In Canada we do not have an estate tax. Rather, when an individual dies the individual is deemed to have disposed of his or her capital property immediately before death at fair market value. The deemed disposition triggers the realization of any accrued but unrealized capital gains. As a result, the income tax liability in the year of death may be higher, sometimes significantly higher, than in prior years.
One tool for managing the income tax liability in the year of death is to transfer property to a spouse or to a qualifying spousal trust. The transfer occurs on a “rollover” basis, such that the income tax liability that would otherwise arise as a result of the deemed disposition is deferred until the spouse or the trustees of the qualifying spousal trust, as the case may be, dispose of the property, or the spouse dies.
Charitable gifts represent another tool to manage the income tax liability arising in the year of death, in addition to achieving an individual’s philanthropic objectives. For example, if an individual dies and her will directs her executors to pay a legacy of $100,000 to a registered charity in Canada, then provided the legacy is paid within 60 months of the individual’s death, the donation tax credit that arises as a result of the gift can be carried back and applied to the year of death, among other years.
What happens if a charitable gift is made by an alter ego trust rather than an estate? This question is becoming increasingly important as the use of alter ego trusts increases.
If an individual (the “settlor”) is 65 years of age or older, she can transfer property to an alter ego trust on a rollover basis. The settlor must receive all of the income from the trust that arises during her lifetime, and only the settlor can have the use or benefit of the capital of the trust during the settlor’s lifetime. When the settlor dies there is a deemed disposition of the capital property in the trust and a deemed year-end for tax purposes. Any tax liability arising as a result of the deemed disposition is a liability of the trust. Can charitable gifts be used to reduce the income tax liability arising in the trust as a result of the deemed disposition?
An alter ego trust cannot make a charitable gift during the lifetime of the settlor, since that would violate the rules set out above regarding the use of the income and capital of an alter ego trust during the lifetime of the settlor. In 2015, when the rules for testamentary charitable gifts were significantly amended, specific amendments were introduced to permit the donation tax credit arising from a charitable gift by an alter ego trust after the death of the settlor to be applied to the deemed year-end (i.e. the taxation year where the deemed disposition occurs), provided the gift is made no later than 90 days following the end of the calendar year in which the settlor dies.
However, the word “gift” is crucially important here. To qualify for the donation tax credit, a transfer of property to a charity from a trust (like all charitable gifts) must qualify as a “gift” at law, and that will not be the case with every payment or transfer of property from a trust. The Canada Revenue Agency recently reiterated this point at the Round Table that was held as part of the Society of Trust and Estates Practitioners National Conference in Toronto. To qualify as a gift at law there must be “donative intent”, a voluntary transfer of property owned by the donor to the donee, and there can be no consideration for the transfer. If the payment to a charity is mandatory (i.e. no trustee discretion), for example if the payment is made to the charity as a remainder beneficiary of the trust, the CRA does not consider the payment to be a gift, as the payment is not voluntary. To qualify as a gift, the payment must be made at the discretion of the trustees pursuant to a discretionary power to make a charitable gift. This requires careful drafting in the trust instrument.
The rules for testamentary charitable gifts are complex, and the technical requirements to make a gift from an alter ego trust, in a manner that qualifies for the donation tax credit, even more so. This blog is not a comprehensive overview of the rules. If charitable gifting is part of your estate plan, it is important to obtain professional advice to ensure you achieve your desired goals, both philanthropic and financial.