Tax Factor 2015-07

July 20, 2015

The 2015-07 issue of the Tax Factor is available for download. In this issue, we cover:

The upcoming changes to the taxation of estates and trusts: Are you ready?
Important developments in tax support for charitable giving

The upcoming changes to the taxation of estates and trusts: are you ready?

As you are likely already aware, new legislation was enacted (on December 16, 2014, as part of Bill C-43) that will bring fundamental changes to the way that estates and certain personal trusts will be taxed in Canada, beginning on January 1, 2016. Since trusts are frequently employed in tax and estate planning, these new rules are likely to have a significant impact on the taxation of trusts and estates going forward.

To assist you in determining whether these changes will impact any trusts that you or your family have set up or that you may have provided for in your will, this article poses several questions that aim to pinpoint certain features of tax and estate planning which may expose you to the application of the new rules. In all cases, if you think we have described your situation or one that is similar, it will be essential that you speak to your BDO advisor as soon as possible.

Does your will provide for multiple testamentary trusts to be created?

A testamentary trust is a type of personal trust that is established upon the death of an individual. Under the current rules, a testamentary trust has access to graduated income tax rates that are normally only applicable to individuals. As a consequence, multiple testamentary trusts are frequently provided for in an individual's will so that each beneficiary of that individual's estate can benefit from an additional set of graduated rates, and thus potentially lower their overall tax burden.

The new rules will see the tax advantages from multiple testamentary trusts evaporate as testamentary trusts will no longer be allowed to benefit from graduated rates. Instead, access to graduated rates will be limited to the first 36 months of an estate following the death of an individual. These estates are referred to as Graduated Rate Estates (GREs). Accordingly, after January 1, 2016, all existing and new testamentary trusts (other than GREs) will be subject to tax at a flat income tax rate of 29% (the highest rate of federal tax for individuals) plus provincial tax at the top rate, like ordinary inter vivos trusts, including family trusts.

There may be other non-tax related reasons why you want to provide for multiple testamentary trusts in your will. These reasons may include, for example, protecting and managing the assets of the trust that are for the benefit of a disabled beneficiary or a beneficiary who is a minor child. However, if no compelling reason exists for you to provide for multiple testamentary trusts in your will, creating additional trusts will only serve to increase the administrative burden on your beneficiaries and your estate after your death.

Do you have a disabled child or family member that you wish to provide for in your will?

As mentioned, an individual with a disabled child or family member may often include provisions in their will to establish a trust for the benefit of that person. The federal government recognized that the trust changes would have a negative impact on disabled individuals and consequently introduced legislation that will allow certain testamentary trusts that have disabled beneficiaries to continue to have access to graduated rates. In particular, a new category of testamentary trusts was created, called qualified disability trusts (QDTs).

While a detailed discussion of the rules governing QDTs can be found in the 2015-04 Tax Factor article titled “Upcoming changes to the taxation of trusts benefiting disabled individuals”, it nonetheless bears repeating that establishing a QDT for the benefit of a disabled beneficiary does not happen automatically. The executor(s) of your estate must be aware that you intend to utilize these provisions, since one of the requirements to qualify as a QDT is for the beneficiary and the trust to jointly elect that the trust be a QDT. Furthermore, you should also be aware that certain rules which come into effect upon the death of the last remaining disabled beneficiary of the QDT may potentially have punitive consequences. In order to minimize the tax burden at the time the trust ceases to be a QDT, advanced tax planning will be required.

Are you planning to leave a bequest to a registered charity after your death?

As discussed in the accompanying article, “Important developments in tax support for charitable giving”, new rules governing these types of gifts were introduced in the 2014 federal budget as part of a plan to provide more flexibility in claiming donations for deaths that occur after 2015. While these changes are in respect of the rules governing charitable bequests, the new trust and estate taxation rules act in conjunction with the charitable bequest rules to add further complexity to the taxation of such gifts.

The new trust and estate taxation rules impact one's ability to maximize the tax benefit from making a charitable bequest in a variety of ways. For example, while the changes to the rules governing charitable bequests should generally make estate planning around large donations much easier, qualifying for this more flexible tax treatment will require that the transfer be made by the estate to a qualified donee within the first 36 months following an individual's death.

A further example of how these new rules can complicate estate planning can be seen in cases where there is an intention to make a gift of a residual interest. A gift of a residual interest essentially allows an individual to benefit from making a large charitable donation after first retaining the funds in a trust for the benefit of a family member and delaying the gift until after the death of that family member. For many reasons, these types of bequests may no longer provide a tax advantage for deaths that occur after 2015.

Will you or your spouse or common-law partner become, or are you already, a beneficiary of a “life-interest” trust?

A life-interest trust is a particular kind of personal trust that provides a specified beneficiary with a right to receive income from the trust during their lifetime. This type of trust includes spousal (or common-law partner) trusts, joint-spousal (or joint common-law partner) trusts and alter-ego trusts.

The new trust taxation rules bring significant changes to what happens upon the death of the life-interest beneficiary. Under the current rules, when the life-interest beneficiary dies, there is a deemed disposition of all of the capital property held in the trust, following which the trustees will generally use the assets of the trust to pay the resulting tax liability before distributing the remaining assets of the trust to the trust's capital (or “residual”) beneficiaries. Conversely, effective on January 1, 2016, when a life-interest beneficiary dies there will be a deemed year-end of the trust for tax purposes at the time of death and all of the income of the trust, including any capital gains arising from the deemed disposition of the trust's assets, will be included on the terminal tax return of the deceased life-interest beneficiary.

On its surface, it would appear as if this new rule would yield a beneficial tax result since it allows the income arising from the final year of the trust to be taxed at the beneficiary's applicable marginal rate. However, there are certain situations where this change could create negative income tax implications for some taxpayers. Specifically, there may be a problem where the income beneficiary of the life-interest trust is not also the residual beneficiary.

If you answered “yes” to any of the questions noted above, your tax or estate plan may need to be revisited in order to make sure that your estate and your beneficiaries are not subject to unintended income tax results as a consequence of the new rules. At a minimum, your existing will and estate plan should be reviewed in the context of these upcoming changes. Speaking to your BDO advisor is the first step in ensuring that your intended goals are met. Rest assured that your BDO advisor will assist you in determining what, if any, advanced tax planning is needed or whether it may be necessary to make changes to update your will.

If you are interested in learning more about the new trust and estate taxation rules and how they may impact you, please click here to register to view a recent webinar that was presented by BDO on this topic.

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Important developments in tax support for charitable giving

The government has announced several tax support measures for charitable giving in the past few years. In this article, we'll review changes affecting individual donors, focusing on the more important developments that need to be kept in mind.

The charitable donation credit

If you make any charitable, Crown, cultural or ecological donations in a taxation year, then you may be entitled to claim a non-refundable tax credit related to those donations. The maximum annual claim for charitable donations is 75% of your net income for the year. However, any donations that you have made in excess of that amount may be carried forward for five years. In 2014, the government extended this carryforward period to 10 years for gifts of ecologically sensitive land made after February 10, 2014.

Note also that if you make a donation of property, the donation limit can be as much as 100% of the resulting taxable capital gain (or recapture, in the case of depreciable property) to the extent that the capital gain has been included in your income.

In 2013, the government announced the new first-time donor's super credit, which enhances the existing federal donation tax credit. An individual will be considered a first-time donor if the individual and the individual's spouse or common-law partner (if they have one), have not previously claimed a donation tax credit in any year after 2007. A taxpayer claiming this super credit is entitled to an additional 25% credit for up to $1,000 of eligible donations of money made after March 20, 2013. Keep in mind that an individual, or their spouse or common-law partner, may only claim this super credit once in the taxation years 2013 to 2017.

Gifts of capital property — capital gains exemption

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. To encourage gifting, a special tax rule provides for an inclusion rate of zero for capital gains arising from gifts of capital property that are qualifying securities. These securities generally include publicly traded shares and units of mutual fund trusts.

Under this rule, the capital gain realized on the disposition of such property will not be subject to tax, while the fair market value of the property donated can generally be claimed as a donation credit. 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 certain conditions are met. As well, this rule applies to gifts of ecologically sensitive land. Note that if there is an advantage associated with the gift (i.e. partial consideration is received in some manner), then only a portion of the capital gain may be eligible for the inclusion rate of zero.

The 2015 federal budget proposed to extend this tax treatment to apply to gains realized on dispositions of private corporation shares and real estate made after 2016 where:

  • Cash proceeds are donated to a qualified donee within 30 days after the disposition, and
  • The private corporation shares or real estate are sold to a purchaser that is dealing at arm's length with both the donor/vendor and the qualified donee to which cash proceeds are donated.

Certain other conditions must be met within a five year period after the gift is made, otherwise the exemption will be reversed. These conditions include:

  • The donor (or a person not dealing at arm's length with the donor) cannot directly or indirectly reacquire any property that had been sold,
  • The donor (or a person not dealing at arm's length with the donor) cannot acquire shares substituted for shares that had been sold, or
  • The shares of a corporation that had been sold cannot be redeemed where the donor does not deal at arm's length with the corporation at the time of the redemption.

Charitable bequests and estate donations

For many individuals, the largest charitable donation they will make is a gift under the terms of their will — often referred to as a charitable bequest. In the 2014 federal budget, the government announced changes for charitable bequests that will significantly impact donation planning on death. The changes impact existing wills, as well as donation planning going forward. For the remainder of this article, we will review the changes and key considerations to keep in mind if your goal is to leave a portion or all of your estate to charity.

Current rules

Gifts that qualify as a charitable bequest are currently deemed to be made by the deceased individual immediately before death. Such a gift can be claimed as a donation credit on the deceased individual's final tax return or their return for the year immediately preceding the year of death. Note that a gift must meet the conditions of a charitable bequest as set out by the Canada Revenue Agency to be claimed as a donation credit. As well, where an individual names a charity as an RRSP, RRIF, TFSA or insurance policy beneficiary (referred to as “direct designation gifts”), the value of the plan will also be treated as a charitable bequest. Donation credits claimed in an individual's final two taxation years are limited to the lesser of total charitable gifts made for the year, including charitable bequests, and 100% of the individual's net income. The 75% net income restriction does not apply.

In the case of a bequest made in a will, the actual funds need not be remitted to the charity immediately. For example, where a charity is named as a residual beneficiary of an estate that will carry on for several years, the value of that residual interest just after death (i.e. the discounted value of estate assets minus debts) can qualify as a bequest depending on the circumstances.

A gift that does not qualify as a charitable bequest may instead be available to be claimed as a donation credit by the estate under the general donation rules. This means the credit could be claimed by the estate in the year the gift is made or in the applicable carryforward period, and would be subject to the 75% of taxpayer net income rule.

New rules for deaths after 2015

Effective for deaths occurring after December 31, 2015, new rules will apply to gifts made by an individual through his/her will and as a direct designation gift, as well as to gifts made by an individual's estate. Where a gift is made under any of these three circumstances, it will be deemed to have been made by the estate (and not by any other taxpayer) at the time the gift is transferred to the qualified donee.

The following are some key points about the changes:

  • Value of gift — The value of the gift will be determined at the time the gift is made, rather than at the time that is immediately before the individual's death. Where property other than cash is gifted, and the value of the property increases from the time of death to the time the gift is made, the estate will realize a gain on the increase in value. As well, the full value of the property will qualify as a donation. If the value decreases, the gift amount will be that lower value and the estate will also realize a loss. For gifts made in the first year of the estate, any loss arising from the gift can be carried back to the individual's final return to be used against capital gains. Alternatively, where conditions are met, the net amount of the loss can be applied against other income on the final return.
  • Flexible timing rules — For gifts deemed to have been made by the estate, the general rules with respect to claiming donation credits apply. A donation credit claim can be made by the estate in the year the gift is transferred to the donee, or carried forward within the applicable carryforward period. For deaths occurring after 2015, there is added flexibility in terms of when the donation credit can be claimed if the gift is made by an estate that is a graduated rate estate (GRE). In such cases, a donation credit claim can be allocated between the following tax returns in order to maximize the benefit of the gift:
    • The return of the estate in the taxation year the property is transferred to the donee,
    • Any preceding taxation year return of the estate,
    • The individual's final personal tax return, and
    • The individual's personal tax return for the year immediately preceding the year of death

Note that a GRE is a testamentary trust that meets certain conditions and which is eligible to apply graduated tax rates to income that is taxed in that trust. The requirement that the estate be a GRE generally means that the donation must be made within 36 months of the individual's death. However, the time period may be shorter if the estate is fully administered with distributions to beneficiaries (including an ongoing trust created under the will) before the end of the 36 month period. An ongoing testamentary trust created under a will that is not the original estate will not be considered a GRE.

  • Gifts of qualifying capital property — The special tax rule that provides for an inclusion rate of zero for capital gains arising from gifts of capital property that are qualifying securities will apply to deemed dispositions of property on death where the property is donated by an estate that is a GRE. Note that at the time of writing this article, draft legislation had not yet been released dealing with the extension of the special tax treatment to dispositions of private corporation shares and real estate. Therefore, it could not be confirmed that this measure will also apply to gifts on death that are made by a GRE.

In order to illustrate how the new rules will work, let's consider the following scenario:

Mrs. Smith is a widow with two adult children. She has a sizable estate including shares of her own small business worth $1.8 million, with an accrued capital gain of about $1 million. Assume that Mrs. Smith has already claimed her capital gains exemption on qualifying small business corporation shares, therefore the deemed disposition of her shares on death will result in a taxable capital gain. Mrs. Smith's two children also hold shares and will continue to run the business after their mother passes on. She wants to leave 60% of her estate to the local hospital for cancer research, in memory of her husband. The remaining 40% will be split equally between her children.

Under current rules, the gift will qualify as a charitable bequest as she has set a specific percentage of her estate to go to a qualified donee on her death. Such a gift will be deemed to be made by Mrs. Smith immediately before her death. The gift can be claimed on Mrs. Smith's final return or her return for the taxation year preceding her death. However, if post-mortem planning is implemented to eliminate or reduce the capital gain on death, it is possible that there may not be a significant amount of income on Mrs. Smith's final two tax returns. If that is the case, the donation credit may be of limited use. Remember that the donation credit can only be used to reduce taxes payable. If there is little income in her final two taxation years, then any taxes payable in those years will be insufficient for purposes of utilizing the donation credit.

For post-2015 deaths, the donation is deemed to be made by the estate at the time the donated property is transferred to a qualified donee. If the transfer is made while the estate is a GRE (i.e. generally during the first 36 months after Mrs. Smith's death), it will be possible to allocate the available donation credit between several taxation years that include the taxation year of the estate in which the gift is made, an earlier taxation year of the estate or the last two taxation years for Mrs. Smith. This provides more flexibility, allowing donation credit claims in additional taxation years in which there may be taxes payable. This will also make integrating the gift with post-mortem planning easier. It is important to note, however, that there are additional issues that we haven't discussed that could impede a donation credit claim. So, it is very important to seek specific advice from your BDO advisor.

Key considerations for donations on death

With changes coming next year for donations on death, it is very important to revisit your gift planning goals, as well as your current will where you have already planned to make a charitable bequest. There have been no exceptions made for wills currently in force therefore, the new rules simply apply for all deaths after 2015. If your will was designed specifically to take the pre-2016 donation rules into account, there is a chance your will may not function properly under the new rules. The following are key considerations to keep in mind when dealing with the new rules:

  • Ensure the estate maintains its GRE status — The changes to the donation on death rules require the estate making the gift to be a GRE. This includes having access to the flexible timing rules for claiming a donation credit, as well as the special tax rule for gifts of qualifying securities. Unfortunately, it may not always be possible to make the gift within the 36 month time period required for an estate to be a GRE. For example, this may be the case for complex estates or those under litigation. You should take steps now to help ensure that gifts can be completed within 36 months.
  • Revisit residual interest gift planning — Although we didn't review a specific example, it has become clear that the new donation rules will not work well generally where a charity is a residual beneficiary of an estate (assuming the estate lasts for more than 36 months). If it was your intention to utilize the donation tax credit from the gift of a residual interest, you will need to revisit your plan and likely make changes to ensure the donation tax credit is not lost.
  • Matching the donation credit to a tax year with taxable income (and taxes payable) will be crucial — As a donation tax credit can only be utilized in a tax year where there are taxes payable, planning must be done prior to death to ensure the credit claim will be available in the appropriate year. Consideration must be given, for example, where a spousal rollover, a capital gains exemption or a nil inclusion rate on capital gains applies in a tax year. The result may be little to no taxable income, while a donation on death results in a sizable donation credit. Your BDO advisor can assist with the planning to ensure the donation credit is not lost.
  • Consider gift timing — The changes to the donation on death rules are significantly impacted by the recent changes to the testamentary trust rules. A discussion of the trust rule changes is beyond the scope of this article. However, due to the interaction of these rules, the issues to deal with when planning are complex. If your goal is to ensure your family is supported, while also making a gift to charity, an alternative to consider is revisiting your financial situation to determine if making a gift during your lifetime is possible, rather than after your death.

If you are planning to make a gift and have questions about your ability to utilize a donation tax credit, contact your BDO advisor. Further, if you are planning to make a gift on death, your BDO advisor will help you plan in the context of the new donation on death rules, ensuring that you maximize the value of your donation tax credit and minimize taxes.

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The information in this publication is current as of July 1, 2015.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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