Estate planning changes

In December 2014, the government passed changes to the income tax rules related to estates and donations through a will. The changes were introduced to address certain tax planning arrangements that the Department of Finance felt were abusive. However, while addressing the specific issues, the legislation has far reaching consequences that go well beyond the scope of the issues identified by the Department of Finance in their original consultations. The result is the most fundamental changes to the rules for estate planning in the past 20 years.

In this newsletter, we provide an overview of the rules that apply until December 31, 2015 and the changes to these rules, a summary of some of the more significant issues that you may need to address in your estate planning and an illustration of the potential impact of the rules. This high level overview is not intended to be a detailed analysis of all of the changes.

The rules until December 31, 2015

When an individual passes away, there is normally an estate established that is administered by the executors. As part of the decedent’s estate plan, the will may also create testamentary trusts. The most common type of testamentary trust is a spousal trust. Any testamentary trust is eligible for the graduated personal tax rates (with no personal tax credits) on its income. Therefore, where a will creates more than one testamentary trust, there is access to the graduated tax rates multiple times. There are some additional more modest benefits for a testamentary trust today such as the ability to have a year-end other than December 31st.

The benefit from the graduated tax rates depends on the province but can be significant. For example, the benefit in Ontario is $17,800, Alberta is $9,600 and Nova Scotia is $16,700 for each testamentary trust based on $100,000 of non-dividend income.

In addition, in the case of a spousal trust, when the spouse who is the beneficiary of the trust passes away, the assets of the trust are deemed to be sold for the fair market value at the time. The gain is reported on the trust return and the tax is payable by the trust on that tax return. The assets are then distributed to the ultimate beneficiaries of the trust (for example, children / grandchildren). In this situation, accessing lower graduated rates can have a significant impact on keeping taxes lower.

Finally, where a taxpayer makes charitable donations under a will, the donation is generally considered to be made at the time of the person’s death and the amount of the donation is the fair market value of the property gifted on the date of death. Under an administrative policy, the Canada Revenue Agency historically has allowed a donation in one person’s will to be claimed as a charitable donation in the spouse’s return for the year of death. This provided greater flexibility in the use of the donation in some circumstances since the spouse could claim the donation credit in that year or in the subsequent 5 years.

The rules after December 31, 2015

The new rules take effect as of January 1, 2016. The most significant change is the introduction of the graduated rate estate (GRE). The major components of the GRE definition are:

• The GRE is an estate that arises as a consequence of death and not a trust created as a consequence of an individual’s will. This can be a difficult distinction to understand as in the past there was no differentiation and these two situations were treated as being the same.
• Not more than 36 months have passed since the death.
• The estate must meet the conditions of a testamentary trust for income tax purposes. There are actions that can be taken after a person’s death that can cause what would have been a testamentary trust to cease to meet the rules.
• The estate must designate that it will be considered a GRE in the first tax return filed after January 1, 2016.
• No other estate designates itself a GRE of the individual after January 1, 2016; and
• The decedent’s Social Insurance Number must be provided in the GRE tax return for all years.

There are a number of tax benefits that will only be available to a GRE in the future. The more common of these benefits are:

• Access to graduated personal tax rates on income earned by the GRE.
• The ability to have a year-end other than December 31st.
• Capital losses incurred in the first year of the estate are available to be carried back to the deceased’s final tax return; and
• No requirement to pay quarterly income tax instalments.

There have also been some very significant changes to the rules that will apply to certain estates and trusts. These rules will be seen most frequently where there is an existing spousal trust. As of January 1, 2016, where a spouse passes away who had been the beneficiary of a spousal trust, the same deemed sale of all of the assets at fair market value will be considered to have occurred as happens under the existing rules. However, under the new rules, all of this income will be deemed to be income of the spouse (and not the estate/trust). Therefore, the income will be reported on the spouse’s final personal tax return and the tax will be owing on that return.

Finally, there are changes in the rules related to charitable donations provided for in a person’s will. In the future, donations in a will are to be treated as follows:

• The donation will be considered to be made at the time of the actual transfer of property to the charity. This means the donation will be made by the estate or a trust created under the will. This will also apply where there is a transfer of assets from a life insurance policy, an RRSP and other similar accounts.
• The amount of the donation will be the fair market value of property at the time the property is transferred to the charity.
• If the estate/trust is not a GRE, the donation credit can only be claimed by the estate/trust in the year of the donation and the subsequent 5 years; and
• If the estate is a GRE, the estate has significant flexibility related to the charitable donation credit. The estate can choose to claim the donation on the terminal personal tax return of the deceased or the prior year. The donation can also be claimed in the estate or the subsequent 5 years of the estate. The donation cannot be claimed by the deceased’s spouse.

Issues with the new rules

There are a significant number of issues with the changes in the rules that need to be considered as part of an estate plan. While this newsletter does not address all of the challenges, we have highlighted some important ones below:

1. Based on the definition of a GRE, there may be questions as to what qualifies as a GRE.
2. In some provinces, it is common for owners of private companies to have multiple wills. The application of the new rules to multiple wills will also require conversations with legal counsel. If there are ultimately two estates that could qualify as a GRE, the executors would have to agree on the designation of the GRE.
3. The new rules apply as of January 1, 2016 to all estates. Where an estate exists today, it may be able to be considered a GRE but only for 36 months in total. Therefore, any existing estate that was created prior to January 1, 2013 cannot be a GRE.
4. Since there are no grandfathering provisions as it relates to the transition of existing estates, there could be adverse tax consequences from the changes. As it may be difficult (or impossible) to revise the structure of an existing estate, some of these adverse tax consequences may be unavoidable.
5. For existing estates/trusts that will not qualify as a GRE, the estate/trust will be required to change its year end to December 31st in 2015. Therefore, if an existing testamentary trust had an April 30th year end, it would have its normal April 30, 2015 year end and an additional tax year end as of December 31, 2015.
6. Where there are multiple existing testamentary trusts, only one trust can qualify as a GRE.
7. If your estate plan is based on creating a capital loss in the first year of the estate to be carried back to the terminal personal tax return, careful review of the existing provisions of the will are required to ensure that the capital loss will be created in a GRE.
8. If a current estate plan calls for the creation of a spousal trust, the implications of the change in who is required to pay tax on the deemed sale of the assets will need to be carefully reviewed as shown in more detail in the next section. This will be particularly important when the ultimate beneficiaries of the spousal trust are different than the beneficiaries of the spouse’s estate - a common situation especially where there is a second marriage involved.
9. Any estate plan that contemplates charitable donations will need to be reviewed to ensure that the charitable donation credit is available on the same tax return as any tax triggered.

Each situation should be reviewed in detail to determine the potential implications and changes required.

An example

The following is an example of potential issues with the changes in the rules. Assume the following:

1. Tax rate of 45%.
2. Mr. Smith passed away in 2005. The basic terms of Mr. Smith’s will were:
   • His assets are to be held in spousal testamentary trust; and
   • On spouse’s death, the assets are to be divided with 15% of the pre-tax value given to charity and the balance divided among Mr. Smith’s two children.
3. Mrs. Smith dies in 2017. The basic terms of her will are:
   • Assets owned by Mrs. Smith transferred to her 3 children – one-third each. The children are different than Mr. X’s children.
   • On spouse’s death, the assets are to be divided with 15% of the pre-tax value given to charity and the balance divided among Mr. Smith’s two children.
4. Value of assets owned by Mrs. Smith is $4,500,000 with an accrued gain of $1,000,000.
5. Value of assets held in spousal trust is $6,000,000 with an accrued gain of $2,500,000.

Below is a comparison of the results under the old rules and the new rules.

Note – there are a number of considerations in determining if the donation credit would be available to the spousal trust. For this illustration, it has been assumed that all of these considerations are met.

As can be seen from the above example, the changes in the rules have made a significant shift in the tax burden and therefore, in the distribution of the assets:

• Mr. Smith’s two children would see an increase of $157,500 in their distributions (since there is no tax in the spousal trust).
• Mrs. Smith’s three children would see a decrease of $562,500 in their distributions (since the tax from the spousal trust shifts to Mrs. Smith’s estate and the donation credit cannot be used by the estate).

In this example, since Mr. Smith had already passed away, it would not have been possible to make any changes in the estate plan. Since there are no grandfathering provisions in the new rules, it does not appear to be possible to avoid the adverse consequences.

Conclusion

As was noted, the changes are far reaching and have the potential to have a very significant impact on estates. In some cases, there can be negative consequences for estates that are already in place and cannot easily be changed. We normally suggest that wills be reviewed every 5 years or when there is a significant change in personal circumstances. This change in the rules should be viewed as a significant change and we suggest that all estate plans and wills be reviewed.

If you have any questions regarding these changes, please do not hesitate to contact your Deloitte advisor.