On death you might say that Canada is a tax haven. Unlike our neighbours south of the 49th parallel, we are not subject to an estate or inheritance tax on death. We are, however, subject to an income tax which while still a tax, is generally less than an estate or inheritance tax.
In Canada when a taxpayer dies, s/he is generally deemed to have disposed of his or her capital property immediately before death for proceeds equal to its fair market value. To the extent the capital property has an accrued capital gain, this gain will be deemed realized and income taxes will be owing. However, if the capital property is distributed to the deceased taxpayer’s surviving spouse or to a spousal trust, a tax-deferral – or rollover – is available until the property is sold or the death of the surviving spouse.
To qualify for the rollover provided by a spousal trust, the terms of the trust must meet certain conditions. Among them are two that can often present challenges. First, the spouse must be entitled to receive all of the income of the trust that arises before the spouse’s death. Second, no person except the spouse may, before the spouse’s death, receive or otherwise obtain the use of any of the income or capital of the trust. It is the latter condition that practitioners and trustees must be cautious about with certain assets.
It is not uncommon for one spouse to own a life insurance policy on the life of the other spouse or on their joint lives (the “Owning Spouse”). In many situations the purpose of the insurance is to ensure a pool of liquid assets exist to fund the tax liability that will arise on the surviving spouse’s death. The strategy is quite common where other property owned by the Owning Spouse is illiquid, such as a family cottage. It is also quite common where one spouse is a US citizen but Canadian resident and the other is a Canadian citizen/resident. To manage the US estate tax liability of the US citizen spouse, typically the goal would be to avoid the US citizen spouse owning a life insurance policy on his or her life.
Ideally, all of the premiums of the life insurance policy owned by the Owning Spouse would be fully funded prior to his or her death. This may, however, not be the case. The issue then arises as to the satisfaction of those premiums after the Owning Spouse’s death. This is of particular concern where the Owning Spouse intends for the life insurance policy, as well as his or her other property, to be held in a spousal trust during the surviving spouse’s lifetime.
Over the last few years CRA has been asked to comment on whether the use of income or capital of an intended qualifying spousal trust to pay the premiums of a policy on the surviving spouse’s life would result in the trust not qualifying for the rollover. See Technical Interpretations 2014-0529361E5 (November 16, 2015) and 2012-0435681C6 (May 8, 2012). On each occasion CRA has responded that the trust would not qualify for the rollover because the trust would not meet the conditions of a spousal trust. In particular, it is CRA’s view that if the trust pays for the policy premiums, then someone other than the spouse would obtain the use of trust capital or income. The rationale being that the sole purpose of the payment of insurance premiums is to establish and maintain the rights of the ultimate beneficiaries to receive the insurance proceeds after the spouse’s death. Accordingly, the premium payments, with income or capital of the spousal trust, would be for the benefit of the ultimate beneficiaries and not the surviving spouse.
It is difficult to accept the CRA’s rationale, as it may also be argued that certain expenditures made by the trustees of a spousal trust that are to maintain (or replace) the capital property of a spousal trust are ostensibly for the benefit of the ultimate beneficiaries. Consider expenditures that are of a capital nature that relate to preserving a house or cottage for the benefit of the ultimate beneficiaries. The replacement of a roof, for example. Would the legal requirement to fund those expenses result in the trust not qualifying as a spousal trust. Similarly, consider the requirement for the trustees to acquire insurance to ensure a home or cottage could be replaced in the event of a fire. While CRA does not consider these expenditures to be analogous to the payment of life insurance premiums, it is difficult to see the policy distinction.
In any event, given the significant tax consequence if the terms of a trust do not meet the conditions of a spousal trust, it is important that those drafting and planning for the use of spousal trusts are aware of CRA’s interpretations with respect to the conditions for a trust to qualify as a spousal trust.