Executive TaxBreaks, Spring 2005

Issues in will planning
2005 federal budget highlights
Impact of new U.S. rules on U.S. citizens/residents living in Canada

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Issues in will planning

A well-drafted will, critical to any estate plan, is an essential document that allows an individual to direct the disposition of his or her estate, to specify the beneficiaries, and identify at what age and in what proportion each beneficiary is to receive the gift.  In addition, a will enables the taxpayer to implement tax planning to either reduce or defer income tax.  Without a will, assets will be divided based on the laws of the province and the benefits noted above are lost.

There are several key aspects to designing a will that are extremely important and should be undertaken with care and forethought.  One primary concern is the decision as to when beneficiaries should receive their inheritance.  In other words, should the assets be distributed immediately or should all or part of the estate be held in trust for some period of time?

Trust or immediate distribution?
In the simplest scenario, all assets are distributed immediately to the beneficiaries.  This provides for a quick resolution, but it may not always be the best choice.  Both tax and non-tax issues must be considered when choosing to create one, or multiple, trusts.

Non-tax considerations.  There are several benefits to creating a trust.  For example, the trust gives the testator more flexibility in establishing who will benefit from the estate and at what age.  If no trust is created, then anything bequeathed to a minor child will vest with them when they attain the age of majority.  Anything bequeathed to a non-minor will vest with them immediately.  Where an estate is significant, the testator may not feel that the beneficiary has attained sufficient maturity to handle the bequest properly.

Creation of a trust through a will results in the transfer of the testator’s assets to a testamentary trust.  These assets are under the control of the trustee named by the testator. Thus, choosing a capable trustee who can maintain or enhance the value of the estate better than the beneficiaries themselves is essential.

The creation of a trust is also a means to ensure that the testator’s assets are disposed of in the desired manner.  A typical situation arises when a testator wishes to provide for his or her spouse, but also wishes to ensure that the inheritance eventually passes to the children.  If the testator leaves the assets to his or her spouse directly, the latter may spend the assets or bequeath them to beneficiaries other than the testator’s children (for example, the surviving spouse may remarry and bequeath the assets to his or her new spouse).  To resolve this issue, the testator may create a spousal trust, leaving the spouse a life interest in the assets so that the capital will be preserved for the children. That being said, however, the testator could also give the trustee the power to touch the capital should the revenues from the trust be insufficient to meet the spouse’s needs.

There can be any number of reasons to establish one or more testamentary trusts. Some of these might be as follows:

• to provide funds for the education of children or grandchildren;
• to provide for the care and maintenance of a physically or mentally infirm adult child;
• to ensure that the estate is preserved for the testator’s children and grandchildren, particularly if the testator’s spouse marries a person who also has children;
• to ensure the separation of funds among beneficiaries so that the accelerated use of funds for the needs of one beneficiary does not erode the funds earmarked for another; and
• to provide income splitting.

There can be drawbacks to the creation of trusts in terms of the commitment required by the trustees, as well as costs and administration.  A trust is a separate legal entity and, as such, must keep records and file tax returns.  In the case of multiple trusts, there are multiple filing requirements.

Tax considerations.  If a trust is created through an individual’s will, it is taxed on the income earned on the trust assets at the marginal income tax rates that apply to individuals.  If properly structured, a will can result in several testamentary trusts, each of which is taxed at the marginal tax rates for individuals.  This can result in significant income tax savings if the income would have otherwise been taxed at the highest marginal rates on the beneficiaries’ personal tax returns. 

There are different types of trusts that can help to achieve the testator’s goals, while significantly reducing the tax payable by the beneficiaries.  These trusts include a spousal trust and trusts for the benefit of children or grandchildren.  A separate trust could be created for each designated beneficiary.  The number and structure of trusts in an estate plan is determined based on each testator’s estate and wishes regarding disposition.

Use of a spousal trust can result in the deferral of income tax on death related to any accrued capital gains on the transferred assets.  It may also allow the income to be taxed at lower rates.  The tax deferred on death becomes payable by the trust on a disposition or on the spouse’s death.  There are a number of conditions the trust must meet in order to qualify as “spousal.”  First, the spouse must be entitled to receive all of the income of the trust.  Second, no-one other than the spouse can access the capital of the trust while the spouse is alive.

As noted above, creation of one or many trusts for the benefit of children or grandchildren can ensure that the testator’s assets are used for the benefit of these children or grandchildren and provide a level of control over the assets.  At the same time, the trust effectively allows access to a second set of graduated personal tax rates.  While children are young and not yet earning a high income, this advantage may not be very important.  However, once the children start to earn income from full-time jobs, the access to the second set of tax brackets can provide a significant advantage.

Probate fee considerations.  One of the areas of non-income-tax consideration in planning a will relates to probate fees.  Probate is the process of validating a will by the court. In most provinces, probate fees are established by the fair market value of the estate and are levied at varying rates.  In Ontario, for example, these fees can be as high as 1.5% of the value of an estate.  This can be a significant cost to an estate.  In Québec, no probate fees are payable if the testator has taken the precaution of having his will drawn up by a notary. If the will is holograph or signed before witnesses, probate fees are payable to the court that probates the will. However, these fees are not calculated on the value of the estate, but are instead a fixed charge.

When the probate fees are established by the fair market value of the estate, they only apply to assets that are subject to probate, that is, those assets that pass to beneficiaries through the deceased’s will.  Consequently, assets that are transferred outside a will as a result of joint tenancy ownership or designations of a specific beneficiary in an investment contract will not be subject to probate fees.

To avoid the probate costs, it is common for some advisors to recommend automatically that certain assets be held in joint ownership or that a beneficiary designation be made.  It should be noted that assets that are jointly owned with another individual and assets for which the testator has made a specific beneficiary designation will not be available for transfer to a trust and therefore all of the potential benefits provided by a trust, as discussed previously, are lost. 

If an asset is placed in joint ownership, and the joint ownership arrangement carries with it the right of survivorship, on the death of the first joint owner, the asset will not become part of the individual’s estate, but rather will pass directly to the surviving joint owner.  Unless the new joint owner is the individual’s spouse, the initial transfer of an asset into joint ownership is a taxable event.  Any accrued gains will be triggered in connection with the disposition of one-half of the value of the asset.  On death, when the remainder of the asset transfers, the deemed disposition will occur on the balance of the property, unless it transfers to a spouse.

If the testator owns life insurance, registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), or similar types of plans in respect of which a beneficiary may be designated, specific beneficiary designations will keep the plan proceeds out of the testator’s estate.

Make an informed decision
In deciding whether to opt for an outright distribution, a trust, or joint ownership of assets to avoid probate fees, the testator must consider the size and nature of the assets, and the ability and maturity of the beneficiaries.  If there is any doubt, it is preferable to create the trust.  The additional expense and inconvenience involved is generally more than compensated for by the advantages described above.  In particular, it is important to compare the potential probate cost to the potential income tax savings.  Consulting a professional in tax and estate planning will help you to make an informed decision in this matter.

Lynda Sinclair, Kitchener
Karen Wilkinson, Hamilton-Halton

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2005 federal budget highlights

The 2005 federal budget, released on February 23, 2005, introduced measures that reduce the tax burden on corporations and individuals, with most of the benefits going to low- and modest-income earners. The budget was also designed to encourage retirement savings and improve tax assistance for persons with disabilities. Some highlights of the 2005 budget are summarized below:

• The basic personal credit will be increased slightly over the next few years from the 2004 amount of $8,012 so that an individual will be able to receive tax-free income of $10,000 by 2009.
• Similarly, the personal credit for spouse, common-law partner, or wholly dependent relative will also be increased yearly to bring the amount to $8,500 by 2009 from the current amount of $6,803 for 2004.
• Increases to the limits for tax-deferred retirement savings in registered pension plans (RPPs), registered retirement savings plans (RRSPs) and deferred profit sharing plans (DPSPs) have been proposed to assist individuals in preparing for retirement. The new proposed limits are shown in the accompanying table.

• In a surprise move, the government reversed its longstanding position on limiting the foreign property in RRSPs and pension plans. The foreign property rule that limited the amount of foreign property held by pensions and other tax-deferred retirement plans to 30% will be eliminated for 2005 and subsequent years. The original limit was 10% when the rule was introduced in 1971 and was raised to 20% in the 1990s and 30% in 2001.
• The requirement to convert the balance in a Life Income Fund (LIF) at age 80 into an annuity is eliminated. A LIF is typically used to provide retirement income when a person transfers locked-in pension benefits out of a registered pension plan.
• The list of qualified investments for RRSPs and other tax-deferred retirement plans has been changed, effective February 23, 2005, to include investment-grade silver and gold bullion, coins, bars and certificates on such investments (subject to purity conditions).
• There have been numerous enhancements made to the disability and medical tax credits, including expanded eligibility for the disability tax credit, and an increased maximum amount that can be claimed by caregivers from $5,000 to $10,000 for 2005.
• A new non-refundable tax credit is proposed to recognize specified expenses, up to a maximum of $10,000, for the adoption of a child.
• The corporate surtax will be eliminated for taxation years ending after December 31, 2007, and will be prorated for taxation years that include that date.
• The general corporate income tax rate will be reduced to 20.5% effective January 1, 2008, 20% effective January 1, 2009 and 19% effective January 1, 2010.

Andrea Heimrich, Toronto
Sharon Godkin, Toronto

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Impact of new U.S. rules on U.S. citizens/residents living in Canada

The American Jobs Creation Act of 2004, signed into force on October 22, 2004, introduced new rules that affect the U.S. taxation of U.S. citizens or residents (such as green card holders) living and working in Canada. 

One change removed the limitation of U.S. taxpayers’ ability to claim a full foreign tax credit (FTC) on their alternative minimum tax (AMT) liability.  This change can represent a substantial saving to U.S. taxpayers who live in Canada.

Under the old rules, a U.S. taxpayer could only eliminate up to 90% of his or her AMT liability by claiming FTCs.  If substantially all of the U.S. taxpayer’s income derived from non-U.S. sources, he or she could thus be subject to an AMT tax of roughly 2.8% (i.e., the remaining 10% times the 28% AMT rate) of his or her income.  This 2.8% AMT liability cannot generally be credited against the U.S. taxpayer’s Canadian tax liability, and therefore is an incremental tax liability.

Under the new rules, the U.S. taxpayer is now able to claim a full FTC with respect to his or her AMT.  As a result, he or she will no longer be subject to AMT in the U.S. simply because all or substantially all of his or her income was from sources outside the U.S.

Another change increases the number of years that a U.S. taxpayer can carry forward excess foreign (e.g., Canadian) taxes (to claim as an FTC on future U.S. tax returns) from five to ten, and decreases the number of years such excess foreign taxes can be carried back from two to one.  For example, most U.S. taxpayers in Canada generate excess Canadian taxes, as Canadian tax rates are generally higher than U.S. tax rates.  While these excess Canadian taxes can be carried forward to be claimed as an FTC against U.S. taxes in a future year (typically, the years after which the taxpayer has returned to the U.S.), the old rules provided that such excess foreign taxes expired after five years.  The old rules therefore made it difficult for the taxpayer to take full advantage of such carry forward unless he or she returned to the U.S. within five or six years.  The new rules extend the carry forward period to ten years and thus make it easier for such taxpayers to take full advantage of any excess Canadian taxes.

Peter Megoudis, Toronto
Maria Tsatas, Montréal

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