Tax Factor 2013-05

May 16, 2013

The 2013-05 issue of the Tax Factor is available for download. In this issue, we cover:

Death and taxes: potential changes to the taxation of testamentary trusts
Donation of publicly traded securities


Death and Taxes: Potential Changes to the Taxation of Testamentary Trusts

As Benjamin Franklin once famously said, "nothing is certain except death and taxes". It appears that the federal government wants to bolster this old adage, as this year's federal budget introduced plans to consult on potential changes to the current system of taxing assets after death. Specifically, the government proposes to confer with the tax community on the possibility of eliminating certain tax benefits currently enjoyed by testamentary trusts. In this article, we will look at these potential changes and contemplate how these measures may impact some of the more popular post-mortem tax planning strategies. But first, we will examine what testamentary trusts are, how they are used and why these trusts are often part of a post-mortem tax plan.

What are testamentary trusts?

Generally, a testamentary trust is a trust that is created upon the death of an individual, under the terms of that person's will. Testamentary trusts can also arise where an unfunded trust is named as a beneficiary of an insurance policy. Typically, the property or assets of the trust come from the estate and are managed by one or more trustees, who are usually the deceased's executors, for the benefit of the deceased's beneficiaries. The beneficiaries are often the surviving spouse and/or the children and grandchildren of the deceased.

There are several instances where establishing a testamentary trust may prove beneficial, aside from those reasons related solely to tax (which we will discuss below). Establishing a trust by will for a disabled beneficiary, or a beneficiary who is a minor child, can help ensure that the income and assets of the trust are properly managed and maintained, since the beneficiaries in these situations often lack the capacity to do so themselves. Testamentary trusts might also prove useful for the purpose of family law planning. For example, the deceased individual may have wanted to safeguard certain assets of the estate against a division of property in the event that a beneficiary's marriage breaks down. Also, a testamentary trust may be required for the continued management of the assets of an estate where the estate proves difficult or complex to administer or wind up. In such cases, an extended period of more than one year (often referred to as the "executor's year") may be needed to put the deceased's affairs in order before assets can be distributed to the beneficiaries.

A will may provide for the set up of more than one testamentary trust. For instance, a separate testamentary trust might be created for each surviving family member, with the assets of the estate generally allocated between each of the trusts as stipulated in the deceased's will. Establishing separate trusts segregates the distribution and administration of the assets within the individual's estate.

Testamentary trusts can also be used to stave off potential conflicts between the deceased's beneficiaries. For example, the deceased may have entered into a second marriage before death and might wish to minimize any potential disagreements between the "new" spouse and his or her children or grandchildren. One common approach is to allow the spouse to benefit from trust income until his or her death while retaining the trust capital for the deceased's children as residual beneficiaries.

How are testamentary trusts used in tax planning?

The most significant tax benefit of using a testamentary trust is the ability to access the graduated tax rates normally only applicable to individuals. This is in contrast to other trusts (i.e. ordinary inter vivos trusts, including personal and family trusts) which are taxed at a flat income tax rate of 29% (the highest rate of federal tax for individuals) plus provincial tax at the top rate. This characteristic creates an opportunity for income splitting. Another advantage is that testamentary trusts may have a non-calendar taxation year. The government, however, does not appear to be concerned about the possible tax deferral opportunities that may arise.

The following are a few of the ways that testamentary trusts can be used to reduce taxes:

Multiple trusts

By setting up multiple testamentary trusts for the benefit of each beneficiary within a single will, a taxpayer may be able to take advantage of multiple sets of lower marginal tax rates. Multiplying the number of trusts effectively reduces the overall taxes on income generated by the residue of the estate. Keep in mind that care must be taken to ensure that each trust has separate and distinct beneficiaries as anti-avoidance rules in the Income Tax Act (ITA) may apply to consolidate multiple trusts that are for the benefit of a single beneficiary, or for a group or class of beneficiaries, into one trust. For more information on creating multiple trusts by will, read our Tax Bulletin titled Estate Planning or speak to your BDO advisor.

High-income earning beneficiary

A trust is generally able to designate an amount in respect of income payable to beneficiaries to be deemed as not having been paid or payable to the beneficiaries. Income so designated would not be distributed to the beneficiaries, thus remaining to be taxed within the trust. This type of planning can be particularly valuable where the beneficiaries of a testamentary trust earn income that is taxed at a higher rate. Since the trust can take advantage of the graduated marginal rates, it will pay tax on the designated portion of income at a lower marginal rate as compared to the beneficiaries who would pay tax at a higher marginal rate. Please read our Tax Bulletin titled Understanding Trusts for a more detailed discussion on splitting income using a testamentary trust.

This strategy can also be useful in inter-provincial tax planning. Specifically, if the trust resides in a jurisdiction with a lower income tax rate than the beneficiaries, there can be a benefit from taxing the income within the trust at the lower provincial tax rate. Note that in light of a recent Supreme Court of Canada decision, care must be taken to ensure that the "central management and control" of the trust resides in the more favourable tax jurisdiction. If it is determined that someone other than the trustee(s) manages or controls the assets of the trust, and that person is shown not to actually reside in the preferred province, there may be negative tax implications to the trust.

Low-income earning beneficiary

A testamentary trust can also be used to put additional income into the hands of a beneficiary who is earning little to no income, and as a result take advantage of that individual's access to graduated tax rates. The provisions within the ITA that allow this type of income splitting are usually reserved for a disabled dependent beneficiary, but may also apply to an infirm minor beneficiary under certain conditions — both referred to as a "preferred beneficiary". Under these trusts, the preferred beneficiary generally has no legal claim to trust income, and to the extent that trust income is not payable to another beneficiary, it can be allocated to the preferred beneficiary without a requirement to actually pay it. Your BDO advisor can explain the benefits arising from a preferred beneficiary election in more detail. These trusts can also be useful in safeguarding social assistance entitlements in certain jurisdictions.

Avoiding OAS clawback

It may be that the beneficiaries of an estate include individuals who are receiving Old Age Security (OAS) pension payments. Most commonly, this would be the deceased's spouse, but there may also be other beneficiaries of the estate (including older children of the deceased) who qualify for OAS pension payments now or in the near future. An individual who receives OAS pension may not be able to receive the maximum OAS entitlement if he or she receives investment income from an inheritance, if the extra income is sufficiently large enough to drive his or her net income above the threshold amount ($70,954 for 2013). Specifically, if a beneficiary receiving OAS pension earns income in excess of this threshold, he or she may have to repay all or a portion of his or her OAS pension (referred to as the "OAS clawback" or "OAS Recovery Tax").

Holding what would otherwise be an immediate inheritance in a testamentary trust can help maximize OAS. By electing to retain and tax income in the trust, the beneficiary can still receive the income from the trust while not exceeding the OAS threshold.

Budget 2013 proposal to consult on trusts and estates

As a result of the tax benefits of using a testamentary trust discussed above, these trusts have caught the attention of the federal government. In particular, concern has been expressed regarding the increased use of testamentary trusts and the impact that this may be having on the erosion of the tax base. Consequently, the government revealed as part of the 2013 federal budget that they are considering eliminating the applicability of graduated marginal tax rates to these trusts (including estates), as well as to certain grandfathered inter vivos trusts that also benefit from graduated tax rates.

By removing access to the graduated marginal tax rates, the federal government would be eliminating most of the tax planning opportunities discussed above. While a testamentary trust will provide non-tax benefits in certain situations, the ability to take advantage of two or more sets of marginal tax rates may no longer be available.

For individuals currently doing will planning or individuals needing to update their wills, this creates a lot of uncertainty. For example, some of the unanswered questions include:

  • Will the government, in fact, be making changes?
  • If changes are made, will trusts created before the effective date of the change be grandfathered?
  • Will testamentary trusts be allowed to access graduated tax rates for a reasonable period to allow for estate administration?
  • If the issue of concern is multiple testamentary trusts arising from the death of a single individual, will the government allow one set of graduated testamentary trust rates that must be shared by these trusts?
  • Will any proposed changes take into account that a trust may be set up for non-tax purposes, such as safeguarding assets for a disabled or infirm beneficiary?

This uncertainty does make planning difficult. For example, individuals may want to use multiple trusts for tax planning purposes, but will not want family members to inherit a compliance burden if the plan does not provide a tax benefit.

The budget document did not specify how the government intends to accomplish the institution of any changes to the tax treatment of testamentary trusts, and in fact does not say that there will be any changes made for certain. However, given that governments are running deficits, we believe that at least some changes are likely to be made. So, at this point, we can merely speculate as to how such changes will be enacted. Only time will tell what plan the government has up its sleeve.

More information to follow

While it appears that the federal government is attempting to balance taxpayers' use of testamentary trusts within the context of estate and post-mortem tax planning against the possibility of abuse, the recent announcement in the 2013 federal budget has created quite a commotion. With many existing wills presently providing for the creation of one or more testamentary trusts, both taxpayers and practitioners are facing uncertainties as to how to proceed. If you have a will that provides for the creation of one or more testamentary trusts, please contact your BDO advisor to discuss whether changes to your will may need to be contemplated.

We will continue to monitor the situation and will provide updates in the future as more information comes available. Unfortunately, for the time being it seems the only detail we can safely muse over may be modifying Benjamin Franklin's oft-quoted observation to reflect a modern-day twist — perhaps something along the lines of: "nothing is certain except death and more taxes".

The federal government has indicated that it will invite stakeholders to comment on possible measures to eliminate the tax benefits that arise from taxing trusts created by will and estates at graduated rates. BDO intends to be amongst those stakeholders who will consult with the government on this issue. If you wish to contribute any comments with respect to the possible elimination of the tax benefits associated with testamentary trusts, we invite you to email your thoughts or ideas to us at national-tax@bdo.ca. We will review these emails and include your observations in our submission to the federal government.


Donation of Publicly Traded Securities

The Merriam-Webster dictionary defines the verb "to donate" as "to make a gift of; especially: to contribute to a public or charitable cause". As we all know, there is so much more to donating. Not only can donating increase your sense of self-pride and social awareness, it can at the same time, and perhaps most importantly, benefit others who are in need. The decision to donate often requires careful consideration of not only to whom or to what organization you will be donating, but also what you will be donating. This article focuses on the donation of securities and examines the tax consequences that you should keep in mind before doing so.

The basics

As you likely already know, if you have made a donation, you may be able to claim a federal and provincial or territorial non-refundable tax credit when you file your personal income tax return. Specifically, you can claim a tax credit based on the eligible amount of gifts you give to qualified donees, which include:

  • Registered charities;
  • Registered Canadian amateur athletic associations;
  • Registered national arts service organizations;
  • Listed housing corporations in Canada set up only to provide low-cost housing for the aged;
  • Listed municipalities in Canada;
  • Listed municipal or public bodies performing a function of government in Canada;
  • The United Nations and its agencies;
  • Listed universities outside Canada with a student body that ordinarily includes students from Canada that meet specific criteria;
  • The Government of Canada, a province or territory;
  • Foreign charitable organizations that are registered in Canada and that carry out disaster relief, provide humanitarian aid or carry out activities in the national interest of Canada;
  • Foreign charitable organizations that are provided for in a tax treaty; and
  • Certain U.S. organizations where the individual making the donation commutes to the U.S. to work.

The Canada Revenue Agency maintains a searchable list of registered charities as well as lists of certain other qualified donees, all of which can be accessed from their website.

Remember that in order to claim a credit, you must ensure that you receive an official receipt from the organization that you have made the donation to. As well, if you find that it is not advantageous for you to claim a tax credit in respect of the donation in the year that you have actually made the donation, you may be able to carry forward the credit and claim it on your return for any of the next five years.

Gifts of capital property including publicly traded securities

It is important to note that the tax consequences of a donation are largely dependent on the type of donation that is made. In most cases, if you donate capital property, you will be considered to have disposed of that property for proceeds equal to its fair market value. Generally, any capital gain or capital loss realized must be reported on your income tax return in the year in which the property is donated. However, certain types of capital property that are donated to a qualified donee may be eligible for an inclusion rate of zero on any capital gain realized. This means that you may not have to include in your income any capital gain realized on the following types of donated property:

  • A share of the capital stock of a mutual fund corporation;
  • A unit of a mutual fund trust;
  • An interest in a related segregated fund trust;
  • A prescribed debt obligation (such as a government savings bond);
  • Ecologically sensitive land donated to a qualified donee other than a private foundation where certain conditions are met; and
  • A share, debt obligation or right listed on a designated stock exchange.

When donating these types of properties, including publicly traded shares, it is important that the property be donated directly to the charity, as opposed to selling the property and donating the cash received instead. For instance, if you sell shares first and donate the proceeds received, the sale of the shares will be taxable if the shares have appreciated in value. Whereas, if you donate the shares in kind, the accrued gain is not subject to income tax, and the donation credit will generally be equal to the full value of the shares.

It is worth noting that this treatment is extended to any capital gain that is realized on the exchange of shares of the capital stock of a corporation for publicly traded securities which are in turn donated when:

  • At the time of issue and at the time of disposition, the shares of the capital stock of the corporation included a condition allowing the holder to exchange them for the publicly traded securities;
  • The publicly traded securities are the only consideration received on the exchange; and
  • The publicly traded securities are donated within 30 days of the exchange.

(If you exchange property that is a partnership interest for publicly listed securities that are then donated, contact your BDO advisor as special rules apply.)

As well, provided certain conditions are met, you may be able to claim an additional deduction on your personal tax return if you have donated publicly listed shares of corporations or mutual fund units that you acquired through your employer's security option plan.

You should keep in mind that proposed legislation limits the recognition of a gift for tax purposes in certain situations where a donor, or a person or partnership who does not deal at arm's length with the donor, receives an advantage in respect of the property contributed. If the advantage exceeds 80% of the fair market value of the donated property, no donation credit is allowed and an inclusion rate of 50% will apply to any capital gain. However, if the advantage is 80% or less, then in accordance with these proposals, where a taxpayer receives or is entitled to an advantage in respect of a gift or monetary contribution, only a portion of the capital gain is eligible for the zero inclusion rate — the remainder is subject to an inclusion rate of 50%. In cases where a taxpayer does not receive an advantage in respect of the gift or monetary contribution, the full amount of the capital gain is eligible for the inclusion rate of zero.

Gifts of flow-through shares - special considerations

What is a flow-through share? In very general terms, it is a share, or the right to buy a share, of a corporation issued to a person who provides funds to a corporation for exploration or development work or for the acquisition of a resource property. This is done under arrangements whereby the tax deductions generated from the work or acquisition are flowed through to the shareholder and deducted in computing the shareholder's income. In the past, taxpayers were able to donate publicly listed flow-through shares to registered charities and receive an exemption from tax on the capital gain that would arise on a disposition of such shares. However, with most flow-through shares, the capital gain is larger than with "regular" shares because the cost of flow-through shares to the shareholder is deemed to be nil (even though an amount is paid for the shares). This creates a capital gain on disposition that is larger than the gain that would have arisen solely due to the appreciation of the underlying assets of the corporation.

Apparently, the government felt that taxpayers who donated publicly listed flow-through shares had an unfair advantage, as they could benefit from both the flow-through share tax incentives and a zero inclusion rate on the capital gain that arose based on the nil cost base. In an effort to eliminate this advantage, relatively new rules for shares issued pursuant to flow-through share agreements entered into on or after March 22, 2011 provide that donations of flow-through shares will be exempt from tax only on the portion of the capital gain that represents the true appreciation. If you are considering donating flow-through shares, contact your BDO advisor for more information on these rules.

There is certainly a lot to think about if you are considering making a donation of securities. It is important to involve your BDO advisor in the decision making process. That way, you can rest assured that the gift giving experience is rewarding for both you and the recipient.

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