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Barry N. Segal*

Avoiding probate has long been a key consideration in developing estate plans for individuals and their families. The reason for this is simple: the estate of a deceased person in Ontario must pay a tax under the Estates Administration Tax Act, 1998 1 at a rate of 0.5% of the gross value of the estate below $50,000 and 1.5% of the gross value of the estate in excess of $50,000. An estate worth $5 million would thus be required to pay $74,500 in probate tax. This tax is not ordinarily deductible to the estate in computing its income.

It is therefore not surprising that many substitutes to the traditional disposition of property through a will have been developed for the purpose of avoiding probate tax. The most common of these include making inter vivos gifts of property and transferring property into joint ownership. However, both of these methods can result in a deemed disposition of the transferred property at fair market value and may therefore create an unwanted immediate income tax liability. They may also create unwanted issues regarding ownership. Another popular technique is the use of a "multiple wills" strategy - one will to deal with assets for which probate is generally required (i.e. bank accounts and portfolio investments) and a second will covering assets that can be dealt with by the estate trustee without seeking probate (i.e. private company shares). The value of the assets covered by the second will are not included in the calculation of the value of the estate for probate tax purposes.

Recent amendments to the Income Tax Act 2 have introduced two types of trust that offer estate planners a new alternative to the customary techniques for avoiding probate taxes. The "alter ego trust" and the "joint spousal or common-law partner trust" (referred to in this article as a "joint partner trust"3) should prove to be simple and effective tools for avoiding probate taxes, without many of the disadvantages associated with other will substitutes.

This article canvasses certain of the rules governing these trusts and discusses both tax and non-tax implications of their use.

Alter Ego Trusts and Joint Partner Trusts

Trusts Defined

An alter ego trust is an inter vivos trust created after 1999 by a taxpayer who had attained 65 years of age at the time the trust was created 4, and which provides that (i) the taxpayer is entitled to receive all of the income of the trust arising before the taxpayer's death, and (ii) no person except the taxpayer can, before the taxpayer's death, receive or otherwise obtain the use of any of the income or capital of the trust.

Similarly, a joint partner trust is a trust created after 1999 by a taxpayer who had attained 65 years of age at the time the trust was created, and which provides that (i) the taxpayer, in combination with the taxpayer's spouse or common law partner, is entitled to receive all of the income of the trust that arose before the later of the taxpayer's death and the death of the taxpayer's spouse or common law partner, and (ii) no other person can, before the later of those deaths, receive or otherwise obtain the use of any of the income or capital of the trust.

No limits have been imposed on who may benefit from the trust's income or capital following the death of the settlor (in an alter ego trust) or the surviving spouse or partner (in a joint partner trust). The ultimate beneficiaries of the trust's property can thus be selected by the settlor as though the trust deed were the settlor's will.

The taxation of these trusts reflects the fact that the trust property essentially belongs to the settlor or the spouse/partner until he or she dies. Thus, as is described below, the settlor is not taxed at the time the property is transferred to the trust but is taxed on all of the income or capital gains of the trust during his or her lifetime.

Avoiding Probate

Property that is transferred to an alter ego trust or a joint partner trust is not included in the computation of a deceased transferor's estate for probate tax purposes. If the individual transfers all of his or her property to the trust (including any property acquired after the trust is established), there should be no property at all in the estate that would require probate. In case after-acquired property inadvertently does not become subject to the trust, the individual could execute a simple will to prevent an intestacy with respect to such property. Any property governed by the will could be bequeathed in the same manner and at the same time as property that passes under the trust. The trustees of the trust could also serve as estate trustees under the will. Depending on the nature of the property, there may be no need to probate the will and the cost of administering it should be negligible. If it is deemed necessary to obtain probate, the probate tax will be based only on those assets not governed by the trust. If a third party (i.e., a bank) thinks it necessary that the transfer of title by the trustees of the trust to the beneficiaries be ratified by an individual's estate trustees, the estate trustees (with or without probate) should be in a position to provide any necessary comfort for the purpose of confirming a transfer of title to the property.

Certain Tax Aspects of Alter Ego Trusts and Joint Partner Trusts

Rollover of Property into the Trust

Ordinarily, an inter vivos transfer of property to a non-spousal trust is deemed to be a disposition by the transferor and an acquisition by the trust at fair market value and is taxed accordingly. An exception to this rule has been created to accommodate alter ego trusts and joint partner trusts.

A transfer of capital property into an alter ego trust or a joint partner trust is, with certain exceptions, a "qualifying transfer" under subsection 73(1.01). Subsection 73(1) provides that where capital property is transferred to a trust in such circumstances and both the individual and the trust are resident in Canada at the time of the transfer5, the property transferred is deemed to be disposed of by the individual at that time for proceeds equal to its adjusted cost base (or, if the property is depreciable property of a prescribed class, for proceeds equal to that proportion of the undepreciated capital cost of all property of that class that the fair market value of the particular property is of the fair market value of all property of that class) and to have been acquired at that time by the trust for an amount equal to those proceeds.

This rollover of property into the trust is generally automatic unless the individual elects not to have it apply, in which case the transfer will be treated as a disposition and acquisition at fair market value. However, it should be noted that subsection 73(1.01) will not apply (and thus the rollover will be denied) if (i) the transfer to the alter ego trust or joint partner trust is part of a series of transactions or events that includes a roll-out of property to the individual (or the spouse or former spouse of the individual) from an existing trust (other than a testamentary trust), and (ii) one of the main purposes of the transfer is to avoid the application of an impending 21 year deemed disposition to that trust. This restriction is intended to prevent what the Department of Finance considers an inappropriate extension of the 21 year rule for deemed dispositions of trust property.

Although it seems an unintended result, a trust into which both an individual and his or her spouse or partner contribute property appears not to be a joint partner trust under the Act. As noted above, a joint partner trust is a trust settled by "a taxpayer" having as its principal beneficiaries the taxpayer and his or her spouse or partner. Therefore, any property transferred into the trust by the taxpayer's spouse or partner will not qualify for the rollover. The absence of a rollover in these circumstances is unfortunate, as in many cases it would be more convenient and less costly for taxpayers wishing to use joint partner trusts to combine and administer their assets through a single trust.

Attribution of Income and Capital Gains

Alter ego trusts and joint partner trusts will be subject to the application of subsection 75(2). As a result, during the lifetime of the settlor, all of the income and capital gains derived from the trust property will be deemed to be the income and capital gains of the settlor.6 As income will already be attributed back to the individual, there should be no hesitation in making these trusts revocable, thus providing an additional layer of flexibility in the estate plan.

Taxation on Death

Most inter vivos trusts are deemed to dispose of all of their capital property for proceeds equal to the fair market value of such property on the 21st anniversary of the establishment of the trust. However, where a trust is an alter ego trust or a joint partner trust, paragraph 104(4)(a) deems a first disposition of trust property to occur at the end of the day on which the settlor dies (in the case of an alter ego trust) or the day on which the survivor of the settlor or spouse/partner dies (in the case of a joint partner trust).7 This is a curious disincentive to using these trusts, as the resulting gains will be taxed at the highest marginal rate applicable to inter vivos trusts rather than at the individual's graduated rates.

In order to avoid double tax, the settlor or last spouse/partner to die should not be taxed on the deemed disposition of his or her capital interest in the alter ego trust or joint partner trust arising on death. Subsection 108(1) provides that the "cost amount" to the settlor of his or her capital interest in such trusts is adjusted to take into account the deemed disposition of the trust's property. This should equate with the fair market value of the settlor's capital interest in the trust on the date of death, with the result that no capital gain should arise on death.8

Following the death of the settlor or last spouse/partner to die, any income and capital gains derived from the trust property would be taxed in the trust, at the highest marginal rate. As well, the trust would be deemed to dispose of all of its property every 21 years after the death of the settlor or last spouse/partner to die.

No Testamentary Trusts

A trust created under a taxpayer's will is a "testamentary trust" (as defined in subsection 108(1)) and any income earned in the trust is taxed at graduated rates. However, an inter vivos trust of which the settlor has died or a trust that receives property from an alter ego trust or a joint partner trust as a consequence of the settlor's or the spouse/partner's death is not considered a testamentary trust.9 As a result, following the death of the individual (or if a joint partner trust, the surviving spouse or partner), the trust would pay the highest marginal rate of tax on its accumulated income. The difference in cost to a trust between taxation at graduated rates and taxation at the highest marginal rate would approximate $10,000 per year for each year in which the testamentary trust is to be maintained, depending on annual rates. The impact of this differential, combined with the fact that the first deemed disposition is taxed at the highest marginal rate, should be compared with the potential probate tax savings. It is likely that in a moderately large estate, the probate savings will outweigh the additional income tax payable.

Taxation on Emigration

An individual planning to emigrate from Canada might have been tempted to transfer his or her property into an alter ego trust or a joint partner trust just prior to becoming non-resident. This would have avoided the application of the emigration rules in paragraph 128.1(4)(b) in respect of both the property transferred to the trust and the individual's capital interest in the trust.10 To discourage this type of planning, paragraph 104(4)(a.3) provides for a deemed disposition of the trust's capital property where it is reasonable to conclude that property was transferred to a trust in anticipation that the taxpayer would subsequently cease to be resident in Canada, and the taxpayer in fact subsequently ceased to be resident in Canada. However, if the transfer into the trust is not in anticipation of the individual's departure, the property in the trust would not be subject to the emigration rules if the beneficiary becomes non-resident subsequently, unless the trust itself terminates Canadian residence.

Charitable Donations

Alter ego trusts and joint partner trust cannot make charitable donations without contravening the entitlement requirements in those trusts. Should the settlor wish to make charitable donations during his or her lifetime, the gift or donation could be treated for purposes of the trust as having been distributed to the settlor first, so that the gift or donation comes from the settlor.

Following the death of the settlor, an alter ego trust or a joint partner trust would only be entitled to claim a charitable tax credit in respect of its charitable gifts if the trust agreement specifically empowers the trustees to make such gifts. If the charity is a named beneficiary but no such power is given to the trustees, the charitable gift would be treated as an allocation of income and a deduction would be available under subsection 104(6).11 The trust document could be drafted so that either the credit or the deduction is available following a charitable gift. A filing position could be taken depending on which option is preferable in any particular year.

One drawback to making bequests out of a trust is that subsection 118.1(4), which permits gifts made by a deceased to be claimed in the taxation year preceding the year of death, will not apply. As a result, there may not be sufficient income in the trust to absorb the credit arising from a sizeable gift. If large bequests are to be made, consideration should be given to making such gifts through a will. The costs associated with probate would have to be netted (if probate would be necessary) against the benefits of applying the tax credit against the deceased's income in the year of death and the immediately preceding year.

Utilizing the Capital Gains Exemption

Holders of appreciated shares (including preferred shares acquired on an estate freeze) should carefully consider non-probate issues when deciding whether to transfer their shares to an alter ego trust or a joint partner trust. For instance, subsection 110.6(2.1) prevents the $500,000 capital gains exemption on the sale of qualified small business corporation shares from being claimed by a trust. If circumstances permit, one way around this issue could be for the taxpayer to exchange his or her shares on a tax-deferred basis for two classes of shares such that one has an inherent capital gain equal to the amount of the unused capital gains exemption ("exemption shares") and the other has a value over and above that amount ("residual shares"). The residual shares could be transferred on a rollover basis to the alter ego trust or joint partner trust. The exemption shares, however, could be transferred into the trust at their fair market by electing out of the subsection 73(1) rollover in respect of that transfer. The capital gains exemption could be claimed by the taxpayer in respect of the exemption shares and the trust would acquire those shares at a high adjusted cost base.

Non-Tax Considerations

Benefits of Avoiding Probate

Apart from saving probate taxes, there are other reasons to prefer not to submit an estate to probate and to transfer the value of an estate to a trust.

Probate is a public process and the probated will is a public document. The value of the taxpayer's estate can be ascertained by any member of the public for only a nominal fee. However, if transferred to a trust, the value of the taxpayer's assets will remain private, as will the identities of the beneficiaries of the trust.

As well, obtaining probate necessarily involves a certain amount of delay. Such delays may cause hardship for family members who need to wait for the completion of the process before the estate trustee may make distributions of property. If assets are held in several jurisdictions, obtaining probate will be even more time consuming and complex. These concerns can be alleviated by having the trustee of an alter ego trust or a joint partner trust hold the assets.

Family Law Issues

It is far more difficult for the dependants of a deceased person to challenge the validity of gifts made through an inter vivos trust than those made under a will. Nevertheless, under the Succession Law Reform Act 12, a dependant can enforce a claim against property that passes outside of a will in certain circumstances, including where the property was previously disposed of in trust and the deceased had retained a power to revoke the disposition or had a power to consume, invoke or dispose of the property. As well, there may be a risk that property in an alter ego trust could be subjected to matrimonial claims for equalization under the Family Law Act 13 .

Power of Attorney Substitute

Alter ego trusts and joint partner trusts can be used as substitutes for powers of attorney. If it is desired to have one or more trustees rather than an attorney take control of an individual's affairs in contemplation of future incapacity, the trustees' powers can be defined such that the individual, if incapacitated, would have no control or decision making power whatsoever over the property, thus avoiding any risk of undue influence being asserted by interested persons on the individual and avoiding the risk of unwise decisions by the individual.

Conclusion

While these new trusts have limited application and will not replace standard estate planning techniques for all taxpayers, in the rights circumstances, they can be used to achieve specific results and should be considered one arrow in the estate planner's quiver.

* Barry N. Segal, Ogilvy Renault, (416) 340-6161, bsegal@ogilvyrenault.com.

1. S.O. 1998, c. 34.
2. R.S.C. 1985, c. 1 (5th Supplement), as amended (the "Act"). Unless otherwise stated, all statutory references in this article are to the Act.
3. A "joint spousal or common-law partner trust" was originally called a "joint spousal trust" in the Department of Finance's 1999 draft legislation and then a "joint partner trust" in the 2000 draft legislation.
4. The Department of Finance's technical notes indicate that the rationale behind the age 65 restriction "is to limit the opportunity to engage in tax planning involving trusts and the maximization of the deferral of the recognition of capital gains."
5. The rollover will not be available if the trust is deemed to be resident in Canada under a provision of the Act. As well, if the trust subsequently becomes a non-resident of Canada, it would be subject to the deemed disposition of its property on emigration under subsection 128.1(4). Thus it seems that alter-ego and joint partner trusts will be of little assistance to offshore estate planners.
6. Although the trust should have no income or capital gains during the lifetime of the settlor, the T3 trust income tax return has been revised to include a reference to alter ego and joint partner trusts. Presumably, trustees can simply file a "nil" return at little cost or inconvenience. CCRA has an administrative policy that a T3 return is not required of a trust has less than $500 in income in the year and has made no dispositions of capital property. It remains to be clarified whether this or a similar policy will apply to alter ego and joint spousal trusts for years during which the provisions of subsection 75(2) apply to attribute the income and gains back to the settlor.
7. Under paragraph 104(4)(a)(ii.1), an alter ego trust may elect in its first taxation year to have a first deemed disposition date that is 21 years after the creation of the trust. If the trust makes this election, transfers of property to the trust will not be "qualifying transfers" and the rollover under section 73(1) will not apply. No similar provisions apply to joint partner trusts. This election could be useful in a situation where a transferor's assets have no aggregate net gain. The transfer to a trust in this scenario would still avoid probate fees on death and would defer until the date that is 21 years after the date of transfer any net gain that might accrue between the date of transfer and the date of death.
8. See Technical Interpretation No. 1999-0013165, dated May 15, 2000.
9. See paragraph (b) of the definition of "testamentary trust" in subsection 108(1). See also Technical Interpretation Nos. 2000-0005135, 2000-00059755 and 2001-0075375, all dated March 23, 2001.
10. The individual's capital interest in the trust would not be subject to paragraph 128.1(4)(b) as it is an "excluded right or interest" of the taxpayer, as defined in subsection 128.1(10).
11. See Technical Interpretation No. 2000-0056625, dated April 4, 2001.
12. R.S.O. 1990, c.S.26.
13. R.S.O. 1990, c.F.3.

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Barry N. Segal
Toronto
416.216.4861
bsegal@ogilvyrenault.com
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