Subsection 104(13.4) of the Income Tax Act (the “Act”) will come into effect on January 1, 2016. If not corrected, this provision will have a catastrophic and devastating effect on many estate plans involving alter ego trusts, joint spousal and common-law partner trusts, and spousal and common-law partner trusts (collectively “Life Interest Trusts”).
On November 16, 2015, the Department of Finance (“Finance”) released a comfort letter in response to submissions regarding subsection 104(13.4). Finance acknowledged that the provision could lead to “unfair and unintended” results and proposed solutions to correct them.
There are two main problems with this provision.
The first problem is that subsection 104(13.4) provides that the tax liability arising from the deemed disposition of certain assets on the death of the last surviving life interest beneficiary (referred to as “Life Interest Beneficiary”) of a Life Interest Trust will be borne by the Life Interest Beneficiary’s estate while the property subject to the deemed disposition will be enjoyed by the beneficiaries of the Life Interest Trust. The potential consequences are illustrated by the following example:
A testator made a will to give his second wife the family home. The testator also established an alter ego trust to provide for his children from his first marriage with an investment portfolio. When the testator dies, the alter ego trust will be deemed to have disposed of the investment portfolio at fair market value. Pursuant to subsection 104(13.4), all the income from the deemed disposition of the investment portfolio will be reported in the final tax return of the testator and the tax will be borne by the estate. As such, the wife will effectively bear the tax burden of the alter ego trust without benefiting from its assets.
Subsection 160(1.4) was enacted as an attempt to address the above problem. Under this provision, the estate and the trust will be jointly and severally liable for the tax. The explanatory notes released with the draft legislation stated that the intention is that the Canada Revenue Agency (the “CRA”) will assess the trust for the tax first, notwithstanding that subsection 104(13.4) places the primary tax liability on the estate. This may lead to further complications due to the following:
(a) notwithstanding the CRA’s assessment, the trustee will probably not have the authority under the trust deed to pay the estate’s tax; and
(b) it is uncertain whether payment of tax by the Life Interest Trust will affect an estate’s status as a graduated rate estate.
The second problem is the possible “stranding” of donation tax credits generated from charitable gifts given by a Life Interest Trust. Where paragraph 104(13.4)(b) applies to a trust, it will generally leave the trust with no tax liability against which it can apply the donation tax credits. Furthermore, paragraph 104(13.4)(a) deems the trust’s taxation year to end at the end of the day on which the death occurs, with the result that the donation tax credits from gifts made by the trust after the day of death will only be available for carry-forward and not available in the trust’s taxation year in which the death occurs. The potential consequences are illustrated by the following example:
An alter-ego trust was established to provide for the settlor’s children and make a substantial donation to a charity after the settlor’s death. It was intended that the donation tax credits from the donation made by the trust will offset the tax from the deemed disposition of certain trust assets on the settlor’s death. However, under paragraph 104(13.4)(b), the income from the deemed disposition will be included in the final tax return of the settlor and the tax will be borne by the settlor’s estate. The donation tax credits cannot be used to offset the estate’s tax liability and would go unused unless the trust earned sufficient income.
Life Interest Trusts can be critical to protecting charitable donations from wills-variation claims. If not corrected, subsection 104(13.4) will effectively deny the benefit of donation tax credits where the donation is made by a Life Interest Trust as part of an estate plan. As a further consequence, subsection 104(13.4) will affect the use of Life Interest Trusts to protect a testator’s testamentary wishes in the context of a second marriage. The use of Life Interest Trusts is especially common in British Columbia where the adult children from the testator’s first marriage have the ability to challenge a will on the ground that it does not make adequate provision for them based on economic and moral considerations. If not corrected, the enacted subsection 104(13.4) will undoubtedly cause problems for many estate plans involving Life Interest Trusts.
In response to these concerns, Finance is considering amending paragraph 104(13.4)(b) so that it does not apply to a trust unless the trust and estate jointly elect to have the paragraph apply. If such amendment is enacted, the tax liability from the deemed disposition of the trust property will by default remain in the trust. To further address the problem of donation tax credits, Finance is also considering making amendments to allocate the amount of donations made by the trust after the day of the Life Interest Beneficiary’s death but before the end of the calendar year to the trust’s taxation year in which the death occurs. (Although not addressed in Finance’s letter, in order to give full credit for charitable donations, it would be generally necessary to remove the 75%-of-income limit on charitable donations made by Life Interest Trusts, as there is no such limit for donations made under a will. Finance has done nothing and recommends nothing with respect this long-standing problem.)
It is good news that Finance is sympathetic to the concerns regarding subsection 104(13.4). Given the severity of the problems, the amending legislation is expected to be on its way.