Amendments to the Income Tax Act (the “Act”) which take effect on January 1, 2016 have the potential to thwart Canadian estate plans that involve trusts. In effect, these new rules shift the liability for income tax on the income of certain trusts arising from the death of an individual from the trust to the estate of that individual. Without proper planning, these rules can result in an unforeseen (and unfunded) tax burden imposed on the deceased’s estate, and complications and delay in the administration and distribution of the trust’s assets.
A simple example illustrates the issue. On death, an individual is generally deemed to dispose of all of his or her capital property at fair market value. Any income resulting from this deemed disposition must be reported in the deceased’s terminal tax return. Spousal trusts are commonly used to defer tax that would otherwise arise on the death of one spouse until the death of the surviving spouse. For example, under a husband’s will property might be transferred on a tax-deferred “rollover” basis to a spousal trust naming his wife as the sole income beneficiary and their children as the capital beneficiaries. Under the current rules, on the wife’s death the trust is deemed to dispose of all of its capital property at fair market value. The resulting tax liability is paid using the trust assets, and the remaining assets can be distributed to the children. Under the new rules, the tax liability from the deemed disposition of the trust property is borne by the surviving spouse (i.e., the wife).
Consequently, the new rules impose a tax liability for income of a trust on an estate that does not have access to the trust’s assets. The result is a mismatch between the tax payable and the assets to which the tax relates. This issue can be particularly acute when the beneficiaries of the estate and the beneficiaries of the spousal trust are different, such as situations involving a second marriage where the capital beneficiaries of the spousal trust are children of the deceased, and the new spouse is the beneficiary of the estate. In addition, rules in the Act which makes a spousal trust jointly and severely liable for the tax liabilities of an estate can create significant administrative inefficiencies and delays in distributing the trust’s assets.
It is strongly recommended that estate plans of Canadian clients which involve the use of trusts are reviewed to deal with the potential inequities among beneficiaries that the new rules might cause.
Please contact Ted Citrome in our Toronto, Canada office at 416-646-4609 for further information.