of publicly traded securities made by the GRE.
Any other changes?
The new rules appear to provide more flexibility for testamentary charitable gift planning but that flexibility comes at a price.
It will allow executors to claim donation tax credits for testamentary charitable gifts for five different tax periods (the year prior to death, the year of death, and three (3) years of the estate) as opposed to just two tax periods (the year prior to death and the year of death). It will also create more flexibility by apparently eliminating the need for testamentary donations to qualify as "Gift by Wills" so long as the transfer of property to the charity takes place within thirty-six (36) months of death.
The new rules also provide certainty as to when to value testamentary charitable gifts for charitable receipting purposes - namely, upon the date of receipt of property by the charity. This should eliminate the current divergence of positions taken by charities as to whether the value of the donation tax receipt is the value of the donated property on the date of death of an individual or the value of the donated property at the time the charity receives the donated property.
Although this flexibility and clarity is in large part welcome, it will provide extra pressures on executors of estates. Executors will need to ensure that estate property is transferred to charities within thirty-six (36) months after death in order to qualify for the ability to allocate donation tax credits in the year of death or the year prior to death. This thirty-six (36) month period may be difficult to meet if (i) the estate is involved in litigation (Family Law Act claims, dependent relief claims, will challenges), (ii) the estate's assets are illiquid (real estate, private company shares), (iii) the donation is made after the death of a life tenant (under current rule such gifts would be claimed in the year of death if the life estate qualified as a charitable remainder trust (no right to encroach on capital during life tenant's lifetime). Moreover, even in ordinary circumstances, if the value of estate property increases or decreases following death, then depending upon the tax outcomes, executors could be criticized for either moving too quickly or waiting too long to transfer property to charities within the thirty-six (36) month period. It is noted that there is no provision for ministerial discretion to extend the time.
It appears, however, that there is some sympathy for the tight timeframe imposed by the thirty-six (36) month timeline. As a result of submissions made by various interest groups commenting on the thirty-six (36) month period, draft legislation tabled January 15, 2016 introduced a proposal to extend the thirty-six (36) month period to sixty (60) months after the death of an individual. These proposals provide that an estate donation made by a former GRE after it ceases to have this status because of the expiry of thirty-six (36) months (but which otherwise qualifies) and before the end of sixty (60) months after the date of death can be claimed in the year in which the transfer is made to the charity, in the year of death and the year prior to death.
As will be noted, while there is flexibility in permitting the allocation of the donation tax credit to the year of death and the year prior to the year of death, the additional flexibility given to gifts made during the GRE thirty-six (36) month period had greater flexibility in permitting the allocation of the donation tax credit over prior years of the estate as well.
Some interest groups have already commented that they would like the flexibility afforded GRE gifting to be extended to transfers to charity during the period from thirty-six (36) months to sixty (60) months such that even if the transfer to charity occurs between the 36th and 60th month the estate be permitted to allocate the donation tax credit among the year of the transfer, all prior years of the estate, the year of death and the year prior to death. This would permit the donation tax credit to be applied in prior years of the estate where taxable income may have arisen due to, among other things, post mortem planning (which often occurs to avoid double tax situations especially where assets are held in private companies).
Some unresolved issues
Charitable remainder trusts
The new regime does not appear to specifically deal with the treatment of gifts to a charity on the death of an intervening life interest. Under the old gift by will rules, if an individual left a life interest to say a spouse and then provided that on the death of the spouse a charity receive the remainder, the gift to the charity would qualify as a gift by will so long as the trustees had no right to encroach on the capital in favour of the life tenant during the lifetime of the life tenant (a charitable remainder trust).
The new rules contemplate that the property that is the subject of a testamentary charitable gift must be transferred to a qualified donee within thirty-six (36) months of death. While a residual interest in a charitable remainder trust is a property interest that can be transferred to a qualified donee within thirty-six (36) months of death, it is only that property interest and not the actual underlying property of the charitable remainder trust that can be transferred prior to the death of the life tenant. As a result, there remain some questions as to manner in which testamentary charitable remainder trusts will be dealt with under the new rules.
It is noted that if a charitable remainder trust is created inter vivos (that is to say a trust is established say for a spouse during the lifetime of the spouse with no right to encroach on the capital and the trust provides that on the spouse's death the trust assets are distributed to charity) the residual gift to charity would qualify for immediate donation tax credit to the person who contributed the property to such a trust at the time the trust was created. There are many types of charitable remainder trusts that can be created yet because of the current tax rules not all are eligible for donation tax credit relief notwithstanding the charitable intent of the settlors/testators. This would appear to be an area where more discussion is warranted and submissions have already been made by CAGP.
Gifts of private company shares/non-qualifying security/excepted gift
In addition it would appear that there are unintended consequences to the new rule that it is not the deceased but rather the estate of the deceased (whether the estate generally or the GRE) which is now considered the donor of the gift. This relates to gifts of private company shares to public foundations or charitable organizations.
Under the prior rules, a testamentary gift of private company shares to either a public foundation or charitable organization (but not to a private foundation in order to avoid the excess corporate holdings rules) and that qualified as a gift by will would give rise to an immediate donation tax credit that could be applied to offset income in the year of death or the year prior to death.
Under the new rules, such a gift would be treated as a non-qualifying security. A brief explanation is needed before returning to the problem created by the new testamentary charitable gifting rules as they apply to gifts of private company shares.
A non-qualifying security is defined in subsection 118.1(18) of the ITA as a share or debt of a private company with which an individual or estate does not deal at arm's length immediately after the relevant time (which in our case would be the time of the gift). Gifts of private company shares by an individual who controls the company are caught by the definition as are gifts of debt by in individual within the debt is in respect of a non-arm's length corporation. If a donation of a non-qualifying security is made, the donor will be denied a tax credit for the donation in the year in which the gift is made. That is, the gift is ignored for the purpose of the charitable donation tax credit. However if the non-arm's length connection between the donor and the issuer of the security is broken within the first sixty (60) months or the recipient charity disposes of the security within sixty (60) months of the time the donation is made, the gift will be deemed to have been made at the time the non-qualifying security is disposed of or ceases to be non-qualifying. The charity can then issue a donation receipt for the gift.
There are certain gifts of shares that do not fall within the definition of a non-qualifying security. These are called excepted gifts. A gift that is an excepted gift will not be subject to the restrictive rules applicable to a non-qualifying security but rather tax relief will apply in the usual way. An excepted gift is a gift of shares made to a charity that is not a private foundation (ie to a public foundation or charitable organization) with the proviso that the donor deals at arm's length with the donee charity and with each director, trustee or officer of the donee charity. It is noted that this exception applies only to shares not listed on a prescribed stock exchange and it does not apply to gifts of debt.
So this is the rule with respect to inter vivos gifts of private company shares and was also the rule with respect to gifts by will.
However, under the new rules, as noted above, such a gift of private company shares, even if made to a public foundation or charitable organization would not qualify as excepted gift and would therefore be a non-qualifying security.
The reason for this is that a testamentary trust is deemed not to deal at arm's length with a person that is beneficially interested in the trust including a public foundation or charitable organization such that, as noted above, a testamentary gift to such charity would not qualify as an excepted gift. No receipt could therefore be issued and no donation tax credit would be usable until such time as the private company shares are liquidated and this has to occur within sixty (60) months if the extension to the GRE becomes law, or thirty-six (36) months if it is desired to have the donation tax credit available not only in the year of death and prior year but also during the three (3) years of the GRE.
The natural question that arises is why there is a difference in tax treatment between inter vivos gifts and testamentary gifts of private company shares. Submissions have been made to the Department of Finance by the Canadian Association of Gift Planners that the simplest way to resolve this difference in tax treatment is to make testamentary gifts of private company shares to public foundations and charitable organizations an excepted gift.
Update on 2015 Federal Budget and Impact on Charities and Non Profits
The Minister of Finance (Canada), the Honourable Joe Oliver presented the Government of Canada's 2015 Federal Budget (Budget 2015) on April 21 2015. On July 31, 2015 draft legislation was tabled to implement such provisions for 2017 and later years. It is hoped that these measures will be reintroduced in the 2016 Budget.
Donations Involving Private Corporation Shares or Real Estate
These provisions proposed to provide an exemption from capital gains tax in respect of certain dispositions of private corporation shares and real estate. A donor would be entitled to a charitable donation credit (or deduction for a corporate donor) for donations of capital property to a qualified donee (such as a registered charity, RCAAA and other qualified entities). However such donations also give rise to capital gains in the hands of a donor giving rise to tax. The capital gains tax payable would be reduced or eliminated by the donation tax credits or deductions but the overall tax benefit of the gift would be reduced.
At the present time there is an exemption from capital gains tax for gifts of publicly traded shares, ecologically sensitive land and cultural property. These new proposals would extend this exemption to gifts of the cash proceeds from the disposition of private company shares and real estate. It is noted that this new rule would be different from the rule applicable to gifts of publicly traded shares, ecologically sensitive land and cultural property as for these types of gifts the exemption is available if the actual property is gifted.
In the case of private company shares and real estate, the exemption would be available where:
- cash proceeds from the sale of the private company shares or real estate are donated to a qualified donee within thirty (30) days after the disposition;
- the private company shares or real estate must be sold to a purchaser who is at arm's length to the donor and to the qualified donee to which the cash proceeds are donated.
If only a portion of the proceeds are donated, the exemption will be determined by reference to the proportion that the cash proceeds donated is of the total proceeds from the disposition of the shares or real estate.
In the case of a deceased donor, one of the requirements was that the donor be resident in Canada immediately before his or her death, property must be deemed disposed pursuant to s. 70 of the ITA, the disposition must be by the GRE and the gift must be made in money by the GRE not more than thirty (30) days after the disposition.
Anti-Avoidance Rules were also proposed by the Budget. These provisions would apply to donations made in respect of dispositions occurring after 2016.
The expansion of the exemption for donations of publicly traded shares to donations of private company shares and real estate has long been sought and these proposals are welcome news. However, the requirement that the shares be sold and only the proceeds donated (rather than a direct donation) may pose a challenge in some cases. It is anticipated that the charitable sector may seek to extend the capital gains exemption to direct donations of at least real estate.