Please follow my thought process:
We know that if a person buys an asset for $1 and sells it years later for $3, they will need to pay capital gains tax on the $2 profit.
We also know that if instead of selling the asset for $3, the person passes away when the asset is worth $3 (FMV) and it is transferred to a beneficiary from his will, the asset is “deemed disposed.” This means the estate would be liable for capital gains tax on the $2 increase in value. This is why, as mentioned in the first article of this series, CRA is often the “first beneficiary” when someone dies.
However, if at the time of death, the asset valued at $3 is transferred to the beneficiary at its original purchase price of $1, no tax is payable by the estate. This is the #1 powerful tax-deferral tool known as the rollover.
This article will briefly introduce rollover in five key aspects:
- In Canada’s tax system, the transfer of property between spouses generally does not trigger a capital gains tax. This is crucial because when someone passes away, their property can be transferred to the surviving spouse, and the rollover is “automatic,” meaning no taxes are owed to the CRA at that point. The ITA provides that there is no taxable deemed disposition if:
- The property is transferred outright to the spouse, or
- It is an intergenerational transfer of farm or fishing property.
- In such cases, the transferee (the surviving spouse) is considered to have acquired the property at the deceased’s tax cost, which results in a deferral of the capital gains tax. If the deceased taxpayer was a Canadian tax resident, non-depreciable property transferred to the surviving spouse becomes indefeasibly vested within 36 months of the death. Simply put, this means the rollover to the spouse occurs automatically, so no deemed realization of capital gains takes place.
- “Indefeasibly vested” means that the spouse must hold absolute ownership of the property, with no possibility of that ownership being revoked.
- The rollover happens automatically if the spouses were legally married. For tax purposes, the rollover is treated as a non-taxable event upon the taxpayer’s death. This provision also extends to common-law spouses, but only in limited circumstances. So Who qualifies as a common-law spouse?
- A common-law spouse is someone who has cohabited with the taxpayer in a conjugal relationship for at least 12 months or shares a child with the taxpayer.
- However, unlike legally married spouses, common-law spouses do not benefit from the automatic rollover. Instead, they need to seek a court order to be entitled to the rollover tax benefit. In such cases, the CRA can extend the rollover to capital property pursuant to the court’s order.
s.248(1) of ITA provides the definition of “common law spouse”:
common-law partner, with respect to a taxpayer at any time, means a person who cohabits at that time in a conjugal relationship with the taxpayer and
- has so cohabited throughout the 12-month period that ends at that time, or
- would be the parent of a child of whom the taxpayer is a parent, if this Act were read without reference to paragraphs 252(1)(c) and (e) and subparagraph 252(2)(a)(iii)
Transferring part of the deceased’s estate into a Qualifying Spousal Trust (QST) is one of the most effective tax-deferral strategies. For a more detailed explanation of QSTs, please refer to the blog series on “trusts” available on this website.
So, what are the conditions for transferring an estate into a QST for tax-saving purposes?
- The beneficiary spouse must be entitled to all income generated by the trust until their death, meaning the spouse must receive all income from the trust during their lifetime.
- However, it is not mandatory for the spouse to receive any of the capital from the trust. If trustees have the discretion to encroach on the capital, they can only exercise that discretion in favour of the spouse while the spouse is alive.
- No other person can benefit from the income or capital of the trust during the spouse’s lifetime, for example, a clause stating, “If the surviving spouse remarries, the trust property flows to a third party,” would disqualify the trust from being a QST.
In essence, the testator cannot impose many restrictions on income distribution in a testamentary spousal trust without “tainting” the trust. Is there a workaround for this? Yes, the testator can create two trusts:
- A QST, plus
- Another tainted Spousal Trust, which may be better referred to as a “family trust”, and give the Estate Trustee full discretion to allocate assets between the two trusts.
This approach is so far accepted by the CRA (see CRA’s Income Tax Folio S6-F4-C1). However, it is unclear whether the CRA allows the Estate Trustee to solely determine the relative values of the two trusts. On the other hand, Ontario’s provincial law, as noted in Re Nicholls [1987], would allow this discretion.
Additionally, there are two relief provisions under the ITA for a “tainted” spousal trust:
An otherwise qualifying spousal trust is deemed not to be tainted if it provides only for the payment of any estate or income taxes with respect to the trust property (s. 108(4) ITA).
If the trust is otherwise tainted only because it provides for the payment of other specified debts, it sets out a procedure for “cleansing” the trust by allowing assets comprising part of the trust having sufficient value to pay those debts to be regarded as having been disposed of at fair market value and by allowing the remaining assets to be rolled over.
After all, after a property is transferred into a QST, it becomes taxable when the property is disposed of eventually.
Under s.70(6.2) ITA, it is possible to elect that assets be subject to the deemed disposition rule even if a spousal rollover is available. Why does the estate want to do so? It could be the reasons of:
- An estate may wish to take this measure where it will have none or little negative impact on the deceased spouse, for example, the deceased spouse may have unused losses, or
- There may be positive impact (eventually) on the surviving spouse by increasing the surviving spouse’s cost base.
The election can be some, but not all, of the deceased’s assets.
An intergenerational transfer of farm or fishing property allows qualifying farm or fishing assets to be transferred from one generation to the next on a tax-deferred rollover basis. This can help defer capital gains taxes that would otherwise be triggered at the time of the owner’s death, provided that specific conditions under the Income Tax Act (ITA) are met. Key aspects include:
- 36-Month Indefeasible Vesting Rule
- To qualify for the rollover, the property must vest indefeasibly in the hands of the child within 36 months of the taxpayer’s death.
“Indefeasibly vested” means the child must have full, guaranteed ownership of the property, with no conditions that could revoke or undo this right. If more time is needed to meet this condition, a written request for an extension can be made to the CRA.
- To qualify for the rollover, the property must vest indefeasibly in the hands of the child within 36 months of the taxpayer’s death.
- Eligible Properties
- Assets that qualify for this tax-deferred transfer include:
- Land used in a farming or fishing business
- Depreciable property, such as buildings and equipment, used primarily in the farm or fishing operation
- Shares in a family farm or fishing corporation
- Interest in a family farm or fishing partnership
- Assets that qualify for this tax-deferred transfer include:
- Conditions for the Transfer:
- The property must have been used principally in a farming or fishing business conducted in Canada.
- The child receiving the property must have been a resident of Canada immediately before the taxpayer’s death.
- The property transferred must be “locked in” for the child within the 36-month period.
- Limitations
- Farm inventory, for example, does not qualify for this rollover and must be transferred at fair market value (FMV), potentially triggering a tax liability.
- Anti-Avoidance Provisions
- If the farm or fishing property is sold within three years of the transfer, and one of the main purposes of the transfer was to benefit from tax deductions such as the capital gains exemption, the rollover may be retroactively denied.
When someone passes away with an RRSP that hasn’t been fully withdrawn or used, this is a common scenario. So, how can the unused RRSP be handled?
- Rollover Options – If the surviving spouse is named as the direct beneficiary of the RRSP, the entire RRSP balance is treated as the spouse’s income. In this case, the surviving spouse has two options:
- Include the RRSP in the spouse’s taxable income
- This means the spouse will need to pay income tax on the full value of the RRSP, which could result in a significant tax bill since the RRSP amount would be considered part of their income for that year.
- Transfer (to “roll”) the RRSP into their own RRSP
- A more common option is for the surviving spouse to transfer the RRSP balance into their own RRSP, effectively deferring the taxes. However, the transfer must be made in the same year that the RRSP proceeds are received to maintain the tax-deferral benefit.
- Include the RRSP in the spouse’s taxable income
- RRSP in the Estate:
- If the RRSP proceeds go into the estate, the estate and the spouse can jointly elect to have the RRSP amounts considered as received by the spouse for tax deferral purposes.
- To do this, the spouse must have a substantial beneficial interest in the estate, meaning it’s reasonable to allocate all payments from the RRSP to the spouse
- Alternative Treatment for Financially Dependent Children or Grandchildren:
- In cases where the RRSP proceeds are paid to a financially dependent child or grandchild of the deceased, the amount will be included in the recipient’s income.
- If the child or grandchild is under 18, they can use the proceeds to purchase an annuity that will provide payments until they turn 18.
- Taxation Caution:
- A testator should be cautious when designating their RRSP as a gift, as significant tax implications can arise after their death. It’s important to note that plan administrators are not required to withhold taxes on payments made from an RRSP following the plan holder’s death, which could lead to unexpected tax consequences for the estate or beneficiaries.
Important Notice:
This blog series provides readers with a basic and general understanding of estate tax issues. If you encounter estate tax matters in your personal situation, it is crucial to consult with your lawyer or accountant. As always, it’s better to leave professional matters to the professionals.