Life-interest trusts used for estate planning will be hit hard by the federal government’s proposed increase to the capital gains inclusion rate (CGIR) if they don’t flow out gains to beneficiaries.
“Gains realized in the trust [at death] are trapped in the trust,” said Ian Pryor, head of the tax group with Pryor Tax Law LLP in Toronto, during a STEP Canada webcast on Monday.
Alter-ego trusts, joint spousal or common-law partner trusts, and spousal trusts are subject to a deemed disposition when the relevant beneficiary of the trust dies. At that point, the trusts cannot allocate gains to a beneficiary to be taxed in their hands.
Absent planning while the beneficiary is still alive, “you have that big gain [in the trust] in the year of death,” said Ryan Minor, director of taxation with CPA Canada in Toronto, in an interview. With the increase in the CGIR, “that’s going to hurt.”
In Ontario, for example, the effective tax rate for capital gains realized in a trust will be 35.70% on or after June 25, compared to 26.76% on gains for an individual (taxed at the highest marginal rate) below the annual $250,000 threshold, a difference of 8.94 percentage points.
In addition, all trusts (except for graduated rate estates and qualified disability trusts) are taxed at the highest marginal rate on the first dollar of income, whereas beneficiaries are taxed at personal, graduated rates.
In the 2024 federal budget, the government proposed increasing the CGIR to two-thirds from one-half for capital gains realized on or after June 25. This applies to all gains realized by trusts and corporations, as well as gains realized by individuals above $250,000.
The budget document did not exclude any trusts from the CGIR increase. As of press time, draft legislation has yet to be tabled.
Life-interest trusts are typically used for probate planning, as a substitute for a will, for privacy and confidentiality purposes, and other estate-planning reasons — not income-tax planning.
Clients with life-interest trusts can consider allocating gains to beneficiaries before death if the trust deed permits it. Alternatively, clients may be able to transfer property out of a life-interest trust on a tax-deferred basis while the beneficiary is alive, which would allow the beneficiary to sell the property.
Either transaction will allow the beneficiary to access the 50% CGIR on the first $250,000 of gain in a year. “What we want to avoid is the deemed gain being trapped in the trust on the death,” Pryor said.
A client considering transferring assets out of the trust should first consider whether any losses or loss carryforwards could offset the gains, Pryor said, mitigating the need to transfer assets out before death.
In addition, transfers of capital out of a life-interest trust may be imprudent if the client’s intention was, for example, to provide income for a spouse during their lifetime while preserving capital for a residual beneficiary.
“You don’t want to roll an asset out to a beneficiary just to get a better tax rate if it completely defeats the purpose [of the trust],” Pryor said.
Sometimes, the trust’s terms do not allow for capital allocation.
“Unless the trust document specifically states that the annual distribution of income includes capital gains realized, you may not actually have the ability to allocate a capital gain,” said Armando Minicucci, tax partner with Grant Thornton LLP in Toronto, in an interview.
When contributing property to a life-interest trust on or after June 25, clients could elect out of the tax-deferred rollover of the property into the trust, meaning the gain on the property would be taxed in their hands and the trust would receive the asset at the new higher cost base.
“That would give us an opportunity to use our $250,000 threshold,” Pryor said. “It also allows us to use up our personal [capital] losses … to offset [gains].”
Until June 25, the trust will continue to have access to the 50% inclusion rate.
However, the budget document did not address the rate at which gains realized in a trust prior to June 25 but allocated to beneficiaries between June 25 and the end of the year will be taxed in the hands of beneficiaries.
“I would allocate [gains] out [before June 25],” Pryor said. “I wouldn’t take my chances and hope they get it right [in the legislation].”
How life-interest trusts work
A person 65 or older can set up or “settle” an alter-ego trust for themselves or a joint spousal or common-law partner trust for themselves and their spouse. A spousal trust can be set up by someone at any age for the benefit of a spouse.
For a trust to qualify as a life-interest trust, the settlor and/or spouse beneficiary must be entitled to receive all trust income arising before their death. Further, no person other than the settlor or spouse can, before death, receive or obtain the use of the trust’s income or capital.
Where the trust meets these conditions, transfers of assets to the trust can take place on a tax-deferred, or rollover, basis. An election can be made to opt out of the rollover into the trust, triggering a deemed disposition at fair market value.
Life interest trusts are not subject to the 21-year deemed disposition rule while the settlor/spouse beneficiary is alive.