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CCH Tax Notes - September

Spouse Trusts

By: David Louis, J.D., C.A., Tax Partner
Minden Gross LLP, a member of MERITAS Law Firms Worldwide.

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Note: This article is based on materials to appear in the upcoming third edition of Tax and Family Business Succession Planning, by David Louis, Michael Goldberg, and Samantha Prasad (Minden Gross LLP), to be published this fall by CCH Canadian Limited.  It is a portion of ¶812, which deals with Spouse Trusts in Chapter 8, Wills & Will Substitutes.

A spouse trust can be a very effective succession and estate planning vehicle. It combines the tax-deferral advantages of leaving assets to a spouse, with the ability to protect family interests. Where a successful business is involved, it is more usual to use a spouse trust rather than leaving the shares and other assets outright to the surviving spouse, in order to preclude the possibility of the surviving spouse changing the terms of his or her will, e.g., in the event of a remarriage[1]. In addition, the appointment of suitable trustees may protect against mismanagement of the business or distributions which could jeopardize financially the viability of the ongoing business. Specifically, this could provide protection from the surviving spouse exercising retraction rights attaching to freeze shares, e.g., where an elderly surviving spouse has remarried and is under the influence of a spendthrift spouse.

Spouse trusts may be used for inter vivos (lifetime) gifts or testamentary bequests. In order to qualify for rollover treatment, the trust must provide that:

● The spouse is entitled to receive all of the income of the trust that arises before the spouse’s death;[2] and

● 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.[3]

Note: to obtain a rollover on a outright disposition to a spouse, both the decedent and the beneficiary must be Canadian residents; for a spouse trust, the decedent and the spouse trust must both be Canadian residents[4]. 

Several comments can be made in respect of these requirements:

1.          As noted above, the spouse must be entitled to obtain all of the income of the trust during his or her lifetime. This means that there can be no provisions disentitling the spouse to an interest in a spouse trust, e.g., if the spouse remarries.  However, if the trust holds shares of a corporation, subject to fiduciary-type considerations, it is possible to effectively control the amount of income received by the trust and, consequently, the amount to which the spouse is entitled. Specifically, where a corporation is held by a trust, the dividends paid on the shares may be regulated by the directors of the corporation. (In such circumstances, it may be prudent to ensure that control of the corporation is not held by the trustees themselves; otherwise, the spouse might assert that distributions should have been made by the corporation as a consequence of the duties of the trustees.)

2.          The requirement that no other person can receive or obtain the use of capital does not mean that the spouse is entitled to receive the capital. In other words, as long as no one else may receive or obtain the use of the capital, the trust will not be disqualified as a spouse trust.

3.          In respect of the use of capital requirement, careful drafting is required in order to ensure that this requirement is not violated. For example, a loan to a relative might be interpreted as allowing someone other than the spouse to obtain the use of capital. Provisions in a trust that allow this could throw the trust offside.[5] Although CRA Document No. 9627345, November 14, 1996, and paragraph 16 of IT-305R4 indicate that a loan to a non-spouse on commercial terms (e.g., commercial interest rates)[6] would not taint a spouse trust, Document No. 2003-0019235, July 17, 2003, indicates that where the trust permits funds to be loaned (or any other form of assistance to be provided) to anyone other than the spouse for inadequate consideration, this would disqualify the trust, whether or not such a loan was actually made. The latter document appears to indicate that the will in question authorized the trustee to lend funds or provide any other financial assistance to any beneficiary with or without consideration.

A recent Technical Interpretation (Doc. No. 2006-0185551C6, September 11, 2006) also raised the question of whether the rollover to a spouse trust would be available if the trustee is required to pay life insurance premiums. The CRA’s negative answer was based on the argument that a duty to fund a life insurance policy out of trust capital or income would be one under which another person may obtain the use of the trust capital or income.  The CRA indicated that “the mere possibility of a person other than the survivor receiving or obtaining, before the survivor's death, use of the trust capital or income is sufficient to disqualify the property transfer from the rollover.”[7]

It appears that the concept of being able to ‘‘obtain the use’’ is potentially very broad.[8] (Notwithstanding the CRA’s administrative policy as stated above, even if a loan is on commercial terms, query whether the debtor is nevertheless obtaining the use of the capital.) As the ‘‘no use’’ requirement must presumably be met under the terms of the trust, appropriate language should be inserted in the document. It therefore appears to be advisable to examine closely the powers given to trustees in a spouse trust in order to make sure (for example) that the ‘‘boilerplate’’ does not trip over the ‘‘no use’’ requirement, e.g., by providing for a power to lend on any terms they see fit. If there are changes to the CRA policy in respect to spouse trusts from time to time, it would necessitate an amendment to the document — if possible. Another approach would be to provide that trustees must adhere to the policies of the CRA in respect of the ‘‘no use’’ and other requirements in respect of qualifying spouse trust status, as delineated from time to time.

4.          The meaning of ‘‘income’’ and ‘‘capital’’ as mentioned above pertains to trust/estate law. As mentioned previously, in a typical succession plan, freeze shares will be an important (perhaps the primary) asset in a spouse trust. While dividends on the freeze shares are treated as income, and therefore must be distributed to the spouse, a redemption is treated as a return of capital, even though the redemption may trigger a deemed dividend. Therefore, it is not a requirement of a spouse trust that the proceeds of a redemption be distributed to the spouse. It should also be noted that, per subsection 108(3), capital dividends from private corporations are excluded from income for these purposes (as are capital gains dividends from mutual fund corporations); this sub­section also applies to alter ego and joint partner trusts.

5.          Question 14 of the 2008 APFF Round Table[9] may suggest that a spouse trust should contain a non-assignability clause.  The question itself related to a self-benefit trust; however, the requirements (that the individual is entitled to receive all the income that arises before the individual’s death and no person except the individual may, before the individual’s death receive or otherwise obtain the use of any of the income or capital of the trust) are similar to the requirements of a spouse trust.  The CRA indicated that, without a non-assignability clause, “an individual, residing in Quebec, has the possibility of transferring his rights in the income and capital of the trust pursuant to the Civil Code of Quebec, without being prevented to doing so by a provision of the trust indenture”, so as to contravene the conditions in subparagraph 73(1.01)(c)(ii).  As can be seen, the question is specifically referenced to Quebec laws, where Article 1285 of the Civil Code of Quebec specifically provides for assignability.  Based on informal discussions, it appears that, at time of writing at least, the CRA has not considered the applicability of the foregoing views outside of Quebec and to trusts other than self-benefit trusts.  However, consideration should nonetheless be given to including a non-assignability clause.