Unlike some other countries in the world, Canada does not impose taxes on wealth or the value of an inheritance upon death; but in its place Canada taxes the deceased’s income for its final year. Canada, unlike the United States, does not charge an estate tax on the value of the capital of an estate. Although there are only taxes on income in Canada, certain specific rules make the tax more burdensome in the year of death. This burden is lessened to some extent by several special concessionary rules applicable only to taxation of income at death.
Two tax sources
In the event of the death of a person, income supposedly earned between the end of the last taxation year and the individual’s death is included in that person’s T1 tax return due in respect of the year of death. This supposedly “terminal” return is, in fact, the income earned between January 1st and the date of death. Now, the day after the taxpayer’s death marks the beginning of the first fiscal period of a new taxpayer; the estate of the deceased! This new entity is taxed in accordance with the principles applicable to the taxation of trusts, to comply with which it has to file a special tax return called the T3 Trust Return. This gives rise to three things to which the personal representative (executor or trustee) of the taxpayer (deceased) must pay close attention:
- It has to be decided whether or not a payment due in consequence of the taxpayer’s death is or is not taxable;
- It has to be determined whether the income is reported in the terminal return or if it is taxed elsewhere; and
- For good measure, it has to be ensured that returns for previous years, which should have been filed, are indeed filed and complied with. Thus a Clearance Certificate must be obtained from the Canada Revenue Agency (“CRA”).
Personal Representative (Trustee or Executor)
As per the Income Tax Act, (section) s. 150(3), the personal representative is not only responsible for addressing the tax consequences of and at a taxpayer’s death, but is also liable for failing to discharge it. Provincial common (case law) and statute law says that a creditor, including a creditor such as the Canada Revenue Agency, can pursue its claim against the beneficiary who has received funds from the estate. It is based on the principle that the right of a creditor to be paid in full takes priority over the right of a beneficiary to receive a gift; a principle supported by the Income Tax Act. Provincial law also states that if a personal representative has distributed assets to beneficiaries in full knowledge of a creditor’s claim, then she or he can be held personally liable for that creditor’s claim. The Trustee Act, (section) s. 53 recommends that the personal representative (trustee or executor of the estate) take out advertising for creditors as the way out (such as advertising in the obituaries), and has a further scheme for establishing priorities among creditors. The Income Tax Act, (section) s. 159(2) furthermore insists that a personal representative has to get a clearance certificate before distributing any asset controlled by her/him from the Canada Revenue Agency. This certificate confirms that all prior and current taxes, interest and penalties have been paid up to and in respect of the taxation year in which the estate distribution is made. Though the failure to obtain this clearance certificate is not a punishable offence like tax dodging, it is not to be taken lightly. According to (section) s. 159 of the Income Tax Act, distribution of estate assets without clearance makes the personal representative “personally liable for the payment of those amounts to the extent of the value of the property distributed”. That means, should the estate be liable for income taxes or other creditor obligations, but the executor or trustee distributed the capital and income of the estate to the beneficiaries, the CRA or creditors can seek recourse from the executor or trustee up-to the amounts distributed to the beneficiaries, should they not be able to recover directly from the beneficiaries.
Even after a clearance certificate has been obtained, there could be a reassessment and thus a fresh demand for taxes from the beneficiaries of the estate. It is not mandatory to get a clearance certificate to distribute the assets of an estate. For instance, a personal representative who happens to also be the sole beneficiary has no need to seek a discharge from personal liability in his or her capacity as a personal representative, when he or she would remain personally liable in any event in his or her capacity as a beneficiary. A clearance certificate sort of assures that there would be no reassessment, and people usually do not want the Canada Revenue Agency to take a second look.
There are certain circumstances when the tax authorities do not think that the death of an individual has caused a deemed realization of non-depreciable capital property or depreciable capital property now making up part of the deceased’s estate. Then, preparation of a T3 Trust tax return and filing thereof appear compulsory upon the death of the taxpayer. However, the Canada Revenue Agency’s administrative policy is that the trust need not file a return when the total taxable income of the estate does not exceed $500 and no beneficiary gets more than $100. This is somewhat reflected in the following statement in the T3 guide, “A trust return may not be required if the estate is distributed immediately after the person dies… In this case, the trustee should give each beneficiary a statement showing his or her share of the estate.” Having regard to this statement, it can be inferred that the reason behind a T3 is to ensure that income does not escape from the tax system simply because it is earned at the estate level. That being said, the beneficiaries may have to claim the income distributions in their own income tax returns. In regards to capital distributions, it is possible to pass through the assets at their original adjusted costs base to the beneficiaries so that they can defer the capital gains until they actually sell the assets for cash. This is obviously preferred over a deemed disposition at market value at the time when the assets are distributed and the estate or beneficiaries do not have any real cash on hand because the assets were not actually sold.
In regards to the time to file tax returns, it is April 30th for deaths in January to October for the year prior. For deaths in November or December, it is six months from the date concerned. [Income Tax Act, s. 150(1)]
Estate and Trust Tax planning should not be taken lightly. The Income Tax Actis a dynamic set of rules evolving from the ongoing battle of wits between tax planners and bureaucrats framing the rules. When the former try to split incomes and dispose capital at less than fair market values. The latter, in turn, make attempts to stop such practices. Do not hesitate to contact the lawyers at Levy Zavet PC for expert tax planning and legal advice, not just for your personal affairs but for that of your estate and its beneficiaries.