In a comfort letter issued September 4, 2019 by the Tax Policy Branch (the “Comfort Letter”), Finance Canada indicated that they are prepared to recommend to the Minister of Finance that the Income Tax Act be amended to allow an inter vivos trust for the benefit of an individual who is eligible for the disability tax credit to be eligible to claim the principal residence exemption as long as certain conditions are met. If such an amendment to the Act is made, this could result in a significant relief from taxation for disabled persons in Canada.
Amendments to the Act in 2016, specifically the definition of “principal residence” in section 54, significantly limited the class of taxpayers eligible to claim the principal residence exemption (“PRE”). In particular, for taxation years beginning after 2016, personal trusts are not eligible to claim the PRE unless:
- the trust designates the “specified beneficiary” of the trust who is beneficially interested in the trust and who ordinarily inhabits the residence; and
- the trust is one of,
- generally, a spousal, alter-ego or joint spousal or common law partner trust,
- a “qualified disability trust”, or
- a so-called “orphan’s trust”.
As a result of this amendment, most non-qualifying trusts that held a principal residence prior to 2017 disposed of those residential properties prior to 2017.
A “qualified disability trust” (“QDT”) is defined as a trust that, for a particular taxation year: (i) is at the end of that year a “testamentary trust”; (ii) is resident in Canada for the year; (iii) has filed a joint election with the beneficiary to be a QDT for the year; (iv) the electing beneficiary is an individual who qualifies to receive the “disability tax credit” (“DTC”) for that year; and (v) the electing beneficiary does not elect jointly with any other trust to be a QDT for that year. As a result of this definition, an inter vivos personal trust of which an otherwise qualifying disabled individual is a beneficiary (and is not otherwise a spousal, alter-ego or joint spousal or common law partner trust or a so-called “orphan’s trust”) is not eligible to claim the PRE for the benefit of that disabled beneficiary.
In the Comfort Letter, Finance considered a pre-2017 inter vivos personal trust established for the benefit of a DTC-eligible beneficiary that, after 2016, was ineligible to claim the PRE. Finance acknowledged the hardship that arose because the trust had been previously established and could never qualify as a QDT. Finance stated that it would recommend that the Act, and specifically the definition of “principal residence”, be amended to include an inter vivos personal trust, provided that all other designation requirements are fulfilled (including the requirements relating to occupation of the property and one property per family unit) and the following conditions are met:
- a beneficiary of the trust is an individual resident in Canada during the year who is eligible for the DTC;
- the beneficiary is a child, spouse, common-law partner, or former spouse or common-law partner, of the settlor of the trust; and
- no person other than a beneficiary described above may, during the beneficiary’s lifetime, receive or otherwise obtain the use of any of the income or capital of the trust.
It is interesting to note that, under the current definition of QDT, the designating beneficiary need not have any particular relationship to the testator under whose will the trust is established; it is only necessary that the beneficiary is an individual named as a beneficiary by the testator “in the instrument under which the trust was created.” So the proposed condition that the designating beneficiary be “a child, spouse, common-law partner, or former spouse or common-law partner, of the settlor of” the inter vivos trust is potentially narrower than the current definition of QDT.
Also, the condition that “no person other than a beneficiary described above may, during the beneficiary’s lifetime, receive or otherwise obtain the use of any of the income or capital of the trust” (as is also the case for spousal, alter-ego or joint spousal or common law partner trusts) would appear to mean that the designating beneficiary and only the designating beneficiary will be permitted to occupy the residence. It is not clear then how Finance intends to square this condition with the definition of “principal residence,” which permits the individual or the spouse or common law partner, former spouse or common law partner or child of the individual to also ordinarily inhabit the residence.
Finance indicates that they will also recommend that the amendment apply to taxation years that begin after 2016. However, they do not specifically state that the amendment will apply to inter vivos personal trusts that are established after 2016. That leaves open the possibility that the amendment could apply only to grandfathered, i.e., pre-2017, trusts.
The proposed amendment, while helpful, leaves open certain issues that are inherent in the QDT restrictions themselves. Under current rules, there can be only one QDT designated in respect of a disabled individual for any given year. If more than one family member establishes an otherwise-qualifying QDT in their will, only one may be designated as the QDT. And because courts in Canada have generally refused to uphold will provisions that purport to “pour-over” assets flowing through the will to an amendable inter vivos trust, it is likely not possible that one testamentary trust be designated as the QDT with other assets being contributed to that trust by way of bequests in other wills. Furthermore, the fact that under the proposed amendment the designating beneficiary must be of a defined familial relationship with the settlor of the trust may mean that it is not possible, or practical, that assets be contributed to the inter vivos trust by multiple individuals.
And finally, because eligibility for the DTC may change over the disabled beneficiary’s lifetime, there will always be a measure of uncertainty in determining the years for which the PRE is available while the residence is occupied by the disabled beneficiary. The computation of eligible years may become much more complex.
It is refreshing to see Finance responding positively to an obvious hardship arising from the 2016 amendments, and many individuals and families affected by those amendments will look forward to the enactment of the proposed changes.