Further Legislative Changes to the Taxation of Trusts

By Melodie Lind
Categories: Blog, Tax

There is good news and bad news with draft legislation released by the Department of Finance on January 15, 2016. In a previous Legal Alert article, I wrote about changes to the Income Tax Act that would impact the taxation of trusts. These changes came into effect January 1, 2016 and represented a major shift in the status quo, with the potential to create some serious problems for estate plans. The draft legislation released on January 15, 2016 is intended to address some of the problems.

The new rules brought in with the January 2016 amendments shifted the tax burden on the death of the life-interest beneficiary of a spousal trust, alter ego trust and joint partner trust. Prior to January 1, 2016, the deemed disposition that occurred on the death of the life-interest beneficiary resulted in the trust paying tax on the accrued capital gain of the trust property. This made a lot of sense as the trust held the assets and could use those assets to fund the tax liability. As of January 1, 2016, the tax liability for that same deemed disposition falls to the estate of the deceased life-interest beneficiary such that the assets of that deceased beneficiary, and not the assets of the trust, will be used to fund the trust’s tax liability. This can create serious problems for existing estate plans and trusts that are already in place: if the ultimate beneficiaries of the trust and the deceased’s estate are different, you have one set of beneficiaries paying for the tax liability associated with the other set of beneficiaries’ assets.

This new draft legislation essentially reverses these problematic changes to the taxation of spousal, alter ego and joint partner trusts. This is very good news as the tax resulting from the deemed disposition of a life interest beneficiary will be back to being taxed in the hands of the trust and not in the deceased life interest beneficiary’s estate (subject to a very limited exception).

There is, however, some bad news with the draft legislation. Before the January 2016 amendments, there was a provision in the Income Tax Act that specifically allowed a spousal trust to use the spouse beneficiary’s lifetime capital gains exemption on the death of the spouse beneficiary. For instance, the lifetime capital gains exemption could be used for qualified shares on the death of the first spouse. The shares could then be placed in trust for the surviving spouse, and the surviving spouse’s lifetime capital gains exemption could be used by the trust on the death of the surviving spouse (assuming the shares still qualified). The same rule applied for farm property or shares of a family farm corporation. That Income Tax Act provision was repealed with the January 2016 amendments, presumably because it wasn’t needed anymore because the lifetime capital gains exemption would have been available by virtue of the tax falling to the deceased’s estate.

The draft legislation changes where the tax liability falls, but it hasn’t brought back the provision that permitted the use of the lifetime capital gains exemption for spousal trusts. The result is that the use of a spousal trust (instead of an outright gift to a spouse) will result in the loss of the ability to use the surviving spouse’s lifetime capital gains exemption with respect to the assets held in the spousal trust.

The draft legislation has not yet received royal assent, and so is subject to further changes. Hopefully, the loss of the use of the lifetime capital gains exemption for spousal trusts is an oversight that will be corrected.