Classification of Trusts
1. Testamentary Trusts
The Income Tax Act defines a testamentary trust as a trust or estate that is formed consequent to the death of a tax-paying individual (ITA, s. 108(1)). It can also be created under the terms of a will or by an order of a court made pursuant to dependants’ relief legislation. As compared to this, an inter vivos trust is defined in the ITA as a trust other than a testamentary trust.
2. Inter Vivos Trusts
From June 17, 1971, inter vivos trusts are taxed at the highest marginal rate, while testamentary trusts are subject to the graduated rates applicable to individuals. Ideally, it is possible for a taxpayer to establish a testamentary trust, to which property can be contributed after his or her death by someone other than the taxpayer. The testamentary trust so created could then take advantage of the graduated rates of tax. With a view to prevent such abuse, the definition of a testamentary trust was amended. Consequently, for taxation years commencing after November 12, 1981, the following trusts are excluded from qualifying as testamentary trusts, thereby being converted into inter vivos trusts taxable at the highest tax rate:
1) A trust created by a person other than the deceased;
2) A trust created after November 12, 1981 if property has been contributed to the trust, otherwise than by an individual on or after his death and as a consequence thereof; and
3) A trust created before November 13, 1981 if, after June 28, 1982 property has been contributed to the trust otherwise than by an individual on or after his death and as a consequence thereof; or the fair market value of property contributed to the trust by someone other than the deceased exceeds the fair market value of property contributed by the deceased on his death.
3. Qualifying Spousal Trusts
4. Testamentary Spousal Trusts
According to ss. 70(5), (5.1) and (5.2) of the ITA, taxes are due on the death of a taxpayer owning capital property, depreciable property, eligible capital property, resource properties, and land included in the inventory of a business. All these properties are subject to a deemed disposition immediately before death at fair market value. If capital property or depreciable property are willed to the deceased’s spouse, or to a qualifying spousal trust, a deferral of tax is available under s. 70(6) of the ITA, unless the legal representative voluntarily elects, under s. 70(6.2), not to have the rollover. There are situations when a personal representative would prefer to forego the rollover, such as, the deceased had not fully utilized his or her lifetime capital gains exemption and it is available to offset some or all of the forthcoming capital gain, or where the deceased had losses from previous years which could absorb any income arising upon a deemed disposition of his or her property at fair market value. As the legal representative of the deceased preferred not to have the rollover, the beneficiaries would be regarded to have acquired the deceased’s property at its fair market value at the time of the deceased’s death. Due to this, on a subsequent sale by the beneficiaries, they would pay less tax than that required if they were deemed to have acquired the property at the deceased’s original tax cost.
It is essential to know that, excepting rare occasions, each time the ITA deems a disposition to have occurred at a certain value (whether adjusted cost base, undepreciated capital cost, or fair market value) it simultaneously deems the recipient to have acquired the relevant property at the same amount.
According to s. 70(6) of the ITA, the requirements of a testamentary spousal trust are:
1) The deceased should have been resident in Canada immediately before death;
2) The trust has to be resident in Canada immediately after the time the property vested indefeasibly in the trust;
3) The spousal trust is to be created by the taxpayer’s will or by an order of a court made pursuant to dependants’ relief legislation;
4) The property should have been transferred or distributed on or after death and as a consequence thereof or as a consequence of a disclaimer, release, or surrender by a person who was a beneficiary under the deceased’s will or intestacy (Subsection 248(8) further explains the meaning of property transferred “as a consequence” of the death of a taxpayer to include a transfer under a will and a transfer as a result of a disclaimer, release or surrender of a beneficiary under a taxpayer’s will.);
5) The surviving spouse should be entitled to receive all of the income of the trust that arises during his or her lifetime. A consequential problem is that while the capital gains of a trust are regarded as “income” for tax purposes, under trust law they are usually treated as “capital”, thereby accruing to the capital and not the income beneficiaries. So, the accrual by the trust of capital gains to someone other than the spouse would prima facie be detrimental to the spousal trust qualifying for the rollover. To avoid this trap for the unwary, s. 108(3) provides that, for such requirement, the income of a trust is to be computed under trust law and without reference to the ITA. In other words, so long as the spouse is entitled to receive all amounts that would otherwise be regarded as income for trust accounting purposes, the trust will qualify as a spousal trust. Considering that the surviving spouse is entitled to receive all the income of the trust for life, a clause in the will terminating the spouse’s entitlement to the income in the event of remarriage will invalidate the trust as a qualifying spousal trust. In addition, the trustees should be prevented from accumulating income or distributing it among other beneficiaries;
6) None but the spouse would, during the surviving spouse’s lifetime, receive, or otherwise obtain, the use of any of the income or capital of the trust. This condition would not be fulfilled when the terms of the spousal trust provide that if the surviving spouse remarries, then the trust property flows to a third party. Such a remarriage clause would prevent the trust from being a qualifying spousal trust; and
7) The property is to vest indefeasibly in the spousal trust within 36 months of the death of the testator.