GRADUATED RATE ESTATES AND GIFTING ON DEATH

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1 Richard Eisenbraun Borden Ladner Gervais LLP Calgary Colin Poon Borden Ladner Gervais LLP Calgary Ruth Spetz Borden Ladner Gervais LLP Calgary 2015 Prairie Provinces Tax Conference

2 INTRODUCTION There have been a lot of recent changes to the tax legislation relating to gifts made upon a taxpayer s death. 1 Importantly, the concept of a graduated rate estate was introduced. Also, the government has enacted changes that, in some cases, enhance the flexibility to make donations at the time of death. However, the legislation has some gaps and has left a few traps for the unwary. This paper summarizes the key issues that we have identified and seeks to provide a roadmap for those interpreting and applying the rules in practice. GRADUATED RATE ESTATES In order to make sense of the new rules, it is critical to understand the concept of a graduated rate estate ( GRE ). Prior to the implementation of this concept, several testamentary trusts could generally be established out of one estate, and in each case they could take advantage of the graduated tax rates applicable to individuals. 2 However, under the new rules, only GRE s and Qualified Disability Trusts ( QDTs ) may access graduated rates. All other trusts arising upon the death of the individual are taxed at the highest marginal tax rate applicable to individuals. This change will have an obvious impact upon prior strategies used to multiply access to the graduated rates, such as Wills that established a separate trust for each of the deceased s children. However, the GRE rules are also a fundamental concept under the new legislation, and many tax consequences now flow from whether or not a particular testamentary trust is a GRE. Under the new rules, a GRE of an individual will be defined in subsection 248(1) as the estate that arose on and as a consequence of the individual s death if the following conditions are met: The estate must at that time be a testamentary trust. This means that all of its contributions must be as a consequence of the individual s death. A loan to the trust by a non-arm s length party and other seemingly innocuous transactions could cause the estate to lose its status as a GRE. 3 The individual s social insurance number must be provided in the estate s Part I tax return for the year and each previous year that ended after Unless otherwise indicated, legislative references are to the Income Tax Act (Canada) (the Act ). Much of the legislation was proposed in Bill C-43, which received Royal Assent on December 16, 2014, and will come into effect at the beginning of Rules coming into effect at the beginning of 2016 are referred to herein as the new rules. Rules under the existing legislation that will be repealed with effect at the beginning of 2016 are referred to herein as the old rules. 2 This planning could be restricted by subsection 104(2), which allows the Minister of National Revenue (the Minister ) to designate multiple trusts to be a single trust if certain conditions are met. 3 The definition of testamentary trust is in subsection 108(1), which, as per subsection 248(1), applies for the purposes of the Act. Also see the broad interpretation of the meaning of contribution in Canada Revenue Agency ( CRA ) Document No , Medical expenses reimbursement within testamentary trust (19 November 1996). CAL01: : v4 1

3 The estate designates itself as the GRE of the individual in its Part I tax return for its first taxation year that ends after No other estate designates itself as the GRE of the individual. A GRE only retains its status as such for the first 36-months after the individual s death. After that 36-month period, it will no longer qualify as a GRE. 4 As discussed in greater detail later in this paper, GRE status is essential for some of the increased flexibility now provided under the Act for charitable gifting upon death. Also, various benefits previously available to all estates will now be restricted to GRE s only. Some examples of rules now applicable to GREs but not to other testamentary trusts are as follows: Low Marginal Tax Rates GRE s can access the lower marginal tax rates applicable to individuals set forth in subsection 117(2). This can have significant tax savings. Other testamentary trusts will be taxable at the federal rate of 29% 5 plus any applicable provincial taxation. Alternative Minimum Tax (AMT) Previously, all testamentary trusts were entitled to a basic exemption of $40,000 from AMT. Beginning in 2016, only GRE s will be entitled to this exemption. 6 Part XII.2 Tax Previously, all testamentary trusts were exempt from Part XII.2 Tax. However, beginning in 2016, only GREs will be entitled to this exemption. As a result, non-gre testamentary trusts will generally be subject to Part XII.2 Tax on distributions in respect of certain Canadian sourced income to non-residents and, in certain circumstances, to tax-exempt entities. 7 Instalment Payments Previously, testamentary trusts were not required to pay instalments and were instead required to pay any Part I tax payable within 90-days after the end of their taxation year. Under the new rules, only GREs are able to take advantage of this rule. 8 Flow-Out of Benefits The ability of a testamentary trust to flow certain pension benefits, deferred profit sharing plan payments, death benefits and investment tax credits out to beneficiaries is now restricted to GREs. 9 4 See paragraph (a) of the definition of GRE in subsection 248(1). 5 Subsection 122(1). 6 Section Part XII.2 Tax generally applies to dispositions of taxable Canadian property and to income from real or immovable properties in Canada, timber resource properties, Canadian resource properties. 8 See paragraphs 104(23)(e) and 156.1(2)(c). 9 See subsections 104(27), 104(27.1), 104(28) and 127(7). CAL01: : v4 2

4 Capital Loss Carry Back Subsection 164(6) of the Act allows a testamentary trust to carry capital losses back to the deceased s terminal year in certain circumstances. This provision is often used in order to minimize double-tax that can arise upon the death of an individual, for example where shares of a private corporation are redeemed by the estate. 10 The ability to utilize subsection 164(6) will only be available to GREs under the new rules, and not to other testamentary trusts. As a result, any planning involving private company shares that could be redeemed should ensure that the estate that holds those shares is the only testamentary trust of the taxpayer that is designated as a GRE. Favourable Loss Restriction Rules Subsection 112(3.2) contains a stop-loss rule that can, in general terms, reduce the capital loss available to a trust where certain dividends have been paid on the share. This rule has historically been relaxed where the trust is an estate, but this advantage will be restricted to GREs beginning in Other Matters GREs, but not other testamentary trusts, are generally entitled to refunds beyond the normal reassessment period, 12 an extended objection deadline, 13 guaranteed personal trust status, 14 the ability to use non-calendar years 15 and the ability to file an agreement in relation to debt forgiveness. 16 If planning in respect of any of the above is contemplated, it will be critical to ensure that the relevant testamentary trust is a GRE. Therefore, it will be necessary for some individuals to re-visit their prior Will planning and to make amendments as necessary. It is also notable that the new rules will generally apply to all deaths that occur on or after January 1, No grandfathering was provided, on the view that taxpayers should have a sufficient amount of time to review and update their estate plans before the end of Assuming a taxpayer holds shares with a paid-up capital and adjusted cost base of $0 and a fair market value of $100 at the time of his or her death, the taxpayer will be deemed to have realized a capital gain of $100 immediately prior to death by virtue of subsection 70(5). The estate will thus acquire the shares with a bumpedup cost base of $100. If the shares were subsequently redeemed for $100, the estate will realize a deemed dividend of $100 under subsection 84(3). By virtue of paragraph (j) of the definition of proceeds of disposition in section 54, the estate s proceeds of disposition will be reduced by the amount of the deemed dividend ($100), which will generally trigger a capital loss of $100 for the estate. Since the capital loss arises in the estate but the capital gain arises in the taxpayer s terminal return, subsection 164(6) is necessary in order to offset them against one another. In order to be carried back, the loss must be realized in the estate s first taxation year. 11 See subparagraph 112(3.2)(a)(iii). 12 Normally, the Minister cannot reassess a taxpayer after its normal reassessment period under subsection 152(3.1). With the taxpayer s consent (e.g. to claim a refund), GRE s can extend this to 10 years after the end of the taxation year, pursuant to subsection 152(4.2). 13 Paragraph 165(1)(a). The deadline for most taxpayers (other than individuals) is 90-days after the day that the notice of assessment is sent. For GRE s, the deadline is extended to the day that is one year after the filing-due date for the trust for the year in question. 14 Paragraph (a) of the definition of personal trust in subsection 248(1). 15 Subsection 249(1)(b). 16 Clause 80.04(6)(a)(ii)(B). CAL01: : v4 3

5 The 36-Month Rule As noted above, GRE s are limited to 36-months. At the end of that period, the estate realizes a taxation year-end and loses its status as a GRE. 17 The 36-month period applicable to GRE s was established since most estates are generally administered within 36-months. However, many estates take longer to administer. For example, there could be litigation in the estate delaying its administration, the executor may be waiting to obtain a clearance certificate from the CRA or a complex estate or family dynamic may simply require more time. In these circumstances, any planning that relies upon the estate being a GRE should be completed before the 36-month period expires. Unfortunately, the issue of extended administration periods has not yet been addressed by the government. Therefore, if practical difficulties such as litigation weigh in favour of waiting past the 36-month period, executors will have to weigh the tax benefits of proceeding before the end of the 36-month period against the practical risks associated with proceeding during the litigation process. Multiple Wills It is possible for a taxpayer to have multiple Wills. This strategy is sometimes adopted in jurisdictions where there are high estate taxes or probate fees. 18 The requirement that only one estate of a taxpayer may be a GRE 19 suggests that it may be possible for multiple estates to be created if multiple Will planning is used, 20 particularly if the different Wills appoint different executors or beneficiaries. However, the Department of Finance has indicated in the explanatory notes to Bill C-43 that its expectation is that a taxpayer will have only one estate. 21 If there are multiple Wills it will be critical for the executors to coordinate the filing of any tax returns in respect of the estate or estates to avoid losing GRE status in respect of the most critical assets of the deceased. Qualified Disability Trusts As noted above, QDTs represent an additional exception to the taxation of testamentary trusts at the top marginal rate. A trust will qualify as a QDT if the following conditions are met: The trust is a testamentary trust under the Tax Act; The trust is resident in Canada for the particular year; 17 Subsection 249(4.1). 18 For more information, see Donahue, J. and Cummey, S., Tax Issues in Will Planning: Part 2 Multiple Wills (2000), Canadian Tax Journal See paragraph (e) of the definition of graduated rate estate in subsection 248(1). 20 For example, see Granovsky Estate v. Ontario, 156 DLR (4 th ) 557, 21 ETR (2d) 25, where the Court refers to the taxpayers first and second estates. Also see CRA Document No E5, in which the CRA required two spousal trusts created under separate Wills of one taxpayer to each file returns, implying they were separate taxpayers and potentially separate estates. 21 Minister of Finance, Explanatory (Technical) Notes Relating to the October 20, 2014 Notice of Ways and Means Motion (now part of Bill C-43, Economic Action Plan 2014 Act, No. 2), October 29, 2014 at Clause 71. CAL01: : v4 4

6 The trust and one or more beneficiaries file a joint election for the trust to be a QDT; 22 The electing beneficiary or beneficiaries qualify for the disability tax credit under the Tax Act; and The electing beneficiary or beneficiaries have not made a QDT election with any other trust. Clearly, the QDT rules will not apply as broadly as the GRE exception in respect of the loss of graduated rates. It should also be noted that a QDT will be subject to recovery tax where the trust ceases to qualify as a QDT or where a capital distribution is made to a non-electing beneficiary. 23 Such recovery taxes will apply in amounts designed to recover the tax savings stemming from access to graduated rates in respect of trust income which was never ultimately distributed to the electing beneficiary. Very generally, to qualify for the disability tax credit, the individual must have a severe and prolonged physical or mental impairment which restricts the person s ability to perform certain basic activities of daily living, and a certificate must be obtained from a medical practitioner and filed with the CRA. 24 As a result, QDT planning may still be a viable option where a beneficiary of a deceased s estate has a physical or mental impairment that restricts the beneficiary s ability to perform certain basic activities of daily living. It is also notable that, unlike GRE s, a QDT s access to graduated rates is not restricted to 36- months. GIFTING ON DEATH General Donation Rules Before embarking on a discussion of gifting on death, it is useful to review the general gifting rules for individuals under the Act. These rules are generally intended to create an incentive for taxpayers to donate to worthwhile causes. From the taxpayer s standpoint, the rules provide an opportunity to direct his or her wealth toward a specific cause, rather than as tax revenue directed to the general government coffers. Where an individual makes a donation to a registered charity, the taxpayer is generally entitled to a tax credit under paragraph 118.1(3), as well as any applicable provincial tax credit. Generally, the tax credit can only be claimed to the extent of 75% of the taxpayer s income for the year and can be claimed in the current taxation year or in any of the next five taxation years There are no provisions providing for late election, so ensuring timely filing is crucial. This may be difficult in certain situations. 23 Recovery tax is payable in respect of years if (i) none of the beneficiaries at the end of the year were an electing beneficiary for the previous year, (ii) the trust ceased to be resident in Canada, or (iii) capital distribution is made to a non-electing beneficiary. See subsection 122(2) of the Tax Act. 24 Section See the definitions of total charitable gifts and total gifts in subsection 118.1(1). CAL01: : v4 5

7 In the year of death, however, the 75% restriction is not applicable, and the individual taxpayer can claim the donation tax credit up to 100% of his or her income. 26 Also, the donation tax credit can be used against up to 100% of the deceased's income from the taxation immediately preceding death. 27 However, the 75% restriction still applies to taxation years of the estate. 28 Donations Made by Will or the Deceased s Estate Beginning in 2016, a gift will generally be deemed to have been made by the deceased s estate (and not by any other taxpayer) at the time that the gift is transferred to the donee if: (a) the gift is made by the individual by the individual s Will; (b) the gift is made by the estate; or (c) the gift is of proceeds of a life insurance policy, a registered retirement savings plan (RRSP), a registered retirement income fund (RRIF) or a tax-free savings account (TFSA). 29 However, if the gift is made, or deemed to have been made, by a GRE, the estate will have the flexibility to allocate the donation to any of: (a) the last two taxation years of the deceased individual; 30 (b) the year of the donation or any of the following five years of the estate; 31 or (c) any preceding year of the estate. 32 Unfortunately, the CRA s administrative practice under the old rules of allowing the deceased s spouse or common law partner to use some of the charitable donation tax credit will not be extended under the new rules. 33 A donation made by a GRE can be allocated to the taxpayer s final taxation year, thereby sheltering all or a portion of the taxes payable upon the taxpayer s death. Alternatively, if the tax liability arises in the estate, the estate will have the flexibility to use the tax credits against its own tax liability. This provides considerable flexibility for post-mortem donation planning which, in turn, will provide additional flexibility to taxpayers when it comes to their overall post-mortem planning. However, to take advantage of these rules, it will of course be critical that the donation be made by the deceased s GRE, and not by any other testamentary trust. These new rules are materially different than the ones that exist until December 31, Under those rules, a gift made by Will was deemed to have been made by the deceased immediately before death. 34 The donation tax credits could be claimed in the deceased s terminal taxation year or the 26 Subparagraph (a)(ii) of the definition of total gifts in subsection 118.1(1). 27 See subsection 118.1(4) of the old rules. Under the new rules, see clause (c)(i)(b) of the definition of total charitable gifts in subsection 118.1(1). 28 Subparagraph (a)(iii) of the definition of total gifts in subsection 118.1(1). 29 Subsections 118.1(4.1) and (5) of the new rules. 30 Clause (c)(i)(c) of the new definition of total charitable gifts in subsection 118.1(1). 31 Clause (c)(ii)(a) of the new definition of total charitable gifts in subsection 118.1(1). 32 Clause (c)(ii)(b) of the new definition of total charitable gifts in subsection 118.1(1). 33 The CRA s administrative practice was to allow a gift by an individual s spouse or common law partner to be included within the individual s total charitable gifts : see CRA Document No E5, Donation by will claimed by spouse (2010). However, this administrative position will not be applied under the new rules: see CRA Document No E5, Letter from Income Tax Rulings Directorate to David Sherman (2014). 34 Subsection 118.1(5) of the old rules. CAL01: : v4 6

8 preceding year. 35 A gift made by the estate that was not made by Will could not be carried back to the deceased s terminal return. To be considered a gift by Will, it was generally required that the terms of the Will itself required the executor to make a gift of specific property, a specific amount or a percentage of the residue of the estate, subject to minimal levels of discretion. 36 If too much discretion was given to the executor(s), the gift would not qualify. As a result, under the old rules, estate plans had to be very carefully structured so as to ensure that the taxpayer entitled to claim the charitable donation tax credits was the same taxpayer that realized the tax liability. 37 Often, this involved some level of guesswork, giving rise to the potential that some charitable donation tax credits could be stranded. As a result, the new rules are a very positive development and should simplify the drafting of Wills. This presents an opportunity for taxpayers to re-visit and better optimize their tax plans, and taxpayers may consider adding the following power or some modification thereof to their Wills: My Trustees are directed to make charitable donations of property acquired by my estate on and as a consequence of my death, or property substituted therefor, to such qualified donees under the Income Tax Act (Canada) as may be selected by my Trustees in an amount sufficient to entirely offset the Canadian income tax liability incurred by myself in my terminal year and the one preceding taxation year (collectively, Tax Liabilities ). My Trustees shall have full discretion to select qualified donees, which may include but are not limited to [list of favorite charities or other qualified donees], as well as the amounts donated to each qualified donee. The total cumulative donations made pursuant to this bequest shall be as close as is practically possible to the amount required to fully offset the Tax Liabilities. Designations of Insurance Proceeds and RRSPs, RRIFs and TFSAs The new rules continue to facilitate donations of life insurance, RRSP, RRIF and TFSA proceeds. The rules apply where subsection 118.1(5.2) deems the gift to have been made in respect of the taxpayer s death. In those circumstances, the gift is deemed by virtue of subsections 118.1(4.1) and (5) to be made by the estate, and not by any other taxpayer, at the time that the property is transferred to the donee. If the estate is a GRE, then the charitable donation tax credits can be applied in the flexible manner described above. Subsection 118.1(5.2) generally applies to a transfer in respect of life insurance made: (a) as a consequence of death; (b) solely because of the obligations under a life insurance policy under which, immediately before the death, the individual s life was insured, and the individual s consent would have been required to change the recipient of the transfer; and (c) from an insurer to a person that is the 35 Subsection 118.1(4). 36 See CRA Document No E5, Subsection 118.1(5) gift by will (2011). Also, for a good discussion of the old rules, see D. Bruce Ball and Brenda Dietrich, Charitable Bequests and Estate Planning in Personal Tax Planning, (2011), vol. 59, no. 1 Canadian Tax Journal, If too much discretion was given to the trustees, the gift would be considered to be made by the estate and the tax credit would not be available to shelter the deceased s tax liability. If, however, the gift was made by Will, the donation tax credit would have to be claimed in the individual s tax returns, and would not be available for use by the estate. See CRA Document No , Charitable donations (6 May 1998). CAL01: : v4 7

9 qualified donee and that was, immediately before the death, neither a policyholder under the policy nor an assignee of the individual s interest under the policy. Similarly, subsection 118.1(5.2) generally applies to a transfer in respect of an RRSP, RRIF or TFSA made: (a) as a consequence of death; (b) solely because of the qualified donee s interest as a beneficiary under an RRSP, RRIF or TFSA under which the individual was, immediately before the death, the annuitant or the holder; and (c) from the RRSP, RRIF or TFSA to the qualified donee. Where these conditions are met, the estate will generally be able to take advantage of the flexible charitable donation tax credit rules described above. Valuation Date Under the old rules, the CRA s administrative position was that the value of the gift was determined immediately before the taxpayer s death. 38 Under the new rules, the gift is valued on the date that the relevant property is transferred to the qualified donee. 39 The new rules will be more intuitive for qualified donees issuing receipts for gifts. Although this change has been made for the timing of gifts, it should be noted that the deemed disposition by the deceased of his or her capital property upon death under subsection 70(5) is still deemed to occur immediately before the taxpayer s death. As a result, any post-mortem planning will have to take into account the possibility of a change in value between the time of death and the time that the gift in question is actually made. For example, if a gift of capital property is made to a qualified donee six months after death, the deemed disposition under subsection 70(5) will be based upon the value of that property upon death. If the value of the property were to decrease between the time of death and the time that the gift is made, it may not be possible to use the donation tax credits from the gift to fully offset the income tax payable as a result of the gift. This may be mitigated to an extent if the subsequent gift triggers a capital loss for the estate, but only if the loss can be carried back to the deceased s tax return under subsection 164(6), a condition of which is that the loss must be realized within the estate s first taxation year. As a result, executors in these circumstances will have an incentive to make donations of capital property as soon as possible after death, and in many cases before the end of the estate s first taxation year. If that is not practical, executors may want to consider selling the relevant capital property for cash, so as to crystallize any gain or loss, and to subsequently donate the cash when the timing is more appropriate. This timing mismatch can also create cash flow issues, particularly where the terminal return of the taxpayer is filed prior to the relevant gifts being made by the estate. 40 In such circumstances, tax liability may exist prior to the offsetting donation tax credits arising. The CRA previously allowed donation 38 CRA Document No E5, Subsection 118.1(5) gift by will (2011). 39 New subsection 118.1(5) states that, subject to subsection (13) in relation to non-qualifying securities (discussed below), the gift is deemed to be made at the time that the property that is the subject of the gift is transferred to the donee and not at any other time. 40 Paragraph 150(1)(b) requires terminal returns to be filed on (a) April 30 th of the year following death for a taxpayer who dies between January 1 and October 31, and (b) Six months following death for a taxpayer who dies after October 31 in a given year. The balance-due date, as defined in subsection 248(1), coincides with these filing dates. CAL01: : v4 8

10 credits to be claimed with respect to gifts not yet received by a qualified donee where evidence of the gift could be provided, such evidence including the Will, a letter to the donee advising of the gift and a letter from the donee stating that it would accept the gift. 41 However, under the new rules, the Tax Act clearly states that a gift will not be considered to be made until the time the property is transferred, 42 meaning the CRAs prior administrative practice may not be applicable under the new legislation. Where such timing issues apply, an amended return may be filed after the gift is made. However, the interim tax liability must be dealt with in order to prevent interest from accruing and to avoid CRA collections procedures. Funding such interim tax liability may be difficult for estates with low liquidity and high value, particularly in cases where the residue of the estate is to be donated to charity. Even where an estate is able to immediately pay the debt, making the interim payment may delay other distributions set out in the taxpayer s Will. Testators and executors should prepare for this by either ensuring that gifts are made promptly before any tax liabilities become due or exercising any applicable borrowing powers. Tax Advantaged Donations Donations of several types of property are subject to advantageous exemptions from tax on capital gains. In addition, donors are generally entitled to claim charitable donation tax credits associated with the gift. These advantages can have a significant positive effect upon a taxpayer s estate plan. Publicly Listed and Certain Other Securities The donation of publicly listed and certain other securities provides favourable tax treatment and should be considered any time a significant gift is being made. More specifically, a taxpayer s taxable capital gain is deemed to be nil where capital property is disposed of to a qualified donee and is a share, debt obligation or right listed on a designated stock exchange, a share of a mutual fund corporation, a unit of a mutual fund trust, an interest in a related segregated fund trust and certain government or government guaranteed debt obligations. 43 The new rules continue to allow such a donation to be made upon death, provided that the gift is made by the taxpayer s GRE and the GRE acquired those securities on and as a consequence of the taxpayer s death. This nil capital gains treatment is a significant advantage and provides additional incentives to make gifts of this nature. For example, if a taxpayer holds publicly listed securities with a significant accrued gain at the time of death, the taxpayer s GRE can donate those securities to a qualified donee. No capital gains will be triggered. Also, the GRE will be entitled to charitable donation tax credits, based upon the full fair market value of the shares donated, and to allocate those tax credits to a variety of tax years based upon the flexible rules described above. This is a very significant tax incentive and should be among the key planning mechanisms considered upon death, in cases where the executors have been given the requisite powers. 41 See CRA Tax Guide T4011 Preparing Returns for Deceased Persons See paragraph 118.1(5.1)(b) of the Tax Act. 43 Paragraph 38(a.1) (i) and (ii). CAL01: : v4 9

11 Ecological Gifts The Tax Act contains rules for ecological gifts that mirror those associated with donations of the securities listed above. 44 To qualify, the gift must be of land that is certified by the government to be ecologically sensitive land, the conservation and protection of which is, in the opinion of the government, important to the preservation of Canada s environmental heritage. The recipients of donations of this type are limited to the federal or provincial government, a municipality, a municipal or public body performing a function of government in Canada or a registered charity that is specifically approved by the Minister and satisfies certain criteria. 45 An outright gift of the fee simple is not always necessary. Rather, the grant of certain conservation easements or covenants can be sufficient to qualify for the charitable donation tax credit. Environment Canada has specific procedures for certifying land as ecologically sensitive land and determining the fair market value of the gift for tax purposes. For example, it will consider areas identified as ecologically significant or important, natural spaces of significance to the environment, sites with significant ecological value or the potential for ecological value, lands that are zoned for biodiversity objectives, natural buffers around environmentally sensitive areas (e.g. water bodies, streams or wetlands) and areas that contribute to the maintenance of biodiversity or Canada s economic heritage. 46 Given the broad scope of land interests that may be established to take advantage of the favourable exemption from capital gains taxes and access to charitable donation tax credits, these rules provide taxpayers with large land interests with an opportunity to minimize tax upon their death and at the same time contribute to the preservation of Canada s environmental heritage. Certified Cultural Property Similar advantageous rules also apply to eliminate the capital gain arising upon the disposition of certified cultural property by a GRE. 47 Special rules apply to gifts made by artists and generally accomplish the same result. 48 In order to qualify for the nil capital gains rate and the favourable charitable donation tax credits, the donated property must be certified by the Canadian Cultural Property Export Review Board. The Board considers: (a) whether the object is of outstanding significance by reason of its close association with Canadian history or national life, its aesthetic qualities, or its value in the study of the arts or sciences; and (b) whether the object is of such a degree of national importance that its loss to Canada would significantly diminish the national heritage. 49 Also, the gift must be made to an institution or public 44 Paragraph 38(a.2). 45 See the definition of total ecological gifts in subsection 118.1(1). 46 See Environment Canada s website outlining the National Criteria for Ecological Sensitivity: 47 Subparagraph 39(1)(i.1). 48 Subsections 118.1(7) and (7.1). 49 Paragraph (a) of the definition of total cultural gifts in subsection refers to paragraphs 29(3)(b) and (c) of the Cultural Property Export and Import Act, which refer to paragraphs 11(a) and (b) thereof. CAL01: : v4 10

12 authority designated under subsection 32(2) of the Cultural Property Export and Import Act. 50 Organizations can be designated either generally or for the purposes of a specific gift Budget Private Corporation Shares and Real Estate The 2015 Federal Budget announced proposed modifications to the Act to accommodate taxadvantaged donations involving private corporation shares and real estate. As of the date this paper was written, no specific legislation had been proposed. However, the Budget papers indicate that the exemption will be available where: (a) cash proceeds from the disposition of private corporation shares or real estate are donated to a qualified donee within 30 days after the disposition; and (b) the private corporation shares or real estate are sold to a purchaser that is dealing at arm s length with both the donor and the qualified donee to which cash proceeds are donated. Non-Qualifying Securities The non-qualifying security ( NQS ) rules are intended to address circumstances where a donation is made and the donated property is a share, debt or other interest in an entity that is controlled by the donor or does not otherwise deal at arm s length with the donor. If the donated securities cease be NQS within 60-months, the charitable donation tax credits are generally denied until the time that the securities cease to be NQS. If, after the 60-month period, the donated securities are still NQS, no charitable donation tax credit is available with respect to the donated securities. A NQS is very broadly defined and includes any security (e.g. debt or share) issued to the taxpayer, his estate or any person or partnership that either of them does not deal at arm s length with (collectively, Non-Qualifying Persons ), with special rules for trust and estates that generally utilize the affiliated person rules. 51 The rules also contain several anti-avoidance provisions. 52 Therefore, these rules can catch taxpayers by surprise and need to be carefully reviewed having regard to all of the specific facts and circumstances of each case. These rules can be particularly difficult for a taxpayer who wishes to donate securities of a familycontrolled corporation. For example, if a taxpayer wishes to donate shares of a corporation that his immediate family controls, the charitable donation tax credit will be denied unless the donated securities cease to be NQS within five years. The taxpayer should thus give some consideration to possible methods of causing the securities to cease to be NQS (each, a Triggering Event ). For example, in some cases a Triggering Event may occur if: the donated shares are redeemed for cash by the issuing corporation; the donated shares are sold for cash to a third party by the recipient of the donation; 50 A list of designated organizations and an application form for designation can be found at: 51 The definition of NQS is in subsection 118.1(18). 52 See subsections 118.1(13.1), (13.2) and (13.3). Also see subsection 118.1(16) with respect to loan-backs. CAL01: : v4 11

13 the donated shares are sold by the recipient of the donation for other property that does not include NQS (e.g. in exchange for publicly listed securities); or control of the issuing corporation changes so that it no longer rests with persons who do not deal at arm s length with the family. Depending upon the taxpayer s circumstances, some solutions may be more practical than others. As noted above, the donation tax credits will be denied outright if a Triggering Event does not occur within 60-months following the date that the donation is made. If a Triggering Event does occur within that 60- month period, the donation tax credits will generally be allowed at the time of the Triggering Event, but they will generally be restricted to the lesser of the fair market value of the donated shares at the time that the donation was made by the estate and the fair market value of the donated shares at the time of the Triggering Event. Also, the 60-month period in this context is a bit of a red herring. For all practical purposes, the period may be restricted to the 36-month period in which the estate is a GRE if the intent is to utilize the donation tax credits in the taxpayer s personal tax returns, rather than against income of the estate. This is often the case because donation tax credits are often intended to offset a significant tax liability arising in the deceased s terminal return, and a GRE can only carry them back to the terminal return while it retains its status as a GRE (i.e. for no more than 36-months). An important exception to the NQS rules is for excepted gifts defined in subsection 118.1(19). A gift is generally an excepted gift if the donated security is a share, the donee is not a private foundation, the donor deals at arm s length with the donee, and the donor deals at arm s length with each director, trustee, officer and like official of the donee. However, there appears to be a technical problem under the legislation preventing access to this exception in many cases where the gift is made by an estate, 53 thereby limiting its use in the context of post-mortem plans. Another possible way to manage the NQS rules during a taxpayer s lifetime is for the donor to elect under subsection 118.1(6) to have the proceeds of disposition equal to the donor s adjusted cost base. Although the NQS rules would deny all or part of the charitable donation tax credit, the election would ensure that the donor does not realize any capital gain or loss on the disposition of the securities. This approach could be particularly useful where the donor wishes to donate an illiquid investment, such as private corporation shares, with a high fair market value but a low adjusted cost base. The CRA issued a favourable ruling under the old rules with respect to this strategy where a gift was made by Will The technical issue arises from the fact that, in such circumstances, the estate will be deemed to make the gift. An estate is deemed to be a trust, a testamentary trust and a personal trust for tax purposes pursuant to subsection 104(1). This creates an issue, as paragraph 251(1)(b) generally deems a personal trust not to deal at arm s length with any person beneficially interested in the trust. The foundation receiving the gift likely holds a beneficial interest in the trust by virtue of its entitlement to the gift, and will therefore be deemed not to deal at arm s length with the estate, meaning the gift may not qualify as an excepted gift. It is unclear whether this is an intended result of the recent amendments to these rules. This is particularly problematic where the gift would otherwise have qualified if it were made by the taxpayer during his or her lifetime. 54 See CRA Document No E5, Gift by will of non-qualifying security (15 July 2013). CAL01: : v4 12

14 However, it may not be possible to use this strategy under the new rules because the capital gain on the relevant property will be realized in the deceased s terminal return, whereas the gift will be deemed to be made by the deceased s estate. 55 Non-Qualified Investments Special rules apply to a non-qualified investment ( NQI ) held by a private foundation. Very generally, an NQI will include any debt or share owned by the private foundation that is issued by a person: (a) who is a member, shareholder, trustee, settlor, officer, official or director of the private foundation; (b) who has, or is a member of a group of persons who do not deal with one another at arm s length, who have contributed more than 50% of the capital of the foundation; or (c) who does not deal at arm s length with any person described in (a) or (b) above. 56 To the extent that the private foundation holds an NQI, it will be subject to an additional tax under section 189 of the Act. Generally, the additional tax on the donated property is determined with reference to the prescribed rate of interest applied based upon the fair market value of the donated property at the time that it is donated to the private foundation, reduced to the extent of any dividends or interest paid within 30-days after the end of the relevant taxation year. 57 Therefore, the NQI rules are much easier to manage than the NQS rules described above. The NQI rules will, however, be relevant where a taxpayer wishes to donate securities of a private family-owned corporation, particularly with respect to gifts made to private foundations. If there is a sufficient enough connection between the foundation and the underlying corporation, the parties will have to ensure that appropriate interest or dividends are paid on the relevant securities, or to report the additional tax in accordance with section 189. Excess Business Holdings Regime Private foundations that hold shares are subject to certain reporting and, in some case, divestment obligations under the excess business holdings regime (the Regime ). 58 The Regime generally provides as follows: If the private foundation does not hold more than 2% of any class of shares of any corporation, no reporting or divestment obligations exist. 55 The deemed disposition of the relevant property, triggering a capital gain, will occur in the taxpayer s terminal return. However, through the application of subsections 118.1(4) and (5), the disposition is deemed to be made by the estate. Since the estate will have acquired the property with an increased ACB, its fair market value and adjusted cost base will generally be equal to one another, thereby limiting the ability of the estate to use the subsection 118.1(6) designation to shelter the capital gain arising in the terminal return. Although the new language in subparagraph 38(a.1)(ii) would provide relief in the context of publicly listed and certain other securities, it does not apply to other property such as private corporation shares. 56 The definition of non-qualified investment is in subsection 149.1(1). 57 See subsections 189(1) to (4) for the computation rules. Also see CRA Views, Liability for Part V tax for a brief discussion of the computation. 58 See sections and for most of the rules. CAL01: : v4 13

15 If the private foundation holds more than 2% of any class of shares of any corporation, it is required to report its holdings and those of any non-arm s length person on an annual basis (subject to certain exceptions). If the private foundation, together with any one or more non-arm s length persons, owns more than 20% of any class of shares of a corporation, the private foundation will generally have certain divestment obligations. The divestment obligations generally require that the private foundation divest a sufficient number of securities to fall below the 20% threshold. The determination of whether or not a particular private foundation will have a divestment obligation will depend upon the percentage of shares of the underlying corporation that it holds, and whether or not the private foundation deals at arm s length with the other shareholders of the underlying corporation. If the private foundation, together with non-arm s length persons, owns more than 20% of the shares of the underlying corporation, then it will generally have to divest itself of a sufficient number of shares of the underlying corporation to fall below that percentage. 59 Where a private foundation exceeds its permitted holdings, it will be subject to significant penalties and can have its charitable status revoked. 60 Generally, the private foundation will have to divest itself of its excess shares: (i) in the year of purchase, if they are purchased for consideration; (ii) within five years after the year of receipt if they are received by way of bequest; (iii) within one or two years after the year of receipt if they are acquired by gift (other than by bequest); and (iv) within ten years after the year of receipt if an extension is granted by the Minister. 61 The extended period of five years for gifts made by bequest may provide an incentive in some cases to gift securities by way of bequest rather than by way of inter vivos gift. Subsection 104(13.1) and (13.2) Designations Normally, when a trust distributes income to its beneficiaries in the year, the income is taxable in the hands of the beneficiary. Subsection 104(13.1) provides an exception to this rule, whereby the trust is entitled to designate an amount of such income that remains taxable in the trust. Subsection 104(13.2) provides a similar rule for capital gains. These designations were particularly useful where the trust had losses to use up or was able to take advantage of lower marginal tax rates than the beneficiary, or in strategies that took advantage of provincial tax rate arbitrage. 59 See the definitions of divestment obligation percentage and excess corporate holdings percentage in subsection For the penalty provisions, see subsection 188.1(3.1). For the revocation rules, see paragraph 149.1(4)(c). 61 See the interaction between the definition of divestment obligation percentage in subsection and the rules in subsection 149.2(5). Subsection 149.2(6) provides for the extension by the Minister. The Department of Finance Technical Notes to subsection 149.2(6) stated: If a large donation were made to a foundation involving complex corporate structures or illiquid shares, the Minister could consider providing additional time for divestiture if the foundation could demonstrate that it had commenced disposition of the shares but that divestment could not occur more immediately because of securities regulations or without significantly depressing the price of the shares. CAL01: : v4 14

16 New subsection 104(13.3) will deny access to these designations where the trust s taxable income is greater than nil. This will essentially restrict the ability to utilize the subsection 104(13.1) and (13.2) designations to trusts that have losses, and it will no longer be possible to designate distributed income to be taxable in the trust in order to take advantage of lower marginal tax rates in the trust. Also, the rules do not permit a designation to use tax credits (e.g. donation tax credits). Life Interest Trusts The new rules relating to spousal trusts, alter ego trusts and joint spousal or common law partner trusts (collectively, Life Interest Trusts ) are substantial and have been met with some criticism. Under new subsection 104(13.4), the death of a beneficiary triggers a taxation year-end and deemed disposition for the trust. In addition, all of the trust s income for the year ending at the time of death, including tax payable upon the deemed disposition of any capital property, is deemed to have become payable in that year to the deceased beneficiary, and not treated as income of any other beneficiary. This is very significant because the trust assets will remain in the trust unless the trustees decide to distribute it to the beneficiary. Therefore, it is possible for the deceased beneficiary to end up with a very significant tax liability without having received any of the capital of the trust. This is very problematic, particularly if the trust s beneficiaries are different than the beneficiaries of the life interest beneficiary s estate. The deceased beneficiary s concerns may perhaps be somewhat alleviated by subsection 160(1.4), which provides that both the trust and the deceased individual are jointly and severally liable for this tax liability. However, the level of comfort offered by this is minimal, since the deceased beneficiary is liable in the first instance. The ability of the life interest beneficiary s estate to compel the payment of tax by the trust is thus questionable, 62 and even if the trust were to pay the tax, it may have a claim against the life interest beneficiary s estate on the basis that the latter was liable in the first instance. Although the Department of Finance has indicated that it is intended that the Minister apply subsection 160(2), in respect of an amount owing under subsection 160(1.4), as though the trust were liable in the first instance for that amount, 63 this does not provide much comfort to trustees who have fiduciary duties at law, and thus a legislative fix would add much needed certainty. We understand that the Department of Finance has been made aware of this problem. Until a legislative fix is made, those drafting life interest trust provisions may want to consider adding language expressing an intention that the tax liability be paid by the life interest trust, rather than the 62 This mismatch of entities in which the tax liabilities and assets accumulate is similar to circumstances in which a testator designates a beneficiary of a RRIF, creating primary tax liability in the estate while the proceeds of the RRIF flow to the beneficiary. In such cases, the estate and the beneficiary are jointly liable for the tax liability under subsection 160(2), which is also the case in regard to the mismatch caused by subsection 104(13.4). However, the jurisprudence suggests that the tax liability should be assessed to the party liable at first instance in such circumstances. For example, see Slater v. Klassen Estate, [2000] C.T.C. 100 (Man. Q.B.). Also see Curley v. MacDonald, [2000] 4 C.T.C. 14, [2000] O.J. No and Slater, supra. However, see Belanger v. The Queen, 2007 TCC 502. This mismatch may therefore give rise to increased litigation. 63 Minister of Finance, Explanatory (Technical) Notes Relating to the October 20, 2014 Notice of Ways and Means Motion (now part of Bill C-43, Economic Action Plan 2014 Act, No. 2), October 29, 2014, at Clause 57. CAL01: : v4 15