New Canadian tax rules taking effect in 2016 may disrupt estate plans that use spousal, alter ego or joint-partner trusts (see “Ottawa overhauls trust rules,”). Here, we’ll examine their impact on U.S. citizens living in Canada.
Alter ego andjoint-partner trusts
An alter ego trust (AET) can be useful for a Canadian resident 65 or older seeking to avoid probate on the transfer of assets following death. The trust can essentially be used as substitute for a will.
Joint-partner trusts (JPT) are similar, but they only apply to spouses, both married and common law. (Unless otherwise noted, references to AETs include JPTs.) The 21-year deemed disposition that applies to inter vivos trusts doesn’t apply to AETs; so, if the settlor establishes an AET at 65 and lives past 86, there’s no deemed disposition. Instead, the disposition is triggered by the settlor’s death, unless the settlor of an AET (but not a JPT) elects to have the 21-year rule apply, with the year the trust is established as year 1. This election would prevent the settlor from transferring property to the trust on a tax-deferred basis.
Other key benefits of AETs:
- preservation of privacy (AETs are not subject to the public process of probate);
- protection against litigation (AETs are more difficult to challenge than wills);
- provision for incapacity (AETs act as substitutes for powers of attorney and continue after deaths of settlors);
- and, in some cases, creditor protection.
There’s a cost to establishing an AET. Plus, there are ongoing administration fees, such as annual tax filings (an AET is a separate taxpayer in Canada).
Current rules under the Income Tax Act (ITA) say AETs and other inter vivos trusts are taxed at the settlor’s highest marginal rate. That treatment makes AETs less appealing to taxpayers in lower brackets, so people have traditionally opted to create testamentary trusts through their wills, which have been taxed at graduated rates. But, new rules taking effect in 2016 eliminate graduated rates for testamentary trusts beyond the first 36 months of the estate.
So, we can expect to see more clients choosing AETs—especially in Ontario and British Columbia, where probate rates are among the highest in the country.
Tax obligations for U.S. citizens
The IRS requires U.S. citizens to pay tax on income earned worldwide, regardless of where they reside. On death, they’re subject to U.S. estate tax on the value of their gross estates (including life insurance) above $5.43 million (2015).
Generally, under the Canada-U.S. Tax Treaty, a U.S. citizen is entitled to foreign tax credits (FTC) for tax paid to the IRS. The U.S. citizen can apply FTCs to his Canadian tax return to avoid double taxation. Any Canadian tax owing should reduce the amount of U.S. tax paid.
However, a mismatch between Canadian and U.S. tax rules can leave clients with no FTCs, and that means double tax. This has been a problem for U.S. citizens living in Canada who wanted to incorporate AETs into their estate plans. The rules taking effect in 2016 remedy this problem.
Cross-border taxation of AETs
Rolling assets into the AET
Canadian residents aged 65 or older can transfer assets into AETs on a rollover basis, as long as the trust terms dictate that all income must be distributed to the settlor each year, and that only the settlor can receive the capital during the settlor’s lifetime.
In the U.S., an AET is considered a Grantor Trust because the AET’s settlor (called a grantor in the U.S.) retains the right to trust assets (similar to Canada’s 75(2) attribution rules).
U.S. law disregards grantor trusts for tax purposes; instead, the grantor must report the trust’s income and capital gains on his or her personal return. The result is that no taxable disposition occurs in either Canada or the U.S.: when assets are rolled into the AET in Canada, they are similarly considered as when rolled into a Grantor Trust in the U.S.
Ongoing AET administration
In Canada, the AET is a separate taxpayer from the settlor, but income distributed to the AET’s settlor is taxed in her hands. And, since the U.S. disregards the AET, the settlor will similarly report and pay taxes on the income to the IRS, subject to available FTCs.
There is no U.S. requirement that AET capital be distributed to the settlor; however, only the settlor has a right to the capital during her lifetime.
The ITA requires that, when the AET includes a right to encroach on (access) capital, all capital gains and losses must be attributed back to the individual. The settlor would report those gains and losses in both Canada and the U.S., and could take advantage of FTCs.
However, where there’s no right to encroach on capital, the AET will report capital gains and losses in Canada, but the individual will report in the U.S., creating a mismatch for FTCs and exposing the individual to double tax.
Death of the settlor/grantor
Under current Canadian tax rules, the death of an AET settlor triggers a deemed disposition of remaining assets (provided the settlor hasn’t elected otherwise). However, the tax consequence occurs at the AET level, not at the settlor’s personal tax level.
This result was one reason AETs (which are taxed at the highest marginal rates) were less appealing than testamentary trusts. But, with the abolition of graduated rates for testamentary trusts after 36 months, AETs have become more popular.
But AETs had created tax problems for U.S.-citizen settlors. In Canada, capital gains resulting from the deemed disposition are taxed in the AET, whereas in the U.S., the settlor is taxed.
The new rules eliminate this result: beginning in 2016, the deemed income inclusion is to the deceased individual, rather than the AET, creating a match between Canada and the U.S.
As a result, the settlor or the AET must have sufficient liquidity to satisfy the tax liability. The new rules say the settlor and the trustees of the AET will be jointly and severally liable for the tax bill.
The new rules make AETs more appealing for wealthy U.S. citizens living in Canada. Similarly, married U.S. citizens living in Canada may wish to take advantage of JPTs to avoid probate.
It remains to be seen how the new rules will affect second marriages where spouses have different capital beneficiaries under their respective wills, and where the surviving spouse is a U.S. citizen.
One view is that the deemed income inclusion to the second spouse’s estate (resulting from the deemed disposition in the spousal trust set up under the first spouse’s will, and triggered by the second spouse’s death) may increase the U.S.-citizen second spouse’s gross estate for U.S. estate tax purposes.
If that deemed inclusion pushes the second spouse over the estate tax threshold, could he or she sue the estate of the first spouse to recover taxes paid? Or will the second spouse’s heirs be at a financial disadvantage because of the new rules?
The ITA will hold trustees of the spousal trust and the second spouse’s estate jointly and severally liable for the deemed disposition tax in Canada. But it’s unlikely the provision extends to recovery in respect to the second spouse’s new U.S. estate tax exposure.
A more likely position is that the deemed income inclusion would not be considered income for U.S. estate tax purposes, provided appropriate U.S. tax provisions are included in the trust. For example, if the surviving spouse is trustee of the spousal trust, she must have limited ability to access trust capital and the trust must provide for the appointment of an independent trustee.
But, it’s also possible the IRS may say that deemed income from an interest in a non-U.S. estate or trust is included in the U.S. taxpayer’s reporting. We await further guidance from CRA and the IRS—2016 will be an interesting year.
by David A. Altro and Heela Donsky. David is a Florida attorney, Canadian legal advisor and the managing partner at Altro Levy. He can be reached at 416-477-8155 or email@example.com. Heela is an associate at Altro Levy who specializes in cross-border tax and Ontario estate law. She can be reached at 416-477-8156 or firstname.lastname@example.org.