As a result of changes to the law over the last several years, such as increased reporting requirements during the probate process, the loss of graduate rate taxation for most testamentary trusts, and restrictions on the ability of most trusts to use the principal residence exemption, alter ego trusts may be used more frequently, either to take advantage of a benefit (e.g. the principal residence exemption) or because a former disadvantage in comparison to testamentary trusts has been eliminated (i.e. top rate taxation versus graduated taxation).

The basic requirements for an alter ego trust can be stated simply enough. The settlor must be age 65 or older, the settlor and the trust must be resident in Canada, the trust must be an inter vivos trust created after 1999, the settlor must be entitled to receive all of the income that arises during the settlor’s lifetime, and no person other than the settlor can receive or otherwise obtain the use of the income or capital of the trust while the settlor is alive. There are, however, potential tax traps. One such trap relates to the deemed disposition that occurs on the death of the settlor.

If the requirements for an alter ego trust set out above are met, the settlor can transfer property to the trust on a rollover basis pursuant to subsection 73(1) of the Income Tax Act (“ITA”). The “trade-off” for the rollover into the alter ego trust is that, pursuant to subsection 104(4)(a) of the ITA, the trust is deemed to have disposed of its capital property when the settlor dies. I was recently asked whether the tax that would otherwise arise as a result of the deemed disposition can be deferred if the terms of the alter ego trust provide that the capital is to be transferred to the settlor’s spouse when the settlor dies.

The “spousal rollover” on the death of taxpayer is set out in subsection 70(6) of the ITA. That subsection provides for the tax-deferred rollover of property to a surviving spouse or a testamentary spousal trust in respect of property “of a taxpayer” that is property “to which subsection (5) would otherwise apply”. Subsection 70(5) provides for the deemed disposition of capital property “of a taxpayer” when the taxpayer dies. While it is true that the settlor of an alter ego trust has a capital interest in the trust, the settlor does not own the actual property held in the alter ego trust. Although the deemed disposition of the property in the alter ego trust occurs on and as a consequence of the death of the settlor, the property in the alter ego trust is deemed to be disposed of pursuant to subsection 104(4)(a) of the ITA; it is not property “of the settlor” that is deemed to be disposed of pursuant to subsection 70(5). Accordingly, the spousal rollover in subsection 70(6) will not apply to a transfer of the property held in the alter ego trust to the spouse of the settlor.

This is consistent with the scheme of the ITA for life interest trusts (of which an alter ego trust is one category) that the tax arising on the deemed disposition of the relevant life interest beneficiary is to be a liability of the life interest trust.[1] While a trust can generally deduct from its income amounts that are paid or payable to a beneficiary, subsection 104(6)(b) prevents life interest trusts from deducting the income tax arising on the deemed disposition of its capital property.

If an alter ego trust is being considered but there is an intention to defer income tax on deemed capital gains until the death of the second of the settlor and the settlor’s spouse to die, a joint spousal or joint common-law partner trust is the appropriate vehicle, provided of course the requirements under the ITA for such a trust are satisfied and the trust meets any non-tax objectives in establishing a trust structure. In a joint spousal or joint common-law partner trust, the deemed disposition will arise on the death of the second of the settlor and the settlor’s spouse or common-law partner to die. This is one tax problem that will have a simple solution in many cases!

[1]       This is subject to a very narrow exception in subsection 104(13.4)(b.1) for testamentary spousal trusts.