An Introduction to Testamentary Spousal Trusts in Canada
What is a Testamentary Spousal Trust?
A testamentary spousal trust is a legal arrangement established through a will to benefit the settlor’s surviving spouse. It provides an alternative to the outright distribution of estate assets, offering certain tax benefits and flexibility for managing complex family dynamics. A testamentary spousal trust allows the trustee to manage and invest the assets, distributing income and capital to the surviving spouse according to the deceased settlor’s wishes.
Key Criteria for Testamentary Spousal Trusts
For a testamentary spousal trust to qualify under the Income Tax Act (ITA), it must meet specific criteria:
Post-Death Transfer: The trust must be created in the settlor’s Will and property must transfer to the trust due to the settlor’s death.
Income Entitlement: The beneficial surviving spouse must be entitled to all income generated by the trust during their lifetime. Capital may be distributed to the surviving beneficial spouse as per the trustee’s discretion.
Exclusivity of Benefits: No other person can access the income or capital of the trust during the surviving beneficial spouse’s lifetime.
Vesting of Property: The property must “vest indefeasibly” in the trust within 36 months of the deceased’s death and before the beneficial spouse's death.
Canadian Residency: The deceased must be a Canadian resident at death, and the trust must be resident in Canada immediately after the property vests.
Non-Financial Benefits
Subsequent Marriages: Testamentary spousal trusts are useful in blended family situations. For example, the trust can ensure that, after the surviving beneficial spouse's death, assets go to the settlor’s children from a previous marriage. The surviving beneficial spouse does cannot change this.
Inexperienced Spouses: If the surviving spouse lacks the expertise or willingness to manage the estate, a settlor can appoint a trustee with experience to manage the wealth and distribute income to the spouse.
Creditor Protection: These trusts can protect assets from the surviving spouse’s creditors by precluding capital distribution. For maximum protection, the spouse should not be a trustee or should not have control over trustee actions.
Control Over Business Assets: Upon the death of the settlor, tax liability on business shares can be deferred until the surviving spouse's death, providing income to the spouse, while facilitating business succession to children.
Taxation of Testamentary Spousal Trusts
Capital Gains Deferral: On death, assets can transfer to the trust at the adjusted cost base, deferring capital gains taxes until the assets are sold or the surviving spouse dies.
Income Entitlement: The surviving spouse must be entitled to enforce payment of income from the trust. Income is calculated under trust law rules, excluding capital gains.
Taxation Rules Post-2016: testamentary spousal trusts are taxed at the top marginal tax rate. Income paid to the spouse is taxed at their marginal rate. Distributions of capital are generally tax-free to the spouse.
Deemed Disposition: Upon the spouse's death, trust assets are deemed disposed of at fair market value, triggering tax liability in the trust at the top marginal tax rate.
Filing Requirements: The trust must file an annual T3 return, and any deemed disposition results in a deemed year-end, requiring timely filing.
Considerations in Drafting and Maintaining the Trust
Avoiding Tainting: If income distributions to the surviving spouse is conditional (for example, not remarrying), the trust becomes tainted and loses it’s trust status and associated benefits. Another way a trust can become tainted is if income or loans are made to individuals besides the surviving spouse. Of note, using trust income to fund the premiums of a life insurance policy on the life of the surviving spouse does not benefit said spouse and will taint the trust.
Registered Retirement Assets: It’s not possible to transfer RRSP/RRIF assets to a testamentary spousal trust on a tax-deferred basis. Such assets should be managed according to rules of the Canadian Income Tax Act for direct transfers to a surviving spouse’s RRSP/RRIF.
A Case Study
Dr. Rai, a successful oral surgeon residing in Vancouver, BC, decides to establish a spousal trust through his Will to protect the financial interests of his wife, Mrs. Rai in the event of his demise, while making sure his children from a previous marriage ultimately benefit upon the passing of Mrs. Rai.
Dr. Rai appoints a professional trust company as the trustee of the spousal trust and transfers shares of his holding company, personal non-registered investment portfolio, and personal real estate holdings into the trust. The trust agreement stipulates that only Mrs. Rai will receive income distributions from the trust during her lifetime, ensuring her financial security.
Following Dr. Rai’s passing, assets are transferred to the spousal trust as outlined in his Will, and Mrs. Rai becomes the primary beneficiary. A corporate trustee has been appointed as per Dr. Rai’s instructions to manage the trust assets prudently, investing for growth while ensuring regular income distributions to meet Mrs. Rai’s financial needs.
Tax Implications:
Dr. Rai’s assets are rolled into the spousal trust at their adjusted cost base, not the fair market values. This defers capital gains tax until the assets are sold or Mrs. Rai passes away, whichever should occur first.
During Mrs. Rai's lifetime, income generated within the spousal trust is distributed to her and taxed in her hands at her marginal tax rate.
Upon Mrs. Rai’s passing, there is a deemed disposition of the remaining assets in the spousal trust and capital gains must be paid at the trust’s tax rate (top marginal tax rate). The trust will continue for the benefit Dr. Rai’s children, with income and capital distributions subject to applicable tax rules.
Conclusion
Testamentary spousal trusts offer a strategic tool for estate planning in Canada, providing tax benefits and addressing various family dynamics. Proper structuring and compliance with ITA requirements ensure the trust achieves its intended benefits, supporting the surviving spouse and safeguarding inheritance for children from previous marriages.
This information has been prepared by Mehul Gandhi, CFP®, CLU®, TEP who is an Estate Planning Specialist and Senior Insurance Advisor for Westmount Wealth Planning Inc., and a Financial Planner for Westmount Wealth Management Inc. Westmount Wealth Planning Inc. is a subsidiary of Westmount Wealth Management Inc. Westmount Wealth Management Inc. is registered as a Portfolio Manager in British Columbia, Alberta, and Ontario.
This material is distributed for informational purposes only and is not intended to provide personalized legal, accounting, tax, or specific investment advice. Please speak to a Westmount Wealth Advisor regarding your unique situation.
