A CHANGE COMING IN 2016 affecting the taxation of spousal trusts could have a significant negative impact on estate planning, particularly in cases of blended families.
The new tax rules governing these trusts could lead to unintended scenarios in which the children of one spouse, in the case of a second marriage, ultimately receive the assets of a trust, while the children of the other spouse receive the tax bill associated with that trust, they say.
“After Jan. 1, when you have the first estate involving a blended family and a spousal trust that actually has to deal with this issue, it’s going to be interesting,” says Pamela Cross, a tax partner in the Ottawa office of Borden Ladner Gervais LLP. “No one has any idea how this is going to turn out.”
The issue has to do with a change affecting life interest trusts – such as spousal, joint partner and alter ego trusts – that comes into force on Jan. 1, 2016. Life interest trusts are so called because only the settlor – the person who established the trust – or the settlor’s spouse can have access to the trust’s income or capital during the lifetime of that settlor and/or spouse.
That person or persons are referred to as the life interest beneficiaries of that trust. When a life interest beneficiary dies, the assets in the trust go to the remainder beneficiary.
Spousal trusts often are used in the case of second marriages so that a surviving spouse can have access to the assets in that trust during his or her lifetime. Upon the surviving spouse’s death, the remainder beneficiaries, often the children of the first spouse from a previous marriage, receive the assets in the trust – instead of those assets forming part of the estate of the second spouse, and thus flowing out to his or her children from a previous marriage.
Upon the death of the life interest beneficiary, assets in a life interest trust are taxed on the capital gains realized on the deemed disposition of those assets. Under current legislation, the trust is liable for those taxes.
Under the new rules in 2016, it will be the life interest beneficiary’s estate – effectively, his or her heirs – who will be primarily liable for those taxes.
“The issue is that the capital gains that are realized on the deemed disposition are included in the life interest beneficiary’s terminal return, and not the trust’s return,” says Jamie Golombek, managing director of tax and estate planning with the wealth advisory services division of Canadian Imperial Bank of Commerce in Toronto. “The assets are basically taxed in the hands of someone who doesn’t get the assets.”
If the deceased spouse’s estate has insufficient funds to pay the taxes, the Canada Revenue Agency may try to collect from the trust. However, the life interest trust’s estate remains primarily liable under the legislation.
The problems raised by the new rules are exacerbated by the fact that there is no grandfathering provision in the legislation to cover existing trusts or estate plans, says Lucinda Main, trust and estates lawyer with Beard Winter LLP in Toronto.
“You’re stuck with some of these spousal trusts that were created five, 10 or 15 years ago, when the first spouse died,” says Main. “Now what do you do?”
The new legislation is likely to lead to some tense family situations, Cross suggests: “You’ll have people who will say, ‘I don’t care if it costs a fortune, we’re going to fight about this, because I don’t want to pay the taxes’.”
Many trust and estate practitioners were surprised when the federal government first proposed the change to the taxation of life interest trusts in August 2014 and aren’t certain why the government decided to do so.
One theory is that Finance was looking to thwart so-called “Alberta trust” tax planning, in which a trust is created in another jurisdiction for the purpose of taking advantage of the second jurisdiction’s lower tax rates. The new legislation would effectively discourage that type of planning.
Advocacy groups such as the Society of Trust and Estate Practitioners (Canada) and the Canadian Bar Association in conjuction with the Chartered Professional Accountants of Canada made submissions last year to the government, asking it to consider changes to address this and other unintended consequences of the new legislation, but to no avail. While the government still may do something about these concerns, Keith Masterman, vice president of tax, retirement and estate planning with CI Investments Inc. in Toronto, for one, is skeptical.
“The government introduced this change in 2014, and it got royal assent in December 2014,” says Masterman. “It’s been more than a year and there’s been no indication that there are going to be some relieving provisions enacted.”
While there are a few possible estate planning solutions that could mitigate the issues raised by the new legislation affecting life interest trusts, none are perfect and each client’s situation is unique.
Financial advisors should advise their clients who have or are considering using spousal or other life interest trusts in their estate plans to seek out legal advice.
“I’m of the view that we shouldn’t be putting our heads in the sand and ignoring it,” Main says. “I think if you know of a trust that exists, or clients have a trust set up in their wills, I think it’s worth having a discussion about it.”
© 2015 Investment Executive. All rights reserved.