TSG (Tax Specialist Group) - Spousal Trust Strategy (Trusts)

A “spouse trust” can be used in a taxpayer’s Will to defer capital gains on death. As long as all the income of the trust is paid or payable to the surviving spouse (or common-law partner) and none of the capital is payable to anyone else until after the surviving spouse’s death, capital gains are not triggered on the assets left to the trust until the surviving spouse dies (or the trust sells the assets).

As noted, all the trust’s income must be paid or payable to the surviving spouse. However, the parties may wish to build up the capital of a spouse trust by retaining income, rather than paying out the annual income to the surviving spouse.

For example, the surviving spouse may have sufficient personal income and/or capital to meet their needs, or there may be a desire to "re-capitalize" the trust's income for the children on the surviving spouse’s death. Recapitalization or "asset-building" can be particularly effective if the terms of the spouse trust provide for the creation of subsequent "springing" trusts for the children’s benefit, on the death of the surviving spouse.

The trustees can make a designation to tax income within the trust, but this will not really solve the problem. The designated trust income must be payable to the surviving spouse and will not form part of the capital of the trust.

A solution to this conundrum is to “trap” the trust’s income in a holding corporation, owned by the trust. Investments otherwise held by the spouse trust can be transferred to a corporation on a tax-deferred basis in exchange for shares of the holding corporation (using a section 85 rollover). All future investment income would then be earned within the holding corporation. The corporate taxes payable would include a portion Refundable Dividend Tax on Hand, eligible for the dividend refund (“RDTOH”).

If this strategy is employed, dividends from the holding company need not be paid to the spousal trust. The result will be the "re-capitalization" within the holding corporation. RDTOH can be recovered on the payment of dividends. If these dividends are not required during the surviving spouse’s lifetime, they can be paid out after the surviving spouse’s death, with less tax, if testamentary trusts for the children "spring-up" in the surviving spouse’s will.

This strategy enhances the capital that can potentially be passed down to the next generation, while optimizing the overall tax considerations through recovery of RDTOH and the ability to "income-split" by using successive "springing-trusts." However, this planning is not suggested for Canadian residents who are U.S. citizens or green card holders, due to the US tax consequences.

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The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.