All About Estates

The Principal Residence Exemption and Trusts for Disabled Persons Revisited

In 2016, the federal government introduced changes to the definition of “principal residence” in the Income Tax Act (Canada). The changes significantly restricted the types of personal trusts that are eligible to claim the principal residence exemption (“PRE”).

As a result of the changes, only three categories of personal trusts are eligible to use the PRE:

  • life interest trusts, i.e. alter ego trusts, joint partner trusts, spousal trusts, and self-benefit trusts;
  • a qualified disability trust (“QDT”) where the beneficiary who is eligible for the disability tax credit is the spouse, former spouse, or child of the settlor; and
  • a trust settled by a parent for a minor child if both parents are deceased at the beginning of the year, or a testamentary trust for a minor child that arose as a consequence of the death of one parent before the beginning of the year.

The concept of a QDT was first introduced in the 2014 federal budget as one of two exceptions to the elimination of graduated rate taxation for income accumulated in a testamentary trust, the other exception being the “graduated rate estate” (“GRE”). Other than QDT’s and GRE’s, effective from 2016 onward income accumulated in a testamentary trust is taxed at the highest marginal rate, in the same way as income accumulated in an inter vivos trust.

As currently defined, a QDT can only be testamentary. This means that inter vivos trusts settled to hold a principal residence for a disabled beneficiary, which may have been eligible to use the PRE under the old rules, are no longer eligible to use the PRE for taxation years after 2016.[1] This could result in a significant, and certainly unexpected, income tax liability on the 21st anniversary of such trusts, when the trust is deemed to have disposed of its capital property. If there is insufficient liquidity in the trust, the consequences for the disabled beneficiary could be severe.

The Department of Finance recently issued a comfort letter confirming an intention to recommend legislative changes to the Minister of Finance to address the potential unfairness.[2] The recommended changes are to permit inter vivos  trusts that meet the following conditions (in addition to the general PRE conditions) to claim the PRE:

  • a Canadian resident beneficiary is eligible for the disability tax credit;
  • that beneficiary is the spouse, former spouse, or child of the settlor; and
  • no person other than that beneficiary may receive or otherwise obtain the use of the income or capital of the trust during the beneficiary’s lifetime.

The third condition is potentially problematic in jurisdictions such as Ontario if the trust is also a Henson trust that is intended to preserve eligibility for Ontario Disability Support Program (“ODSP”) benefits. Henson trusts typically include a class of income beneficiaries. That way, when income can no longer be accumulated in the trust after the 21st anniversary, any income that exceeds the annual ODSP limits for trust distributions can be distributed to someone other than the ODSP recipient. If the trust contains both a principal residence and income-producing assets, or if the principal residence is sold and a portion of the proceeds invested, the income restrictions in the proposed changes may be problematic.

If the changes recommended by the Department of Finance are implemented (the comfort letter does not guarantee they will be), the interaction between the ODSP rules and the PRE rules will need to be carefully considered at the planning stage. Nevertheless, the proposed changes are a very welcome development and it is hoped that the Department’s recommendation will be positively received by the Minister.

[1]       Unless the trust qualifies under one of the other categories of eligible trusts.

[2]       See for reference https://www.nortonrosefulbright.com/en-ca/knowledge/publications/6dc67c60/principal-residence-trusts-for-disabled-persons

About Darren Lund
Darren Lund is a member of the Trust, Wills, Estates and Charities at Fasken, Toronto office. Darren has expertise in a broad range of estate planning matters, including multiple wills, inter vivos trusts, disability planning, estate freezing, and planning for beneficiaries and assets outside Canada. Darren advises trustees and beneficiaries on all aspects of estate administration, both contentious and non-contentious, and his experience includes passing of fiduciary accounts, trust variations, post-mortem tax planning, and administering the Canadian estates of non-residents. He also speaks and writes on a variety of related topics such as estate planning for spouses and couples, inheriting overseas property and estate planning for persons with disabilities. He previously practised estates law at a large national law firm. Email: dlund@fasken.com

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