Changes to Taxation of Alter Ego and Joint Partner Trusts

There are a number of significant changes to Canadian tax law that will have a significant impact on estate planning. I have written about the elimination of graduation income rates for testamentary trusts, including a post here. That change, though most unwelcome, at least doesn’t come as a surprise, in view of the previous consultation by the Minister of Finance and that it was announced in the 2014 Budget. One change that does come as a surprise is that the Government is making a significant change to how alter ego and joint partner trusts are taxed, a change that could cause some significant unforeseen consequences to estate plans.

I wrote some time ago about the use of alter ego and joint partner trusts. An alter ego trust is a trust settled by a Canadian resident who is at least 65 years old. Under the terms of the alter ego trust, all of the income must be payable to the settlor during his or her lifetime, and only the settlor may have access to capital during his or her life. Then on the settlor’s death, the trust property may be distributed to other beneficiaries as set out in the trust documents. The advantages include that the settlor may transfer appreciated assets into the trust without triggering capital gains or other income tax, and such tax may be deferred until the death of the settlor. Alter ego trusts may avoid or minimize probate fees (because the trust is not probated), maximize privacy, and may in some circumstances be used to protect assets against claims in British Columbia under wills variation legislation.

Joint partner trusts are similar, except that the income must be paid to either or both the settlor and his or her spouse or common-law partner (as those terms are defined under the Income Tax Act (Canada), but for simplicity, I will refer to both as “spouses”), during their joint lives, and capital may be distributed to either or both spouses, until the death of the surviving spouse, at which time the trust property may be distributed as set out in the trust documents.

Under the current tax rules, the alter ego trust is deemed to have disposed of all of its assets immediately after the date of death of the settlor. The effect of this is that any capital gains or other taxes are taxed in the alter ego trust, at the top income tax rate. Although paid out of the trust, the incidence of the tax ultimately falls on the beneficiaries of the trust by reducing the trust property. In some cases, using an alter ego trusts results in a higher overall tax than if the assets had just remained as part of the settlor’s estate, because of the high tax rate in the trust, as opposed to the graduated rates available in the settlor’s year of death in respect of taxes triggered by the deemed disposition of those of the settlor’s assets that are not in a trust. Furthermore, capital losses in the trust cannot be used to offset gains of property that are not in the trust, and vice versa.

Similarly, for a joint partner trust, the deemed disposition occurs immediately after the death of the last to die of the spouses, and as with the alter ego trust, the tax is paid out of the trust property at the top tax rate, and not the marginal rate available to either of the spouses.

Under the changes that are coming into effect in 2016, the taxes arising from the deemed disposition of trust property at the death of the settlor in an alter ego trust will be treated as the settlor’s income in the settlor’s year of death and payable out of the settlor’s estate. If there are insufficient funds in the estate, then the Canada Revenue Agency may collect the tax out of the trust property.

In a joint partner trust, the taxes arising from the deemed disposition of the trust property on the death of the last of the spouses to die will be treated as the income of the last of the spouses to die and will be payable out of his or her estate, unless there are insufficient funds, in which case Canada Revenue Agency may collect the tax out of the trust property.

In some cases, this may reduce the overall tax burden of the estate and the trust. This is because the graduated tax rates should apply to income from the deemed disposition death including the disposition of assets in the trust which would under current rules be taxed at the top rate. Furthermore, tax losses and credits available in the deceased terminal return should be available to reduce gains and taxes that would otherwise be payable in the trust. Similarly, losses in the trust may be available to offset gains on property owned by the deceased.

There may be some advantages under the new rules. But no, the Government was not doing us a favour. There is a significant downside to the changes.

Under the current rules, the taxes in respect of the deemed disposition of trust property is ultimately borne by the beneficiaries of the trust, while under the new rules, it will be borne by the beneficiaries of the estate of the settlor of an alter ego trust, or the estate of the last of the spouses to die, in the case of a joint partner trust.

Consider this example of how it might work. Jim and Janet are married, and each comes into the marriage with his or her own assets, and each has two children. Janet owns a cottage and a large portfolio of investments, and she transfers both into a joint partner trust “the Janet Joint Partner Trust.” Under the terms of the trust, income is payable to either or both of Janet and Jim while they are both alive, and then if Jim outlives Janet, he will continue to receive income, and have use of the cottage during his lifetime. Janet has set up the trust so that on his death, the trust property goes to her own children. Jim has a similar estate plan. His will provides income from his, more modest property, to Janet if she outlives him, but on her death, his property goes to his own children. Janet dies first. Under the current rules, on Jim’s death any capital gains on the Janet Joint Partner Trust property are paid out of the trust, reducing the property that will go to Janet’s children. Any capital gains tax on Jim’s own property is payable out of his estate, reducing the amount that his children will receive. But if Jim dies in 2016 or later, then the taxes in respect of both the Janet Joint Partner Trust property and Jim’s own property will be payable out of Jim’s estate, which means that the incidence of the tax will fall entirely on Jim’s children. Janet’s children would only bear part of the tax if Jim’s estate was insufficient to pay the full amount of tax, in which case, Jim’s children will have been completely disinherited as a result to the changes in tax law.

Going forward, at least estate planners will be cognizant of the changes, and can consider the impact of tax when creating trusts. But the new rules will also apply to trusts that are already in existence, and were planned on the basis of the rules that imposed tax on the trust. In some cases, these cannot be changed to adapt to the new rules, in which cases the result will be that the Government of Canada will have distorted estate plans, including carefully thought out plans intended to balance the interests of spouses and children in blended families.