Introduction
Charitable remainder trusts have been popular in the U.S. for some time but not as widely used in Canada as a result of differences in our tax regime. A charitable remainder trust involves an individual who wishes to make a gift to charity, but only following the death of the life tenant of a trust, all while benefiting from a donation tax credit at the time that he or she transfers the gifted property to the trust. Charitable remainder trusts work well in the inter vivos (i.e., during one’s lifetime) context, but have posed issues in recent years in the testamentary (i.e., on death) context as a result of changes to the laws on testamentary charitable giving. This article provides an overview of charitable remainder trusts (“CRTs”), the issues surrounding testamentary CRTs, and Canada Revenue Agency’s (“CRA”) views on the matter.
CRTs: What are they?
CRTs can be a useful charitable giving tool. A common example of a CRT in the inter vivos context is where an individual establishes an alter ego trust[1], whereby property is transferred on a tax-deferred basis to the trust for the benefit of the individual during his or her lifetime and for a charity’s ultimate benefit. The individual is the life tenant and is entitled to all of the income of the trust, but has no right to the capital of the trust. The charity is the capital beneficiary, meaning it is entitled to the capital of the trust on the death of the life tenant. The charity issues a donation receipt for the fair market value of the residual interest at the time the property is transferred to the trust. The charitable donation, for donation tax purposes, is the net present value of the remainder interest in the trust. Factors, such as the age of the life tenant, the fair market value of the property transferred to the CRT, and mortality/actuarial tables for the life tenant, are considered in order to determine the value of the remainder interest. Actuarial and valuation reports will be required for valuation purposes. The charitable donation tax receipt can be used to shelter tax on the individual’s income for the year the property is transferred to the trust and/or against the individual’s income in other years where permitted.
Testamentary CRTs Prior to the Graduated Rate Estate
Prior to the recent changes to the testamentary charitable giving rules, testamentary CRTs worked in a similar way. The trust was created in the Will of an individual for the benefit of another person during his or her lifetime, with no right to encroach on the capital, and on that person’s death, the capital was transferred to a charity. Charitable gifts made through a Will were deemed to be gifts made by the individual immediately prior to his or her death. The charity would issue a donation receipt at the time the trust was established following the death of the testator, so that the estate of the deceased individual could apply the donation tax credit to the deceased’s terminal income tax return in the year of death, thereby reducing taxes triggered on the deemed disposition on death, or to the deceased’s tax return in the immediately preceding year. This worked well because the tax liability from the deemed disposition was matched with the donation tax credit.
Testamentary Charitable Giving and the Graduated Rate Estate
In 2016, the rules changed such that now a charitable donation made by an individual through his or her Will is deemed to have been made by the estate at the time the gift is transferred to the charity. The value of the gift is tied to the fair market value of the gift at the time of the donation (rather than the value immediately prior to death). The estate is able to carry forward the unused tax credit for five years from the date of death, which could not previously be done. The tax credit cannot be used in the year of death unless the estate is a “graduated rate estate”[2] (“GRE”).
There are additional timing advantages if the gift is made during the 36 months the estate qualified as a GRE, or within the next 2 years provided the estate would have been a GRE except for the expiry of the 36-month GRE period. In such circumstances, the donation tax credit can be claimed (i) in the year of death of the deceased (which can be used to reduce tax liability from the deemed disposition on death); (ii) in the year immediately preceding the year of death; (iii) by the GRE in the year the donation is made or any prior year of the GRE; or (iv) in any of the 5 tax years of the estate following the gift.
CRA’s Views on Testamentary CRTs
If the charitable gift made through a Will is deemed to have been made by the estate at the time the gift is transferred to the charity, then a question arises whether a donation of a capital interest in a CRT created by a Will to a qualified donee[3] (generally registered charities), which is made by the deceased individual’s GRE, is still eligible for the donation tax credit and whether subsection 118.1(5.1) of the Income Tax Act will apply to the gift. If subsection 118.1(5.1) of the Income Tax Act applies, then the flexible rules that permit GREs to use the donation tax credit in prior years will apply.
CRA was asked this exact question and provided its response in technical interpretation 2016-0625841E5. Under subsection 118.1(5.1) of the Income Tax Act, one of the requirements is that the subject of the gift made by an individual’s GRE is property that was acquired by the estate on and as a consequence of the death or is property that was substituted for that property. CRA concluded that the subject of the gift is the equitable interest in the testamentary CRT and that the equitable interest cannot have been acquired by the estate on and as a consequence of the deceased individual’s death. Accordingly, subsection 118.1(5.1) of the Income Tax Act does not apply.
We learned from this response that CRA is of the view that a testamentary CRT is not a gift by a GRE. As a result, no donation tax credit can be claimed in the year of death or the year prior to death.
More recently, CRA was asked whether the equitable interest in the CRT could be characterized as property that is substituted for the remainder interest in the property owned by the deceased at the time of death that is received by the GRE on and as a consequence of the death of the individual. If this argument was accepted, the rules that permit the GRE to use the donation tax credit in prior years would apply. In technical interpretation 2017-0734261E5, CRA provided its views on the application of subsection 118.1(5.1) of the Income Tax Act to this issue.
CRA explained that an equitable interest in a trust is created upon the transfer of any property to a trust with the requirement that the property be distributed to a beneficiary at some future date (i.e., when an income interest of another person ends). It has been CRA’s long-standing view that the subject of a gift to the qualified donee is not the property transferred to the CRT, but the equitable interest in the CRT. More particularly, the CRT receives the property and the qualified donee receives an interest in the CRT.
In order to determine whether an equitable interest in a CRT, to which the property is transferred, is considered to be substituted property for the property received by the GRE on and as a consequence of the death, CRA considered the ordinary meaning of the term “substituted property” and the extended meaning of substituted property in subsection 248(5) of the Income Tax Act.
The Canadian Oxford Dictionary (2001) defines “substitute” as follows:
“… A thing that is or may be used in place of another, often to serve the same function but with a slightly different effect… replace (a person or thing) with another…”
Black’s Law Dictionary (1999) defines “substitution” as follows:
“… the property by which one person or thing takes the place of another person or thing.”
Subsection 248(5)(a) of the Income Tax Act provides that where there are multiple substitutions, the final property held will be considered to be substituted for the original property held.
CRA concluded that the equitable interest in the CRT is created as a result of the transfer of property to the CRT by the GRE. The gift of the equitable interest in the CRT is considered to have been made to the qualified donee when the property is transferred to the CRT, provided that the equitable interest in the CRT vests with the qualified donee at that time (and all other requirements are met). The GRE does not receive the equitable interest in the CRT in return for the transfer. CRA further explains that the property received by the GRE on and as a consequence of the death of the individual is not substituted property for or replaced by the equitable interest in the CRT received by the qualified donee. As a result, the equitable interest in the CRT is not property received by the GRE on and as a consequence of the death, or property substituted for that property. Therefore, subsection 118.1(5.1) does not apply.
However, the GRE may receive a donation receipt for the gift of the equitable interest in the CRT to a qualified donee and use the donation receipt in the year that the gift is made or any of the five following years.
Contact a member of Miller Thomson’s Social Impact Group to learn more about charitable remainder trusts and whether a gift you have made qualifies as a gift that is eligible for a donation receipt and can be used to offset your income tax.
[1] An alter ego trust is a special type of trust permitted under subsection 73(1.02) of the Income Tax Act.
[2] “Graduated rate estate” (“GRE”) is defined in subsection 248(1) of the Income Tax Act to mean the estate that arose on and as a consequence of an individual’s death if:
- that time is no more than 36 months after the individual’s death,
- the estate is at that time a testamentary trust,
- the individual’s Social Insurance Number (or if the individual had not, before the death, been assigned a Social Insurance Number, such other information as is acceptable to the Minister) is provided in the estate’s return of income under Part I for the taxation year that includes that time and for each of its earlier taxation years that ended after 2015,
- the estate designates itself as the graduated rate estate of the individual in its return of income under Part I for its first taxation year that ends after 2015, and
- no other estate designates itself as the graduated rate estate of the individual in a return of income under Part I for a taxation year that ends after 2015.
[3] Under the Income Tax Act, qualified donees are organizations that can issue official donation receipts for gifts they receive from individuals and corporations.
