Recent rule changes have the potential to complicate estate-planning strategies using spousal trusts. So, the Department of Finance is currently considering input from professional bodies in the tax and estate planning community to devise a solution.

The problem: With a spousal trust, there’s a deemed disposition when the beneficiary spouse dies. (Same applies on the death of the settlor under an alter-ego trust and the surviving partner under a joint partner trust.) Amendments to the Income Tax Act adding subsection 104(13.4), effective January 1, 2016, deem there to be a year-end at the end of the day of death of the beneficiary spouse (i.e., 11:59 pm). The amendments also deem the trust’s income for the year (including amounts deemed to be realized as a result of death) to have become payable to the beneficiary spouse in the same year.

This means the trust’s income is in the deceased beneficiary spouse’s hands for tax purposes. Even though subsection 160(1.4) makes the trust jointly and severally liable for the tax payable in the beneficiary spouse’s hands, potential problems arise:

  • The deceased spouse’s estate may end up being responsible for the tax liability, while having none of the assets that generated that liability, because they are still in the trust. This is particularly egregious in situations where the spousal trust ultimately benefits children from the testator’s prior marriage who are not the beneficiaries of the deceased spouse.
  • There could be interference with charitable gifts made immediately after death by the spousal trust, credits from which would have otherwise offset the tax liability resulting from the deemed disposition on the death of the beneficiary spouse. Because the spousal trust has a deemed year end, the gift will only create a donation credit in the year of the gift, with a carryforward. And since the spousal trust is not a graduated rate estate, there is no flexibility to do a carry back to the deceased.
  • It is uncertain whether the trust could absorb capital losses carried back to the year of death of the beneficiary spouse if the income is deemed payable to the beneficiary spouse and no elections to bring that income back into the spousal trust are permitted.

Finance’s suggested solution: Amend subsection 104(13.4) so it would not apply on the death of a beneficiary spouse, unless:

  • the trust is a testamentary trust that is a post-1971 spousal or common-law partner trust;
  • the testator dies before 2017;
  • the deceased beneficiary spouse is a resident in Canada at death; and
  • the trust and the graduated rate estate of the deceased spouse jointly elect to have that subsection apply.

(Finance may have proposed this limited opt-in window in case any testators modified their planning to account for subsection 104(13.4) and actually want it to apply.)

Finance also suggested the trust be permitted to allocate the eligible amount of a donation the trust makes after the date of the beneficiary spouse’s death—but during the same calendar year as the beneficiary spouse’s death—to the taxation year in which the death occurs.

This would effectively bring things back to where they were before the rule changes. Stay tuned for updates on how Finance proceeds.

Also read:

The trouble with new spousal trust rules

Ottawa overhauls trust rules

Make sure clients understand Graduated Rate Estates

Florence Marino is Assistant Vice-President, Tax, Retirement and Estate Planning Services, Retail Markets, at Manulife.
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