Prior to rule changes made last year, “when money entered a spousal trust, it rolled into the trust at the ACB,” says Keith Masterman, vice-president, Tax, Retirement and Estate Planning at CI Investments. “The deemed disposition of those assets was delayed until the trust sold the assets or the trust was wound up. The capital gain from that deemed disposition at the time the trust was wound up, which was the death of the life tenant [i.e., the second spouse], was taxed in the hands of the trust.”
Under changes made by the previous government, “the deemed disposition on the death of the life tenant is not to be reported on the terminal return of the trust; it’s reported on the terminal return of the deceased spouse. So it shifted the tax liability.”
What’s the problem with that?
Masterman gives an example. Rick is married to Jill and they have two adult children, Albert and Bob. Jill dies and Rick remarries two years later. His second wife, Beth, has a child from a previous marriage, named Charles. When Rick wrote his will after he married Beth, he put a spousal trust into the estate plan with two objectives:
1. to make sure Beth has money while she’s alive, and
2. to ensure the remainder of his assets would eventually go to Albert and Bob.
Prior to last year’s changes, when Rick died the money would go into the spousal trust; when Beth died the tax liability would be paid by the trust and then Albert and Bob would get the assets. This was what Rick intended.
With last year’s changes, that’s not what happens: Rick dies, the money flows into the spousal trust; when Beth dies the assets flow to Albert and Bob as before, but the tax liability lands on Beth’s estate. “So in other words,” says Masterman, “[Beth’s son] Charles is paying the tax on [Rick’s] kids’ inheritance.”
There’s general agreement in the tax community this was an unintended consequence of last year’s rule changes. So, what’s the solution?
Masterman explains that the proposed legislation essentially reverts back to the rules in place prior to the Conservatives’ changes: the tax bill on Beth’s death gets paid by the spousal trust instead of falling on her estate.
But the draft rules also say that the spousal trust’s trustees and Beth’s estate could jointly elect to have the tax liability for the capital gain land on Beth’s estate. This could make sense if, for example, Beth’s estate has capital losses that would otherwise go unused. But there must be a joint election for this to happen; otherwise, the trust pays the tax.
This election, notes Masterman, would only be available for deaths prior to 2017. After January 1, 2017, in all cases the tax bill on the death of the second spouse would be paid by the spousal trust. “I think what [Finance] is basically saying is, ‘We’re going back to the previous rules, but if you’re one of these people who did a whole bunch of [estate planning] to get around [the problem caused by the previous government’s rule change], we’re going to give a one-year window to make sure we’re being fair to your estate.”
Charitable donation rule changes
Masterman notes the draft legislation also changes the rules around donations made by will.
Under rules that kicked in on January 1, 2016, a Graduated Rate Estate (GRE) can allocate donation tax credits to the year of the GRE the donation is made; a prior year of the GRE; the terminal year, and the year prior to the terminal year. A donation made in the third and final year of the GRE can thus be allocated to one of five possible tax years.
The draft proposal says donations can now be made five years after death, giving a total of seven possible tax years to allocate the credit.
The proposals are open for comment until February 15, 2016.