Certain spousal (or common-law partner) trusts and joint spousal (or common-law partner) trusts enjoy special tax treatment under the Income Tax Act. In most cases, property can be transferred into the trust on a tax-deferred basis, either during your lifetime, or upon your death (for a spousal trust). A spousal trust will have your spouse as beneficiary, and a joint spousal trust will have you and your spouse as beneficiaries (certain other conditions must be met).
As a typical example, you could set up a testamentary spousal trust under your will. On your death, property passing to the spousal trust would do so on a tax-free basis, without triggering capital gains (other property upon your death is normally subject to a deemed disposition at fair market value).
However, upon the death of your beneficiary spouse (or, for a joint spousal trust, the later of your death or your spouse’s death), the trust is deemed to dispose of its properties at fair market value. This may generate capital gains or losses in the spousal trust at this later point in time.
Before 2016, any capital gains resulting from the deemed disposition on the spouse beneficiary’s death were generally taxed to the spousal trust and not the beneficiary. Furthermore, any income of the trust up until that death was taxed to the trust, unless it was actually paid out to the beneficiary.
The government recently amended the rules effective as of January 1, 2016, providing that on the death of the beneficiary spouse, there will be a deemed year-end for the spousal trust. The amended rules further provide that capital gains on the deemed disposition at the beneficiary’s death, plus any income of the trust in the year ending upon the death, will be deemed to be payable to the beneficiary and therefore taxed to the beneficiary rather than the trust (“beneficiary-taxed rule”).
The beneficiary-taxed rule (paragraph 104 (13.4)(b) of the Income Tax Act) proved to be a concern to many in the tax community. The concern was that the deceased beneficiary could be subject to tax on such gains or income, even if the beneficiary did not receive any property or income out of the trust.
Not surprisingly, the Department of Finance was lobbied extensively by concerned parties. In response, on November 16, 2015 the Department released a “semi-comfort” letter addressed to the Canadian Bar Association / CPA Canada Joint Committee on Taxation, the Society of Trust and Estate Practitioners (STEP), and the Conference for Advanced Life Underwriting (CALU), under which it more-or-less proposed to alleviate the above-noted concern relating to the beneficiary-taxed rule. The letter is not as definite as comfort letters usually are, as Finance continues to review the issue, but it is likely that what it proposes will be enacted.
Under this proposal, the beneficiary-taxed rule would generally not apply. As such, the spousal trust would remain taxed on the capital gains resulting from the deemed disposition rule and on any income in the trust year ending on the beneficiary’s death, effectively reinstating the pre-2016 tax rules.
However, the beneficiary-taxed rule would apply to a testamentary spousal trust if, among other criteria, the trust was created by the will of a taxpayer who died before 2017 and the trust and the beneficiary’s graduated rate estate jointly elected to have that rule apply.
Assuming these proposals are enacted, the trust will be taxed on the deemed gains and income in the year ending at the time of the death of the spouse beneficiary, unless the joint election is made and the other criteria are met. Hopefully, more details on these proposed changes will be forthcoming in the near future.
Charitable donations credit for spousal and similar trusts
On a related note, if a spousal trust makes a charitable donation, it can claim it in the year of donation or in the subsequent five years.
In conjunction with the proposals described above, in the same comfort letter the Department of Finance proposes that a gift made by the trust after the beneficiary’s death but in the same calendar year will be able to be claimed in the trust’s year ending at the time of death, to offset any tax owing as a result of the proposed alternative treatment under which the trust is subject to tax in that year (as discussed above).