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1 RBC Wealth Management Services The Navigator C HARLES W. C ULLEN III CFP(Canada and U.S.),CIM Associate Portfolio Manager & Wealth Advisor D AYNA P ARK Associate P AMELA H UNTER Marketing Associate Upper Water Street Suite 1400 Halifax NS B3J 3N2 Estate Planning for U.S. Citizens in Canada Maximize your wealth with cross-border estate planning strategies The United States (U.S.) can impose U.S. estate, gift and U.S. Generation-Skipping Transfer Tax (GSTT), collectively known as the U.S. transfer tax system, on U.S. citizens no matter where in the world they reside. As a result, estate planning for U.S. citizens in Canada is more complex since both Canadian and U.S. estate and income tax laws must be considered. This article discusses common cross-border (Canadian and U.S.) estate, Will and trust planning strategies for U.S. citizens in Canada. Not everyone is aware of their U.S. citizenship status. The fact that you do not have a U.S. passport or that you never lived or worked in the U.S. does not mean you are not a U.S. citizen! If you were born in the U.S., you are automatically a U.S. citizen. If you were born outside the U.S. to U.S.-citizen parents or your parents are naturalized U.S. citizens, you must refer to U.S. citizenship laws in effect at the time of your birth to determine if you are a U.S. citizen. Even if only one of your parents is a U.S. citizen, you may have obtained U.S. citizenship under the laws at the time of your birth. If you are unsure, you should contact a lawyer who can review your situation and help you make this important determination. This article is provided to help U.S. citizens living in Canada to start learning about their specialized estate planning considerations. It is for information purposes only and does not provide tax or legal advice. Many of the rules and strategies discussed may also apply to U.S. green card holders and U.S. resident aliens; but this article does not specifically address their issues. This article only addresses planning for U.S. federal estate and income tax 1 RBC WEALTH MANAGEMENT SERVICES

2 The U.S. transfer tax system (composed of gift, estate and GSTT) applies to U.S. citizens who transfer assets by way of lifetime gifts or bequests made upon their death. purposes; certain U.S. states may have their own transfer tax system and these are not covered here. It is imperative that you obtain professional advice from a qualified tax or legal advisor specializing in cross-border tax and estate planning before you act on any of the information provided in this article. This will ensure that your own circumstances have been considered properly and that action is taken on the latest information available. U.S. Transfer Tax and Canadian Income Tax Systems Before considering which cross-border estate and trust planning strategies are appropriate for you, it is important to start with a basic understanding of the Canadian and U.S. estate and income tax systems that may affect the type of planning chosen. Canadian Income Tax Canada does not have an estate or gift tax system; however, assets transferred by way of gifts made during your lifetime or bequests made upon your death may be subject to Canadian deemed disposition rules contained in the Canadian Income Tax Act. These rules require you to include in your income any net capital gains (gains less losses) triggered on capital property you own as if you sold the property on the date of death or on the date it was gifted. Transfers to a spouse either directly or to a Canadian qualified spousal trust through your Will are exempt from these rules and may be transferred at the asset s original cost. In addition to the deemed disposition rules, income earned on lifetime gifts to a spouse or minor child or grandchild may trigger the Canadian income attribution rules that requires the transferor to pay Canadian income tax on that income. United States Transfer Tax System The U.S. transfer tax system (composed of gift, estate and GSTT) applies to U.S. citizens (and in some cases non-u.s. citizens) who transfer assets by way of lifetime gifts or bequests made upon their death. U.S. Gift Tax U.S. gift tax may be triggered by donors (U.S. or non-u.s. citizens) who gift property in the year if the fair market value of the gift exceeds the annual exclusion amounts set for that year. For 2014, the annual exclusions allow for non-taxable gifts of US$14,000 per person to be made to anyone or US$145,000 to be made to a non-u.s. citizen spouse. U.S. gift tax is not triggered on gifts made to a U.S. citizen spouse. For U.S. citizens only, there is a lifetime gift tax exemption (US$5.34 million for 2014) that may be used to eliminate U.S. gift tax on taxable gifts. However, the use of the lifetime gift tax exemption reduces the U.S. estate tax exemption available dollar for dollar. For U.S. citizens, gifts of any type of property transferred may trigger U.S. gift tax; however, for non-u.s. citizens, only gifts of U.S. tangible property may trigger it. U.S. tangible property consists of property that is physically located in the U.S. such as U.S. real estate and cars, boats, jewellery and cash physically located in the U.S. A gift that is not U.S. tangible property may still be subject to U.S. gift tax if it is considered to be a disguised gift (i.e. an otherwise intangible gift made to an individual to facilitate the purchase of U.S. tangible property by that individual from the donor). For both U.S. and non-u.s. citizens, U.S. gift tax is calculated on the fair market value of the gift based on graduated tax rates with a maximum rate of 40%, which is reached when 2 RBC WEALTH MANAGEMENT SERVICES

3 For both U.S. and non-u.s. citizens, U.S. estate tax is based on graduated tax rates with a maximum rate of 40% (which is reached when the value of the taxable estate exceeds US$1 million). the value of taxable gifts exceeds US$1 million. U.S. Estate Tax U.S. estate tax may be triggered on the estate of U.S. or non-u.s. citizens upon their death. For U.S. citizens, U.S. estate tax is calculated on the fair market value of their assets on death. Every U.S. citizen is entitled to a unified credit to reduce or eliminate U.S. estate tax. For 2014, the unified credit amounts to US$2,081,800, which translates to a U.S. estate tax exemption of US$5.34 million (i.e. US$5 million set in 2011 indexed to inflation). This means U.S. estate tax will not apply to a U.S. citizen who dies in 2014 where the fair market value of the assets does not exceed the US$5.34 million exemption. Note: U.S. estate tax for U.S. citizens may be reduced by a credit that may be claimed for Canadian deemed disposition tax (triggered upon death) related to assets considered to have a Canadian location or connection, such as real estate located in Canada or shares in a Canadian corporation. For Canadian tax purposes a foreign tax credit may be claimed for U.S. estate tax paid on U.S. situs assets. For non-u.s. citizens, U.S. estate tax is calculated on the fair market value of U.S. situs assets only. Non-U.S. citizens who are Canadian residents are entitled to a prorated unified credit based on the ratio of the value of their U.S. situs assets to their worldwide estate. Therefore, U.S. estate tax may apply only in cases where the value of the U.S. situs assets exceeds US$60,000 and the value of the worldwide estate exceeds US$5.34 million. U.S. situs assets are assets which have a U.S. connection or location, for example shares in a U.S. corporation, U.S. real estate or cash on account in a U.S. brokerage (deposits in a U.S. bank are not U.S. situs provided they are not connected to a trade or business in the U.S.). A non-u.s. citizen s estate must file a U.S. estate tax return if the value of the U.S. situs assets exceeds US$60,000 even though no U.S. estate tax liability will be incurred. Note: For Canadian tax purposes, a non-u.s. citizen s estate can claim a foreign tax credit on their Canadian return for U.S. estate tax paid on U.S. situs assets. For both U.S. and non-u.s. citizens, U.S. estate tax is based on graduated tax rates with a maximum rate of 40% (which is reached when the value of the taxable estate exceeds US$1 million). Where the estate s assets are transferred to a U.S. citizen spouse an unlimited marital deduction may be claimed by the estate to eliminate U.S. estate tax. Where the surviving spouse is not a U.S. citizen, the estate of the deceased may claim a marital credit or a marital deduction. The marital credit may minimize or eliminate U.S. estate tax on U.S. situs assets transferred to the surviving spouse or spousal trust. Alternatively, the marital deduction will defer (but not eliminate) U.S. estate tax on U.S. situs assets transferred by the deceased s estate to a Qualified Domestic Trust (QDOT) for the surviving spouse. The marital credit and QDOT are discussed in more detail later. U.S. Generation-Skipping Transfer Tax (GSTT) GSTT may apply to taxable gifts or bequests made by U.S. citizens or non-u.s. citizens to skip individuals (e.g. grandchildren, great grandchildren and more distant descendants) in addition to U.S. gift or estate tax. GSTT prevents skipping a generation of U.S. estate or gift tax that may otherwise occur by making a gift or bequest to a skip individual. GSTT is levied at a flat tax rate equal to the highest marginal estate or gift tax rate in the year (which is 40% for 2014). GSTT will not apply if U.S. gift or estate tax does not apply because the same annual exclusion and lifetime exemption amounts for U.S. gift or estate tax exist for GSTT purposes. However, one key difference is that a GSTT exemption of US$5.34 million for gifts or bequests may also be used by non-u.s. citizens for taxable transfers made during their lifetime or after their death. Note: Since the lifetime U.S. gift tax exemption is not available to non-u.s. citizens and they can only claim a prorated unified credit, it is possible that a non-u.s. citizen may incur U.S. estate or gift tax even though they are not subject to GSTT. RBC WEALTH MANAGEMENT SERVICES 3

4 Common Estate Planning Strategies for U.S. Citizens in Canada Table 1 summarizes many of the common cross-border estate, Will and trust planning strategies that U.S. citizens in Canada may use to defer, reduce or potentially eliminate U.S. gift, estate or GSTT (this is not an exhaustive list). Table 1 Common Estate Planning Strategies U.S. Transfer Taxes For each spouse where both are U.S. citizens For a U.S. citizen spouse where a non-u.s. citizen spouse may be the survivor For a non-u.s. citizen spouse where the U.S. citizen spouse may be the survivor The portability provisions provide the surviving U.S. citizen spouse with the potential to transfer up to US$10.68 million of wealth to their beneficiaries. Portability provisions Credit Shelter Trust (CST) Lifetime gifts Dynasty Trust Irrevocable Life Insurance Trust (ILIT) Charitable donation Marital credit 3 Qualified Domestic Trust (QDOT) Canadian qualified testamentary spousal trust Portability Provisions Portability provisions, which first came into effect in 2011, allow a surviving U.S. citizen spouse to use their deceased spouse s unused U.S. estate or gift tax exemptions as well as their own. The provisions are available only when both spouses are U.S. citizens and an election to transfer the unused exemptions to the surviving spouse is made on the U.S. estate tax return of the first spouse to die. For a spouse who dies in 2014, the portability provisions provide the surviving U.S. citizen spouse with the potential to transfer up to US$10.68 million of wealth to their beneficiaries (i.e. US$5.34 million of their predeceased spouse s unused lifetime gift or estate tax exemption and another US$5.34 million of their own exemption). Note: The unused exemptions cannot be used to make gifts or bequests to skip individuals. The portability provisions may be helpful to couples with small estates who have neglected to plan. However, relying solely on the portability provisions may result in a greater exposure to U.S. estate tax for the beneficiaries of larger estates. This is because other estate planning strategies may protect not only the assets transferred from U.S. estate tax but also any future growth of those assets. 4 RBC WEALTH MANAGEMENT SERVICES

5 Where the maximum unified credit and marital credit can be claimed, it is possible to transfer approximately US$10.54 million in assets to a surviving non-u.s. citizen spouse directly or to a spousal trust (free of U.S. estate tax). Credit Shelter Trust (CST) A Credit Shelter Trust (CST), also known as a bypass trust or A/B trust, is a special type of irrevocable testamentary trust (established by U.S. citizens through their Will) that protects assets transferred in and any future growth from U.S. estate tax. The beneficiaries, who may include your spouse, children and/or grandchildren, have limited access to the capital of the trust. Income earned in the trust may be paid to a beneficiary; however, distributions of capital are permitted only for health, education, support and maintenance (referred to as ascertainable standards ). The fair market value of assets up to the deceased U.S. citizen spouse s U.S. estate tax exemption may be transferred to the CST free of U.S. estate tax. Assets intended to fund the CST must flow from the estate; therefore, assets should not be held jointly with rights of survivorship (JTWROS). TIP: Since non-u.s. citizens are subject to U.S. estate tax on U.S. situs assets only, where some of the beneficiaries are non-u.s. citizens, consider transferring U.S. situs assets to the CST first. Remaining assets (in excess of the U.S. estate tax exemption) may be transferred to a surviving spouse directly or to a properly structured spousal trust. If the surviving spouse is a U.S. citizen an unlimited marital deduction may be used to transfer the assets free of U.S. estate tax. (Refer to Appendix 1 for an example of an estate plan using a CST where both spouses are U.S. citizens). Where the surviving spouse is not a U.S. citizen the marital credit or a Qualified Domestic Trust (QDOT) may be used. (Refer to Appendix 2 for an example of an estate plan using a CST where only one spouse is a U.S. citizen and the U.S. citizen spouse dies first). These assets may be subject to U.S. estate tax on the death of the surviving spouse. The marital credit and QDOT are discussed in greater detail next. Note: It may be possible to structure a trust (i.e. CST, spousal trust and/or the QDOT) as a Canadian qualified testamentary spousal trust to qualify for Canadian tax benefits. The Canadian tax benefits of implementing a Canadian qualified testamentary spousal trust are discussed later. Marital Credit The marital credit may be claimed by a U.S. citizen or a non-u.s. citizen spouse s estate as a result of transferring assets subject to U.S. estate tax to a non-u.s. citizen spouse directly or to a spousal trust. Where the maximum unified credit and marital credit can be claimed, it is possible to transfer approximately US$10.54 million in assets to a surviving non-u.s. citizen spouse directly or to a spousal trust (free of U.S. estate tax). For example, a U.S. citizen could transfer US$5.34 million, by claiming the maximum unified credit of US$2,081,800, and another US$5.2 million (i.e. US$2,081,800 divided by 40% maximum U.S. estate tax rate) by claiming the maximum marital credit of US$2,081,800, and incur no U.S. estate tax. Qualified Domestic Trust (QDOT) A Qualified Domestic Trust (QDOT) is a type of trust that may be used by the estate of U.S. citizens or non-u.s. citizens to defer U.S. estate tax (when the surviving spouse is a non-u.s. citizen) until distributions of capital are made from the trust to the surviving spouse or the surviving spouse dies. The deferral is possible by claiming an unlimited marital deduction as a result of transferring assets subject to U.S. estate tax to a QDOT for the benefit of a surviving non-u.s. citizen spouse who must be the sole beneficiary of the trust. When the deferral ends, U.S. estate tax payable at that time is calculated based on the tax rates that existed in the year the deferral was made. An estate cannot claim the marital credit and also use the QDOT to claim an unlimited marital deduction. Therefore, it is important to draft your Will to allow your executor the ability to choose the best option for your estate. RBC WEALTH MANAGEMENT SERVICES 5

6 The QDOT strategy should be considered when you cannot eliminate or substantially reduce your U.S. estate tax liability by claiming the marital credit. TIP: Generally, the QDOT strategy should be considered when you cannot eliminate or substantially reduce your U.S. estate tax liability by claiming the marital credit. There are a number of criteria in order for a trust to qualify as a QDOT. First, at least one trustee must be a U.S. citizen or U.S. corporation. If the assets in the QDOT have a value of at least US$2 million at the time of the U.S. citizen spouse s death (or an alternate valuation date, if applicable), additional requirements are necessary. Under a large QDOT, at least one trustee must be a U.S. bank or a bond or letter of credit must be provided in favour of the Internal Revenue Service (IRS). A QDOT set up through your Will can qualify as a testamentary trust for Canadian tax purposes. To defer the Canadian deemed disposition that occurs upon your death, it may also be possible (although often difficult) to structure the QDOT as a Canadian qualified testamentary spousal trust. Speak to a professional cross-border tax and/or legal advisor for advice on how to structure and incorporate a QDOT in your estate planning where appropriate. Lifetime Gifts U.S. and non-u.s. citizens can minimize or eliminate their exposure to U.S. estate tax by gifting assets before they die. Before making a gift, consider whether U.S. gift tax or GSTT or the Canadian deemed disposition and income attribution rules will be triggered. For Canadian tax purposes there is a deemed disposition when gifts are made to anyone other than a spouse and the income attribution rules may apply to future income and capital gains realized on gifts made to a spouse or a minor child/grandchild. Common gifting strategies for U.S. citizens with assets that exceed US$5.34 million include making annual gifts to children, grandchildren and to a non-u.s. citizen spouse that do not exceed the annual exclusions (i.e. US$14,000 for each child and grandchild and US$145,000 to a non-u.s. citizen spouse). TIP: Since a non-u.s. citizen spouse is subject to U.S. estate tax on U.S. situs assets only, it may be appropriate for them to make gifts of U.S. situs assets and to receive gifts of non-u.s. situs assets. Keep in mind that a non-u.s. citizen who makes a gift of U.S. situs assets that is also a tangible U.S. property (such as gifts of U.S. real estate) will be subject to U.S. gift or GSTT if the value exceeds the annual thresholds. Gift SpliTTing Where both spouses are U.S. citizens gift splitting may be used, where one U.S. citizen spouse funds the entire amount of the gift (i.e. US$28,000) with their assets and makes an election on a gift tax return to split gifts. This election allows each U.S. citizen spouse to be treated as having made one half of the gift (i.e. US$14,000), which is within the annual exclusion amount. Gift splitting is not possible when one spouse is not a U.S. citizen. A U.S citizen couple with three children may gift up to US$84,000 (US$28,000 x 3) annually without triggering gift tax. If they also make gifts to three grandchildren they will be able to make tax-free gifts of US$168,000 (US$28,000 x 6) annually. These gifts can also be made to your spouse s child or grandchild, which can further increase the number of tax-free gifts that can be made. Payments Not Considered Gifts U.S. citizens can also make direct 6 RBC WEALTH MANAGEMENT SERVICES

7 A U.S. citizen can potentially minimize their exposure to U.S. estate tax by rebalancing assets with their non-u.s. citizen spouse. payments on behalf of children and grandchildren to educational organizations for tuition expenses (e.g. college tuition), or to healthcare providers for medical services (e.g. braces for teeth). These payments may exceed the annual exclusion amounts since they are not considered to be gifts. The payments must not be made to a child or grandchild to pay for these expenses otherwise the payment will be considered a gift. Note: paying for books, supplies, room and board, or other types of educational expenses directly would be considered gifts as they would not qualify as tuition payments. Rebalancing Non-U.S. Situs Assets With Your Non-U.S. Citizen Spouse A U.S. citizen can potentially minimize their exposure to U.S. estate tax by rebalancing assets with their non-u.s. citizen spouse. A rebalancing strategy could involve making tax-free gifts annually of non-u.s. situs assets first that do not exceed the annual exclusion amount. Generally, it is not advisable to use your lifetime gift tax exemption since every dollar used reduces your U.S. estate tax exemption. However, there may be situations where making taxable gifts and using your lifetime exemption could make sense. For example, a U.S. citizen living in Canada that owns a home (i.e. a non-u.s. situs asset) in sole name may benefit (for U.S. estate and income tax purposes) from gifting the home to their non-u.s. citizen spouse, especially if its value has increased substantially and there is an intention to sell it. For U.S. gift tax purposes the transfer of the home will be considered a taxable gift if the value exceeds the annual exclusion; however, the lifetime gift tax exemption may be used to minimize or eliminate U.S. gift tax. If the U.S. citizen dies subsequent to gifting the property, U.S. estate tax will not apply since the U.S. citizen spouse no longer owns the property. If the home is sold before the gift is made there may be no Canadian income tax on the capital gain if the property qualifies for the principal residence exemption. However, for U.S. income tax purposes, while there are similar rules that allow for an exclusion of the capital gain, different criteria must be met to qualify and the exclusion amount is subject to a limitation. Therefore, there may be income tax on the capital gain triggered if it is greater than the limitation. It is common for a U.S. citizen married to a non-u.s. citizen to elect to file their U.S. income tax return separately (i.e. selecting the filing status: married filing separate) because it requires only the U.S. citizen to file a U.S. return. Married filing separate tax filers qualify for an exclusion amount of up to US$250,000 of the capital gain triggered on the sale of a home that qualifies. If the capital gain on the sale exceeds this amount, the excess will be subject to U.S. income tax. Where the home is gifted before the sale and the capital gain exceeds US$250,000 the U.S. income tax saved is equal to the U.S. income tax rate on the excess capital gain. For example, a home that has increased in value by US$1 million dollars would result in U.S. income tax savings of approximately US$150,000 assuming a 20% long-term capital gains rate (i.e. proceeds of US$1 million less US$250,000 exclusion multiplied by 20%). These tax savings must be weighed against such costs as legal fees, potential land transfer tax and probate tax exposure resulting from sole ownership, as well as the U.S. gift tax that may be triggered. U.S. citizens should speak to their tax advisors regarding whether a particular rebalancing strategy makes sense. Concerns With Making Larger Gifts Since outright gifts received by your beneficiaries may be exposed to U.S. estate tax in their hands and you may not be comfortable with the idea of making larger outright gifts and giving up control of a significant portion of your wealth, you may consider making gifts to a Dynasty Trust. RBC WEALTH MANAGEMENT SERVICES 7

8 Dynasty Trust A Dynasty Trust (sometimes referred to as a Generation-Skipping Transfer Trust) is a special type of irrevocable trust that maximizes the amount of wealth that can be transferred from generation to generation without exposing it and any future growth to U.S. estate tax. It may also protect assets from uncontrolled spending by the beneficiaries, potential claims of beneficiaries creditors, and spouses (in the case of matrimonial disputes). Probate tax and estate administration delays may also be avoided where assets are transferred to a Dynasty Trust since you no longer own the assets. A Dynasty Trust can be created during your lifetime as an inter-vivos trust or upon your death as a testamentary trust by including provisions in your Will. To ensure U.S. estate tax protection, a beneficiary of the trust must not be given broad powers to access the trust assets. For example, a beneficiary cannot be given a general power of appointment. While assets that remain in the trust are protected from U.S. estate tax, income earned is still subject to U.S. income tax (taxable in the trust or in the beneficiaries hands as decided by the trustee). Note: While the tax rates of the trust or on the beneficiary s personal return are similar, the tax brackets for income taxed in the trust are much more compressed as compared to those on the beneficiary s personal income tax return. Dynasty Trusts are typically set up as U.S. trusts in order to avoid the Canadian 21-year deemed disposition rules that apply to Canadian trusts and the punitive U.S. tax rules known as the throw-back rules. In simplified terms, the throwback rules apply to U.S. beneficiaries of a foreign nongrantor trust where the trust does not distribute income earned annually to the beneficiaries (i.e. accumulates income). In general, a foreign nongrantor trust is a non-u.s. trust with U.S. beneficiaries where the settlor/ transferor of property (if still alive) is not a U.S. citizen and does not maintain significant control over the trust and the distribution of trust property to the beneficiaries. When the U.S. throw-back rules apply, accumulated income and capital gains distributed are taxed at the highest U.S. tax rate and an interest charge is calculated on the tax owed because U.S. tax was not paid during the period the income was accumulating in the trust. For Canadian tax purposes, appreciated assets transferred to a trust are generally subject to Canadian deemed disposition rules; therefore, any accrued capital gains will be triggered and subject to Canadian income tax. If you and your beneficiaries are residents of Canada, the Canadian income attribution rules will apply where distributions are made to minors or to a spouse. Furthermore, under Canadian tax rules regarding non-resident trusts, where the beneficiaries of a Dynasty Trust set up in the U.S. are residents of Canada, or a Canadian resident settlor transfers assets to the trust during their lifetime, the trust may be deemed to be a Canadian resident trust and may be subject to Canadian taxation and the 21-year deemed disposition rules. It is imperative that a Dynasty Trust be structured to take into account your specific circumstances. It must be structured properly by a qualified estate lawyer who has expertise in this area. Speak to your tax and legal advisor regarding the appropriateness of a Dynasty Trust and how to implement one in your estate planning. U.S. Citizens Funding a Dynasty Trust U.S. gift tax, estate tax or GSTT may be triggered on gifts or bequests made to a Dynasty Trust unless you can reduce or eliminate the tax through the use of your lifetime gift tax exemption or the annual gift tax exclusions. For example, for 2014 U.S. citizens can transfer US$5.34 million to a Dynasty Trust without triggering gift tax or GSTT by using their lifetime gift tax exemption. TIP: Using the exemption during your lifetime can maximize the amount of assets that are protected from U.S. estate tax. This is because any future growth of the assets while in the trust is also protected. If a U.S. citizen transfers assets to a Dynasty Trust upon their death after the assets have grown in value, the maximum that can be transferred is limited to their U.S. estate tax exemption. Any excess wealth including any growth will be exposed to U.S. estate tax and GSTT. Non-U.S. Citizens Funding a Dynasty Trust Non-U.S. citizens can fund a Dynasty Trust during their lifetime without incurring U.S. gift tax or GSTT (provided the assets gifted are not U.S. tangible property). They may also fund a Dynasty Trust through their Will. TIP: Where the beneficiaries reside in the U.S., there are benefits to funding a Dynasty Trust set up in the U.S. upon your death instead of during your lifetime. First, a testamentary Dynasty Trust resident in the U.S. will not be subject to the application of the Canadian non-resident trust rules that would deem a foreign trust with a Canadian resident contributor to be a Canadian resident trust. Second, the 21-year deemed disposition rules that 8 RBC WEALTH MANAGEMENT SERVICES

9 An ILIT that holds the policy may provide the best protection against U.S. estate tax exposure for U.S. and non-u.s. citizens that would otherwise result from owning the policy or having incidents of ownership. apply to Canadian resident trusts will not apply. Irrevocable Life Insurance Trust (ILIT) An Irrevocable Life Insurance Trust (ILIT) is an inter-vivos trust established to purchase or hold ownership of an insurance policy in order to minimize exposure to U.S. estate tax. U.S. estate tax exposure may otherwise result from purchasing or owning a life insurance policy outright or having incidents of ownership in the policy. Incidents of ownership may include having the ability to name or change beneficiaries, borrow against the policy, access the cash value and assign or cancel the policy. When a U.S. or non-u.s. person who is the life insured on a policy dies and they own the policy or have incidents of ownership in the policy, the death benefit paid must be included in their worldwide estate for purposes of determining U.S. estate tax (i.e. for a U.S. citizen the death benefit is subject to U.S. estate tax, and for a non-u.s. citizen it reduces the unified credit that can be claimed to reduce the U.S. estate tax liability). While it may be possible to reduce U.S. estate tax exposure by having a spouse or a corporation own the life insurance policy on the life insured, there can be issues with using such strategies. For example, if a spouse owns the policy and dies before the life insured dies, the policy will need to be transferred to someone else. Also, where the life insured is providing the spouse with the funds to facilitate the purchase of the policy, the life insured may be deemed to have incidents of ownership in the policy. When a corporation owns the policy there may be exposure to U.S. estate tax if the life insured has ownership in the corporation. For example, if the life insured is a U.S. citizen who owns more than 50% of the shares of the corporation, it is possible he/she will be considered to have incidents of ownership in the policy. Even where ownership in the corporation is less than 50%, the value of the life insured s shares that are subject to U.S. estate tax are increased by the proportionate amount of the death benefit paid to the corporation. An ILIT that holds the policy may provide the best protection against U.S. estate tax exposure for U.S. and non-u.s. citizens that would otherwise result from owning the policy or having incidents of ownership. However, the ILIT must be set up properly. The life insured cannot be the trustee of the ILIT or they will be considered to have incidents of ownership. Cash may be transferred to the ILIT in order to fund the purchase of the life insurance policy. The amounts a U.S. citizen contributes to the ILIT may be subject to U.S. gift tax or GSTT; however, tax-free gifts can be made by making gifts within the annual exclusions or by using your lifetime gift tax exemption. A non-u.s. citizen can fund the ILIT with an unlimited amount of assets without incurring U.S. gift tax or GSTT (provided the assets gifted are not U.S. tangible assets). Note: If you already own the policy, it is also possible to transfer it to the ILIT; but a transfer within three years of the life insured s death will result in the death benefit being included in their worldwide estate. When the death benefit is paid into the ILIT upon the life insured s death it can be accessed to pay for the estate tax or other tax liabilities by having the ILIT loan the funds to the estate, or to purchase estate assets. Other Issues to Consider For Canadian income tax purposes, the transfer of an existing life insurance policy to an ILIT will trigger a deemed disposition of the policy at fair market value resulting in Canadian taxation (gains are treated as ordinary income). Since an ILIT is established during your lifetime, the income splitting benefits that currently apply to Canadian testamentary insurance trusts are not available. (Note: the 2014 federal budget proposes to remove the income splitting benefits of testamentary trusts starting in 2016, with an exception for disabled individuals). RBC WEALTH MANAGEMENT SERVICES 9

10 There are ways to leverage the Dynasty Trust strategy to reduce exposure to U.S. estate tax even further by structuring an ILIT as a Dynasty Trust. Keep in mind that access to the cash surrender value and borrowing against the policy is not permitted. Therefore, an ILIT may not be appropriate if there is the potential the policy will be required for investment or retirement purposes. When a Canadian insurance policy is issued on the life of a U.S. citizen by a Canadian insurance provider, U.S. excise tax of 1% of the gross amount of the insurance premiums must be remitted to the U.S. Also, a Canadian insurance policy must meet the U.S. definition of a life insurance policy and must avoid the U.S. MEC (modified endowment contract) and the transfer for value rules in order to be considered an exempt policy under U.S. income tax laws. A discussion of these rules is beyond the scope of this article. You should contact a cross-border professional who can advise you on whether you should incorporate the use of life insurance in your estate planning and the implications for both U.S. and Canadian tax purposes. They will also help you evaluate whether a reduction of your exposure to U.S. estate tax using an ILIT out-weighs the costs of setting one up and the annual fees associated with maintaining it. Dynasty ILIT There are ways to leverage the Dynasty Trust strategy discussed earlier to reduce exposure to U.S. estate tax even further by structuring an ILIT as a Dynasty Trust. While reducing one s own exposure to U.S. estate tax, the Dynasty ILIT can provide inheritances to not only a spouse and children, but also to grandchildren and even greatgrandchildren to protect them and successive generations from U.S. estate tax. Canadian Qualified Testamentary Spousal Trust A Canadian qualified testamentary spousal trust is a special type of Canadian spousal trust established through your Will. It may be set up by U.S. or non-u.s. citizens in Canada for the benefit of a surviving spouse in order to take advantage of beneficial Canadian taxation. It may even be possible to protect the assets transferred in and future growth from U.S. estate tax on the death of the surviving spouse. For Canadian tax benefits, when structured properly there is an exemption from the Canadian deemed disposition rules that would otherwise apply when assets are transferred to a trust and every 21 years of the trust s existence. Currently, for testamentary trusts, Canadian income tax is based on graduated tax rates instead of the top marginal tax rate. However, the 2014 federal budget proposes to apply flat top-rate taxation to this type of trust starting in 2016, subject to certain exceptions for disabled individuals. U.S. citizens in Canada that incorporate the use of QDOTs, spousal trusts or CSTs to transfer assets to a surviving spouse to reduce their exposure to U.S. estate tax may be able to structure these trusts as Canadian qualified testamentary spousal trusts to take advantage of these Canadian tax benefits. To be considered a Canadian qualified testamentary spousal trust, the surviving spouse and the deceased spouse must both be Canadian residents immediately before death. All income earned in the trust during the surviving spouse s lifetime must be paid to the spouse, but the capital may be preserved for other beneficiaries 10 RBC WEALTH MANAGEMENT SERVICES

11 To protect the assets transferred to the trust and future growth from U.S. estate tax, access to the capital of the trust must be limited to payments for ascertainable standards for health, education, support and maintenance. (typically children or grandchildren) upon the death of the surviving spouse. It is possible to allow the surviving spouse to draw on the capital for emergencies or under specific circumstances, but this needs to be spelled out ahead of time. While it is possible to include children and grandchildren as beneficiaries of testamentary trusts along with the surviving spouse for purposes of protecting the assets from U.S. estate tax, the trust will not qualify as a Canadian qualified testamentary spousal trust. As a result, assets with accrued gains and losses that are transferred to the trust will be subject to the Canadian deemed disposition rules, which may trigger capital gains and losses on the transfer. In addition, the trust will be subject to a deemed disposition every 21 years. To protect the assets transferred to the trust and future growth from U.S. estate tax, access to the capital of the trust must be limited to payments for ascertainable standards for health, education, support and maintenance. In addition, U.S. estate tax may apply on the death of the first spouse since the marital credit or marital deduction cannot be claimed for assets transferred to the Canadian qualified testamentary spousal trust that is set-up to protect the surviving spouse from U.S. estate tax exposure. (Refer to Appendix 3 for an example of an estate plan for non-u.s. citizens using a qualified testamentary spousal trust to reduce the exposure to U.S. estate tax for their surviving U.S. citizen spouse). TIP: If a non-u.s. citizen is the first spouse to die and is subject to U.S. estate tax on death, the executor should consider whether it makes sense to elect to transfer U.S. situs assets to the Canadian qualified testamentary spousal trust at fair market value to trigger Canadian capital gains on the appreciated property. This will enable the executor to claim a foreign tax credit on the deceased s final Canadian income tax return for U.S. estate tax paid, which may result in a smaller capital gain upon disposition of these assets in the future. A Canadian qualified testamentary spousal trust may be appropriate where the intention is to have the income of the trust support the surviving spouse while they are alive but to preserve the capital of the trust for the benefit of children or grandchildren. The children and grandchildren cannot be beneficiaries of the trust but the capital of the trust will pass to them once the surviving spouse is deceased. The children and grandchildren may receive the capital of the trust outright or as beneficiaries of successive Canadian testamentary trusts. TIP: Where the beneficiaries (children and grandchildren) are U.S. citizens, a testamentary Dynasty Trust set up as a U.S. trust may be more appropriate than a Canadian testamentary trust. This is because U.S. beneficiaries of Canadian testamentary trusts may be subject to the adverse U.S. throw back rules (discussed earlier) if income earned in the trust is not distributed annually. While distributing income annually will avoid these punitive U.S. tax rules, the annual distributions may result in a payout that is larger than what the beneficiaries are able to use up during their lifetime, which may expose the excess assets to U.S. estate tax in the beneficiaries hands. Note: if the beneficiaries of a Dynasty Trust set up in the U.S. are residents of Canada, the Dynasty Trust may be deemed to be a Canadian resident trust under the Canadian non-resident trust rules notwithstanding the fact that it may also be considered a U.S. resident under U.S. tax laws. However, the nonresident trust rules allow foreign tax credits to be claimed in Canada for U.S. income tax paid, which may minimize the possibility of double taxation. Speak to a cross-border tax or legal professional regarding the RBC WEALTH MANAGEMENT SERVICES 11

12 When some of your family members are not U.S. citizens, the planning is more complex. appropriateness of using a Canadian qualified testamentary spousal trust in your estate planning. Charitable Donations Charitable donations during your lifetime or through your Will may reduce your exposure to U.S. estate tax. U.S. citizens can make charitable gifts (which are not subject to U.S. gift tax and reduce the amount of assets in their estate) or charitable bequests (which can be deducted in calculating their U.S. estate tax liability). The charitable gifts or bequests must be made to qualified U.S. or foreign charities. The same benefits may be achieved by non-u.s. citizens except they must make gifts or bequests of U.S. situs assets only and they can only be made to U.S. qualified charities. Note: Generally, for Canadian income tax purposes, a donation credit for gifts to U.S. qualified charities may only be claimed against U.S. source income. However, a donation credit for gifts made to a qualified university in the U.S. or to a U.S. charitable organization to which the Government of Canada has made a gift may be claimed against Canadian sources of income. Speak to a tax advisor for advice regarding implementing a charitable giving strategy and choosing charitable organizations that qualify for the donation tax credit. Foreign Account Tax Compliance Act (FATCA) U.S. citizens in Canada face a significant compliance burden. When they consider planning for their Canadian and U.S. estate needs, they may use non-u.s. based entities such as Canadian trusts which may increase their U.S. reporting obligations. The U.S. has recently enacted FATCA to improve tax compliance involving foreign financial assets and offshore accounts. Under FATCA, U.S. taxpayers living in Canada may be required to report ownership of foreign assets to the IRS. In addition, FATCA will require foreign financial institutions to report information to the Canada Revenue Agency related to certain financial accounts held by U.S. taxpayers, or held by foreign entities in which U.S. taxpayers hold a substantial ownership interest to avoid a 30% withholding tax on U.S. source income. Speak to a cross-border tax or legal advisor to discuss the reporting obligations that may result from owning foreign assets or including non-u.s. trusts in your estate planning. Planning for the Future Estate planning for U.S. citizens in Canada must take into consideration both Canadian and U.S. tax and estate laws. When some of your family members are not U.S. citizens, the planning is more complex. This article has presented some of the common cross-border estate, Will and trust planning strategies that may be considered in reducing one s exposure to U.S. estate tax. However, you should consult with a cross-border tax or legal professional to discuss the appropriateness of any of these strategies in meeting your estate planning needs. 12 RBC WEALTH MANAGEMENT SERVICES

13 Appendix 1 Both Spouses are U.S. Citizens The following diagram illustrates an example of a possible estate plan to reduce U.S. estate tax exposure for U.S. citizen spouses. On the death of the first spouse, the first US$5.34 million in assets is transferred to a Credit Shelter Trust (CST) with no U.S. estate tax liability for the deceased due to the deceased s U.S. estate tax exemption (i.e. the marital deduction cannot be claimed with a CST). The assets in the trust, and any future growth on them, are protected from U.S. estate tax for the surviving spouse. The remaining assets in the estate are transferred to the surviving spouse outright or to a spousal trust with no U.S. estate tax for the deceased due to the ability to claim an unlimited marital deduction. U.S. estate tax may apply upon the death of the surviving spouse. The transfer of assets to the CST or to the spousal trust is not subject to Canadian capital gains tax if these trusts qualify as Canadian qualified testamentary spousal trusts. On death of 1st U.S. citizen spouse * US$5.34 million is the U.S. estate tax exemption for deaths in RBC WEALTH MANAGEMENT SERVICES 13

14 Appendix 2 Only One Spouse is a U.S. Citizen and the U.S. Citizen Spouse Dies First The following diagram illustrates an example of an estate plan used by a U.S citizen spouse to minimize U.S. estate tax. The estate plan uses a Credit Shelter Trust (CST) to transfer the first US$5.34 million (2014 value) of assets using the deceased spouses U.S. estate tax exemption. The U.S. situs assets in the trust, and any future growth on them, are protected from U.S. estate tax for the surviving non-u.s. citizen spouse. The remaining assets in the estate may be transferred to the surviving non-u.s. citizen spouse directly or to a spousal trust using the marital credit. If the remaining assets are valued at US$5.2 million (this value is calculated based on the maximum 2014 U.S. unified credit divided by the maximum U.S. estate tax rate) or less, U.S. estate tax for the deceased may be eliminated by claiming the marital credit. U.S. estate tax may apply to U.S. situs property held directly or in the spousal trust upon the death of the surviving spouse. Alternatively, if the remaining assets are much greater than US$5.2 million, consider transferring the assets to a Qualified Domestic Trust (QDOT) instead, to defer U.S. estate tax for the deceased spouse until distributions are made or the surviving spouse dies. Note: if you use the marital credit you cannot use the QDOT. On death of 1st spouse (the U.S. citizen) * US$5.34 million is the U.S. estate tax exemption for deaths in RBC WEALTH MANAGEMENT SERVICES

15 Appendix 3 Only One Spouse is a U.S. Citizen and the U.S. Citizen Spouse Dies Last The following diagram illustrates an example of an estate plan used by a non-u.s. citizen spouse to minimize U.S. estate tax for a surviving U.S. citizen spouse by drafting their Will to create a Canadian qualified testamentary spousal trust. This strategy protects the surviving spouse from U.S. estate tax exposure while enjoying the income tax benefits associated with transferring assets to a Canadian qualified testamentary spousal trust (i.e. rollover of assets to the trust at cost, no deemed disposition every 21 years, and tax on income at graduated tax rates). However, U.S. estate tax may apply on the death of the first spouse since the marital deduction cannot be claimed. Note: The 2014 federal budget proposes to eliminate the income splitting benefits of testamentary trusts starting in 2016 (subject to certain exceptions for disabled individuals) by applying flat top-rate taxation on income earned instead of graduated tax rates. On death of 1st spouse (the non-u.s. citizen) * U.S. situs assets may be subject to U.S. estate tax since the estate cannot claim the unlimited marital deduction. Note: In general, the Canadian qualified testamentary spousal trust strategy may be used by either U.S. or non-u.s. citizens to transfer assets to a surviving spouse who is a U.S. citizen or non-u.s. citizen to protect the assets and future growth from U.S. estate tax while enjoying Canadian income tax benefits. RBC WEALTH MANAGEMENT SERVICES 15

16 Please contact us for more information about the topics discussed in this article. This document has been prepared for use by the RBC Wealth Management member companies, RBC Dominion Securities Inc. (RBC DS)*, RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC), RBC Global Asset Management Inc. (RBC GAM), Royal Trust Corporation of Canada and The Royal Trust Company (collectively, the Companies ) and their affiliates, RBC Direct Investing Inc. (RBC DI) *, RBC Wealth Management Financial Services Inc. (RBC WM FS) and Royal Mutual Funds Inc. (RMFI). Each of the Companies, their affiliates and the Royal Bank of Canada are separate corporate entities which are affiliated. *Members-Canadian Investor Protection Fund. RBC advisor refers to Private Bankers who are employees of Royal Bank of Canada and mutual fund representatives of RMFI, Investment Counsellors who are employees of RBC PH&N IC and the private client division of RBC GAM, Senior Trust Advisors and Trust Officers who are employees of The Royal Trust Company or Royal Trust Corporation of Canada, or Investment Advisors who are employees of RBC DS. In Quebec, financial planning services are provided by RMFI or RBC WM FS and each is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RMFI, Royal Trust Corporation of Canada, The Royal Trust Company, or RBC DS. Estate & Trust Services are provided by Royal Trust Corporation of Canada and The Royal Trust Company. If specific products or services are not offered by one of the Companies or RMFI, clients may request a referral to another RBC partner. Insurance products are offered through RBC WM FS, a subsidiary of RBC DS. When providing life insurance products in all provinces except Quebec, Investment Advisors are acting as Insurance Representatives of RBC WM FS. In Quebec, Investment Advisors are acting as Financial Security Advisors of RBC WM FS. The strategies, advice and technical content in this publication are provided for the general guidance and benefit of our clients, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. This publication is not intended as nor does it constitute tax or legal advice. Readers should consult a qualified legal, tax or other professional advisor when planning to implement a strategy. This will ensure that their individual circumstances have been considered properly and that action is taken on the latest available information. Interest rates, market conditions, tax rules, and other investment factors are subject to change. This information is not investment advice and should only be used in conjunction with a discussion with your RBC advisor. None of the Companies, RMFI, RBC WM FS, RBC DI, Royal Bank of Canada or any of its affiliates or any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. Registered trademarks of Royal Bank of Canada. Used under license Royal Bank of Canada. All rights reserved. NAV0130-EN (04/2014)

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