Our prior posts in this series gave an overview of the government’s consultation paper, and outlined the paper’s proposals to limit the lifetime capital gains exemption and to limit income splitting. This post will focus on some ways in which the proposals are expected to have consequences for trusts and estates.
Fewer tax incentives for family trusts
It is common for shares in closely-held private companies to be held through discretionary family trusts. In the typical structure, the trustee holds the shares and has complete discretion to allocate income (such as dividends received on the shares) or capital (including proceeds of disposition of the shares) between the various beneficiaries. Family trusts can provide a number of tax and non-tax benefits; the government’s proposal eliminates two of the main tax advantages while leaving other tax and non-tax benefits intact.
The two widely-used tax benefits of family trusts that would be eliminated by the proposals if enacted as proposed are:
- Multiplication of Lifetime Capital Gains Exemption. It has been possible for beneficiaries of a family trust to claim their lifetime capital gains exemption on a capital gain realized by the trust on a disposition of the shares, to the extent the trustees distributed a sufficient portion of the proceeds to the beneficiary. The proposals will disallow this planning as the exemption will no longer be available for shares held in discretionary family trusts. The exemption will also be disallowed on the gain accrued while the shares are held in a trust, even if the shares are distributed to a beneficiary and disposed of by the beneficiary.
- Income Splitting. Dividend and interest income received by a family trust and paid (or made payable) to beneficiaries has been subject to tax in the hands of the beneficiaries as though the income had been paid to them directly, meaning at their applicable marginal tax rates. The consultation paper proposals would instead review each corporate distribution received by a beneficiary to see if the beneficiary is related to a “connected person” having influence over the corporation. If they are, and the income does not pass the “reasonableness test”, the income will be taxed in the beneficiary’s hands at the highest marginal tax rate.
Benefits of family trusts that should not be impacted by the proposals include the following:
- Deferral of capital gains. An owner of a business company can reorganize its shares to cause the company’s future growth to accrue to shares held by a trust. Although the trust would be required to recognize unrealized gains on its property every 21 years, the trustees prior to that anniversary can transfer the shares having the accrued gain out to any of the beneficiaries on a tax-deferred basis. This can allow the owner to shift the gains to a younger generation, reducing the owner’s exposure to capital gains tax on his or her own death.
- Protection of assets. Property held in a discretionary trust remains subject to the trustee’s exercise of discretion and therefore is typically not subject to claims of creditors and others against the beneficiaries.
- Estate planning. Property held in a discretionary trust is not part of the owner’s legal estate. As such it is not subject to probate (and probate fees) on the owner’s death, and is not at risk of wills variation or other claims against the owner’s estate.
Income splitting rules in the estate context
A prior post in our series described how the consultation paper proposes that dividends, gains and other taxable income paid to shareholders who are related to “connected persons” will in some circumstances be subject to “tax on split income” at the highest marginal rate. If the income is not considered “reasonable” in light of all of the shareholder’s contributions to the corporation, it will be deemed to be subject to the additional tax.
The income splitting proposals contain a number of special rules for income splitting in the context of estates:
- income on shares and other property received by a beneficiary under the age of 24 from the estate of their deceased parent will not be taxed as split income;
- income on shares and other property received by a beneficiary under the age of 24 from any person’s estate will not be taxed as split income if the beneficiary is a full-time post-secondary student or a person entitled to the disability tax credit;
- for the purpose of the reasonableness test, when a beneficiary receives shares from the estate of a deceased shareholder, the beneficiary is deemed to have made all of the same contributions to the business that the deceased shareholder made.
It is interesting to note that the proposals may in some circumstances provide a tax incentive to leaving shares to children and other relatives under a person’s will, rather than in a trust.
Pipeline planning in jeopardy?
The proposed new anti-avoidance provision in proposed section 246.1 (introduced in our prior post) which was intended to address aggressive tax planning that converted taxable dividends into lower-taxed capital gains, may also impact planning techniques commonly used to prevent unfair double taxation after the death of a shareholder. On death, the shareholder is deemed to have disposed of shares at their fair market value, so that accrued capital gains to the date of death are realized and subject to tax. However, the shareholder’s estate is subject to tax again if funds or property is withdrawn from the company. One way to prevent double taxation involves selling the shares to another corporation taking a promissory note back as consideration. The note creates a “pipeline” allowing corporate assets to be withdrawn without paying tax a second time.
While it is not clear that the new anti-avoidance provision was intended to prevent this type of planning, its wording as proposed probably does. If estates cannot use pipeline planning any longer, the only option left to prevent double tax will be more restrictive loss carryback planning which involves repurchasing shares within one year of death – a step that is not possible or practical in many circumstances.