Beware: A New Era in Estate Planning Qualified Disability Trusts ... · Beware: A New Era in Estate Planning Qualified Disability Trusts Graduated Rate Estates Life Interest Trust

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Society of Trust and Estate Practitioners (Canada) Webcast – November 14th, 2014 Page 1

Beware: A New Era in Estate Planning

Qualified Disability Trusts

Graduated Rate Estates

Life Interest Trust Taxation

Lisa Heddema, LLB, TEP Vancouver: Smetheram & Company

Angela Ross, LLB, Toronto: PwC LLP

Pamela Cross, LLB, TEP, Ottawa: Borden Ladner Gervais LLP; Secretary: STEP Canada


Agenda

• Background

• Qualified Disability Trusts (“QDTs”)

• Graduated Rate Estates (“GREs”)

• Life Interest Trusts (Spousal Trusts/Joint Partner Trusts/Alter Ego Trusts)

• Planning Implications

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Background • Budget 2013 – Flat Top Rate Taxation for Testamentary Trusts

announced

• June 3, 2013 – Consultation on Flat Top Rate Taxation; submissions due December 2, 2013

• Budget 2014 – Flat Top Rate Trust Taxation confirmed. Charitable donation changes announced.

• August 29, 2014 – Draft Legislation released (30 day consultation)

– Flat Top Rate Taxation for all Trusts except GRE and QDTs

– Access to certain provisions relating to post mortem planning and charitable giving on death restricted to GREs (New)

– Introduction of Life Interest Trust Taxation Rules (New)

• October 10, 2014 – NWMMs released (re-released October 20th)

• November 3rd – Bill C-43 received second reading.

• Effective for taxation years ending after 2015. No grandfathering



Requirements

• At end of year, is a testamentary trust that arose on and as a consequence of death • Excludes inter vivos trusts

• Includes insurance trusts

• Trust resident in Canada for the year (not just the end of the year)

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Requirements (cont’d)

• In tax return for the year, trust elects jointly with ‘electing beneficiary’ to be QDT and includes electing beneficiary’s SIN • No relief for late election

• If incapable, electing beneficiary may need court appointed guardian to make election



Electing Beneficiary

• Beneficiary qualifies for disability tax credit under 118.3 (not same as ‘preferred beneficiary’) • Can have other beneficiaries included in trust

AND

• Does not make a QDT election in respect of any other trust • Only one QDT per disabled beneficiary

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Recovery of Tax

• QDT subject to graduated rates for any year elects to be QDT, BUT subject to pay a recovery of tax in respect of previous year if: • None of the beneficiaries at the end of the year were

electing beneficiary for preceding year, OR

• Trust ceased to be resident in Canada, OR

• Capital distribution is made to non-electing beneficiary



Recovery of Tax (Cont’d)

• Amount of recovery tax: • Amount of tax that would have been paid in previous

year if trust had been subject to highest marginal rate and taxable income for that year excluded amounts that were subsequently distributed as capital to electing beneficiary

• Intent is to claw back tax savings for income taxed at graduated rates which was subsequently distributed as capital to non-electing beneficiary

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Recovery of Tax (Cont’d)

• Recovery tax = A-B

A: hypothetical tax for preceding year if tax rate of 29% and taxable income for that year reduced by amounts paid to electing beneficiary and tax payable that reasonably relates to distribution to electing beneficiary

B: amount of tax payable for the preceding year



Recovery of Tax PLUS loss of QDT Status

• In year when electing beneficiary dies, or trust becomes non-resident, or distribute to non-electing beneficiary: – potential double penalty of ‘recovery of tax’

AND

– loss of graduated rates (no 36 month grace period)

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Qualified Disability Trusts • Recovery Tax Mechanism (example)

• Assume: One beneficiary (Olivia) eligible for DTC and Trust is QDT

• 2019 – no income in trust; $5000 capital distribution to Olivia

• 2020 – taxable income of $10,000; capital distributions: $34,000 to Olivia and $100,000 to others.



• Para. 122(1)(c): Recovery Tax Mechanism

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Example 1– Only one QDT per electing beneficiary

• Disabled individual with 4 grandparents

• Each grandparent sets up trust for individual under their Will (i.e. 4 testamentary trusts)

• Each trust generates $20,000 (total $80,000)

• Only one trust can be QDT, so only $20,000 taxed at graduated rates. Other $60,000 taxed at highest marginal rate.



Example 2 – Insurance trust and testamentary trust

• Parent creates trust under Will for disabled child

• Parent also creates an insurance trust for child to be beneficiary of life insurance policy

• Either the testamentary trust or the life insurance trust can qualify as QDT, but not both

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Summary Points

• Only testamentary trust (including insurance trust) can be QDT

• QDT only available for beneficiaries who qualify for disability tax credit

• Only one QDT per individual

• Make election each year in tax return

• Beware making capital distributions to other beneficiaries


Graduated Rate Estate Overview of Legislation – applicable in 2016

• A graduated rate estate (GRE) is first and foremost an estate and is not a trust created under a person’s Will

• Conditions for an estate to be a GRE

• no more than 36 months have passed since death

• estate is a testamentary trust

• estate designates itself as the GRE in its first tax return

• deceased’s SIN provided in estate tax return

• no other estate is designated as the GRE of the deceased

• There is no grandfathering of existing trusts or estates

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Graduated Rate Estate Overview of Legislation – applicable in 2016

• Why status of GRE is important:

• graduated tax rates on income earned and retained in the estate

• no tax instalment obligations

• off calendar year end permitted

• access to new flexible donation credit rules for donations made in will or by the estate (for deaths after 2015)

• nil capital gains inclusion for donation of shares on death (for deaths after 2015)

• availability of 164(6) and 112(3.2)

Not clear why GRE status of an estate is necessary for these provisions to apply; does not impact access to graduated tax rates


Graduated Rate Estate Issues for Estate/Tax Planning

Only one GRE

• If an individual has multiple Wills where each Will has different executors and beneficiaries, is there more than one estate?

• If multiple Wills, can a single estate tax return be filed? Who will sign? If different executors, how is 159 liability determined?

• If multiple estates filing separate tax returns, who determines which is the GRE (and gets benefits of designation)? What if executors are not the same? What if an incorrect designation is made?

Estate must be designated as the GRE in first estate tax return

• What if an error made and designation not made? Can a late designation be filed?

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Example 3

Jane’s main assets consist of private company shares and marketable securities

• Both have a value of $1 million and a nominal cost base

• It is recommended that Jane have two separate Wills each with different executors

• Jane wishes to leave the marketable securities to a charity and the value of the private company to her children


Graduated Rate Estate Issues for Estate/Tax Planning Example 3 – cont’d

• Ideal post mortem plan under new rules:

• Securities gifted to charity such that 38(a.1)(ii) applies – no capital gain in Jane’s terminal return

• Double tax planning implemented for private company shares so that deemed dividends in the estate (50% being tax-free capital dividends as permitted under 112(3.2)) and 164(6) election made to carry back capital loss on shares to Jane’s terminal return to offset gains on death

• Donation tax credit claimed by estate to offset taxes on deemed dividend

• Result should be no tax payable as a result of death

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Example 3– cont’d

• HOWEVER:

• If two estates and two tax returns, only one can be designated as the GRE

• If the estate with public securities NOT the GRE, not entitled to nil capital gains for donation of securities and not entitled to flexible donation rules to allow claim of donation tax credit in terminal return; result is tax on gain of marketable securities in terminal return

• If the estate with the private company shares NOT the GRE, not entitled to 164(6) and 112(3.2) for post mortem double tax planning (pipeline/bump becomes only option)


New Trust Provisions Overview of Legislation – 104(13.3)

104(13.3)

• invalidates a designation under 104(13.1) and (13.2) if, after the application of the designation, the trust has taxable income

• Designations will only be available to allow the trust to use losses and other tax attributes

• Does not allow a designation to use tax credits (donation tax credits or ITCs) in trust

• Applies starting in 2016

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New Trust Provisions Issues for Estate/Tax Planning – 104(13.3)

• Not a material issue for testamentary trusts because no longer have access to graduated tax rates

• Provision applies to GREs

• 104(13.1) and (13.2) designations must be made in trust’s tax return; in loss carry back situation, no provision in the Act that permits late designation (but CRA currently accepts)

• Provincial tax planning may be frustrated



• Applies starting in 2016 to trusts for which a deemed disposition occurs under 104(4)(a), (a.1) and (a.4) on the death of the life interest beneficiary (or the death of the surviving life interest beneficiary where a joint partner trust) (life interest trusts):

• spousal and common-law partner trusts,

• alter ego trusts,

• joint spousal and common-law partner trusts

• No grandfathering – applies to all life interests trusts starting in 2016 regardless of when the trust created

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• 104(13.4) provides that on the death of the life interest beneficiary (or on the second death for a joint partner trust):

• trust has deemed year end at end of day of death, and

• all income of trust for shortened year (including any capital gains realized on the 104(4) deemed disposition) is deemed payable in year to deceased life interest beneficiary

• Result is capital gains on deemed disposition included in the deceased life interest beneficiary’s terminal return; trust claims a deduction for the income

• Provincial planning will be frustrated


New Trust Provisions Overview of Legislation – 104(13.4) • 160(1.4) provides that the life interest beneficiary and trust are

jointly and severally, or solidarily, liable for taxes owing as a result of 104(13.4)

• Explanatory Notes (released on October 30, 2014)

• “Existing subsection 160(2) of the Act empowers the Minister of National Revenue to assess the liability that arises under subsection 160(1.4) against the trust at any time, and it is intended that the Minister apply subsection 160(2), in respect of an amount owing under subsection 160(1.4), as though the trust were liable in the first instance for that amount.”

• So, while income of the trust included in the terminal return, it is intended that the tax be paid by the trust

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• Experience with CRA is that section 160 is not utilized by auditors who process and assess returns, but is used by the collections department

• CRA has not made any public statements confirming that it will apply 160(2) in the way intended by Finance and it is assumed that changes will need to be made at the CRA to “properly” administer these new rules

• Until the CRA comments on how it will administer 160(1.4), unclear whether the estate of the life interest beneficiary can rely on collection only being enforced against the trust



• If 160(2) not used to enforce payment by trust, tax will be payable by the life interest beneficiary who does not have the property; can lead to inequities where beneficiaries of estate of life interest beneficiary not the same as beneficiaries of life interest trust

• The terms of virtually every life interest trust do not provide for the distribution of property to the life interest beneficiary’s estate (i.e., the life interest beneficiary’s interest in the trust ceases on death), nor do they provide for the payment of the life interest beneficiary’s taxes upon death, such that the trust may not be permitted to fund the taxes owing (unless 160(1.4) is enforced by the CRA)

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• Even if 160(1.4) will be applied in the way intended by Finance,

• There is a timing issue – the tax becomes owing on the date the terminal return is due; presumably 160(1.4) and 160(2) can only be applied once the terminal return is filed and assessed; seems that interest will always apply to tax payment because the trust will only pay after receiving a 160(2) demand to pay

• What will advice be to estate trustee? Not to pay the taxes owing as set out in the terminal return? Is the trustee responsible for determining the amount subject to 160(1.4)?



• Even if 160(1.4) will be applied in the way intended by Finance,

• The tax of first instance remains chargeable to the life interest beneficiary’s estate; if the trust pays the taxes owing, the trust may have a claim against the estate to pay the amount to the trust; this can result in litigation between the trust and the estate regarding which should bear the economic burden of the tax

• What will CRA do if the assets of the trust are illiquid, but the assets of the estate are liquid?

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• To address litigation risk, life interest trusts can be drafted to ensure the trustees make no claim for tax against the estate; however, life interest trusts currently in existence and/or provided for may not be able to be amended to properly address 104(13.4) and 160(1.4) – for example, if settlor deceased or incapable

• If life interest trust an inter vivos trust and trust pays the life interest beneficiary’s taxes owing because of 104(13.4), will taint the life interest beneficiary’s estate such that it can no longer be a testamentary trust and therefore a GRE



• 104(13.4) provides that a trust’s income is deemed to have become payable in the year to the life interest beneficiary

• This income is income for tax purposes, not income for trust law purposes (108(3) does not apply for 104(13.4))

• So a life interest beneficiary with no capital entitlement could have a higher income allocation in the year of death because taxable capital gains and other types of non-trust income earned prior to death included in the terminal return

• If the life interest beneficiary is a non-resident of Canada at the time of death, the income of the trust will only be subject to non-resident withholding tax

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New Trust Provisions Issues for Estate/Tax Planning – 104(13.4) Example 4

• Jack and Diane are married; second marriage for each

• Each has children from first marriage; no children together

• Jack dies; under his will a spousal trust is established for Diane under which Diane entitled to all of the income but cannot receive any capital; on Diane’s death, the property of the spousal trust will go to Jack’s children

• After 2015, Diane dies; at the time of her death, the spousal trust holds assets with a value and unrealized capital gain of $1 million; Diane personally owns assets with a value and unrealized capital gain of $1 million

• Under the terms of Diane’s will, the residue of her estate will go to her children




• On Diane’s death (if 160(1.4) applies as Finance intends):

• Diane’s terminal tax return will include $2 million of capital gains, resulting in taxes owing of $500,000

• CRA will apply 160(1.4) and 160(2) to enforce payment of $250,000 of the tax from the spousal trust

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• However:

• Timing of when CRA will assess the $250,000 taxes against the spousal trust is not known and interest will continue to accumulate on the unpaid taxes; if Diane’s estate pays tax to stop interest, spousal trust will have no obligations

• When the spousal trust pays the $250,000 tax bill, it could bring a claim against Diane’s estate for repayment of the $250,000; given fiduciary obligations, trustees of spousal trust may be compelled to try to collect from Diane’s estate

• What if the CRA does not apply 160(1.4) and enforces payment against Diane’s estate?




• While planning may be available to address some of the concerns, this can only be accomplished if the terms of the spousal trust can be amended

• If Jack already dead or terms of spousal trust cannot otherwise be amended due to Jack’s incapacity, planning may not be available

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Example 5

• John establishes an alter ego trust to which he transfers all of his property other than his RRIF

• After John’s death, his children are to receive the remaining capital in the alter ego trust

• John designates a charity as the beneficiary of his RRIF

• After 2015, John dies; at the time of his death, his RRIF is worth $500,000; the assets in the alter ego trust have a value and unrealized capital gains of $500,000


New Trust Provisions Issues for Estate/Tax Planning – 104(13.4) Example 5 – cont’d

• On John’s death (if 160(1.4) applies as Finance intends):

• John’s terminal return will include the $500,000 of RRIF value and the $500,000 capital gain realized in the alter ego trust

• CRA will apply 160(1.4) and 160(2) to enforce payment of $125,000 of tax from alter ego trust

• However,

• Under donation rules, amount donated to charity can be claimed in John’s terminal return to offset taxes owing; how is the donation credit to be applied in determining the alter ego trust’s tax liability under 160(1.4)?

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Example 6

• On Diane’s death, she established a spousal trust for Jack’s lifetime; Jack is entitled to all of the income and the trustees have the power to encroach on capital for Jack’s benefit

• The terms of the spousal trust provide that, on Jack’s death, 20% of the trust capital remaining is to be donated to charity

• Under the new donation rules, on Diane’s death she will not be entitled to claim a donation credit for the remainder interest of the charity in the spousal trust

• On Jack’s death (if 160(1.4) applies as Finance intends), Jack’s terminal return will include the capital gain realized in the spousal trust, but 160(1.4) will charge the tax to the spousal trust



Example 6 – cont’d

• While 20% of the spousal trust residue goes to charity, no ability to use donation credit to offset capital gains because:

• Cannot be claimed in Jack’s terminal return even though income of spousal trust in terminal return (the new donation rules not extended to life interest trusts);

• Not clear that donation tax credit will be available for the spousal trust’s tax liability stemming from the application of 160(1.4) and 160(2); even if it is available, the timing of the donation credit not likely to match the timing of the tax liability

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Planning Implications

• Existing Planning:

– Can trust terms be amended?

– Can planning be restructured?

– Can trust be wound up with capital encroachment?

– Variation application?

– Negotiate with life interest beneficiary to address tax implications?

• Future Planning?

Documents

Beware: A New Era in Estate Planning Qualified Disability Trusts ... · Beware: A New Era in Estate Planning Qualified Disability Trusts Graduated Rate Estates Life Interest Trust