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In celebration of the New Year with all the positive energy and optimism it brings, this article is dedicated to honouring due diligence and best practice in drafting.

Historical Roots

The concept of a trust structure to “keep safe” property for the benefit of someone else is as old as ancient civilization. Property owners in biblical, ancient Greek and Roman times faced dangers which warranted relinquishing control and management of their property to a trusted person, the fiduciary, to safeguard, care and hold it in trust for the benefit of the intended beneficiary. In the Middle Ages, feudal landlords, the settlors of the trust structure, conveyed property to a trusted a friend to hold and care for that property to the benefit of the settlor or a third-party beneficiary, upon certain terms of management and distribution.  A body of law evolved in England’s Courts of Equity protecting the settlor and the intended beneficiary from a dishonest trustee, advancing the English doctrine of trusts.

Fast forward to modern-day: The foundational purposes and principles embedded in the trust construct of ancient times remain the same. Technically, the trust structure arises upon the separation between the legal and the beneficial interests (bundles of rights) vis-a-vis property, with the three certainties – intention to settle a trust, description of the property, identification of the beneficiaries, clearly expressed. Not unexpectedly, tweaks and nuances have developed in the law of trusts addressing new social circumstances. Inter-vivos trusts, created during lifetime, and testamentary trusts, created as a result of death, are two distinct categories of trusts. However, they are both creatures of the Canada Income Tax Act (the “ITA”). This article focuses on the second category, the testamentary trust, and particularly, the testamentary trust created in a Will in favour of a survivor spouse only, during his or her lifetime (the “Spousal Trust”).

The Generic Testamentary Spousal Trust

At first blush, the gifting via a Spousal Trust by the first-to-die spouse to the survivor spouse, whether the gift is any or all of a residence, rental real estate, business interest or corporate shares, or non-registered investment accounts, appears to be an attractive strategy. Ideally, it is a gift which provides all that the survivor spouse may need or want during his or her lifetime – incapacity planning for the survivor spouse, protection of the assets from creditors, deferral of capital gains tax at the first death, elimination of the 21-year deemed disposition tax liability, provision of gifts to next generations, and reduction or elimination of probate tax at the survivor spouse’s death. The Spousal Trust structure seems to address all the important estate planning needs, concerns and goals spouses may have.

But as always, the devil is in the details and the details are in the drafting.

The Nature of the Gift

Unlike an outright testamentary gift which is delivered in one event, the Spousal Trust is a testamentary structure spanning the lifetime of the survivor spouse that requires lifelong attention and management.

As stated earlier, it is the splicing of legal from beneficial interests in the property, undertaken by the testator, that creates the Spousal Trust. This trust, for the benefit of the survivor spouse, who holds the beneficial interest, is to be managed and controlled by the trustee, who holds the legal interest. Consequently, the survivor spouse, unless he or she is the trustee of his or her own Spousal Trust, is not in control of the decision making with respect to the management, investment, generation of income, or distributions. Without proper legal advice, this outcome may be contrary to the survivor spouse’s expectations. Depending on circumstances, the survivor spouse may have cause to challenge the limitations of the gift as drafted, and may file a Spousal Election.

Why embark upon an estate planning endeavour which is clearly prone to challenge? Because embedded in the bundle of benefits of the Spousal Trust (creditor protection, preservation of capital, tax deferral), is a tax deferral, also known as the spousal rollover, the most sought-after benefit of the Spousal Trust.

For the Spousal Trust to be eligible for the ITA’s tax deferral, the following requirements must be met (the “ITA Requirements”):

1. The Spousal Trust must be created pursuant to the Will of the first-to-die spouse, at his or her death.
2. The survivor spouse must be i) entitled to receive all of the net income generated in the Spousal Trust, annually, during his or her lifetime, and must ii) receive all said net income, annually, subject to a written request to the trustee stating otherwise, as discussed below, under Tainted Spousal Trust section. Only the survivor spouse may receive any of the income from the Spousal Trust.
3. Only the survivor spouse may receive distribution of any of the capital of the Spousal Trust during his or her lifetime. No one else may receive distribution of any of the capital from the Spousal Trust while the survivor spouse is alive.
4. The property intended to comprise the Spousal Trust must “vest indefeasibly” in the Spousal Trust within 36 months of the testator’s death and before the death of the survivor spouse. Property vests indefeasibly when the survivor spouse acquires the absolute and unconditional legal or beneficial right to the property, such that no future event can deny him or her of that right. See discussion below under Obstacles to Indefeasible Vesting section.
5. The deceased testator must be a Canadian resident immediately before death and the Spousal Trust must be a Canadian resident trust immediately after indefeasible vesting.

If all of the above ITA Requirements are met, the Spousal Trust is settled at the adjusted cost base instead of the fair market value^[1] and the capital gains tax ordinarily payable is deferred. This tax liability will be crystalized at future actual or deemed disposition of the assets.

The Principal Residence Exemption, the 21-Year-Rule and other Tax Benefits

The 2016 changes in the ITA have eliminated the availability of the principal residence exemption with respect to a residence held in a personal trust. However, there are a few important exceptions, one of which is where a Spousal Trust holds a residence. This exception makes the use of the Spousal Trust an effective planning strategy, whether in the context of an intact or a blended family, since the availability of the principal residence exemption, notwithstanding the 2016 changes in the ITA, is not lost.

The inapplicability to Spousal Trusts of the 21-year deemed disposition rule, which applies to most other trusts, is an additional tax advantage which makes the Spousal Trust an attractive long-term planning strategy.

Additionally, depending on circumstances, income generated in the Spousal Trust and distributed annually will be taxed in the hands of the survivor spouse at his or her marginal tax rate, and not in the Spousal Trust at the highest tax rate. Capital property of the Spousal Trust with embedded gain can be distributed to the survivor spouse at the cost base, therefore such tax liability is again deferred. So long as the survivor spouse is a Canadian resident and the Spousal Trust has not been tainted (see discussion below), the Spousal Trust incurs no tax liability upon income and capital distributions during the survivor spouse’s lifetime.

Obstacles to Indefeasible Vesting

Indefeasible vesting is one of the ITA Requirements for the creation of a Spousal Trust with eligibility for the spousal rollover.

A temporary obstacle to indefeasible vesting is the survivorship clause, requiring the spouse to survive the testator by a prescribed period of time (e.g. 30, 60 or 90 days)^[2]. While this clause plays an important role in probate planning it also delays indefeasible vesting of the deceased’s property in the Spousal Trust, until the expiry of the specified time period.

If improperly drafted, the survivorship clause may not only be an obstacle to indefeasible vesting but it may also inadvertently interfere with the survivor spouse’s entitlements. The survivorship clause by virtue of the drafting prohibits all access to and use, occupation, enjoyment of, by the survivor spouse, to his or her home, bed, household contents, declared dividends on shares and other estate assets. These assets are intended to comprise the Spousal Trust but due to the survivorship clause they are not yet available to the survivor spouse’s benefit. To counteract this feature of the survivorship clause, best practice is to draft a “notwithstanding” paragraph which accompanies the survivorship clause, enabling access and use of by the survivor spouse, to all property intended to comprise the Spousal Trust, during the survivorship time-period.

Likewise, a direction in the Will which authorizes the executor to exercise discretion in determining which assets will comprise the Spousal Trust as discussed below in the context of planning for an intact family (“… as my Trustees shall select and allocate…”), delays the indefeasible vesting until such time as the executor completes the selection and allocation. If the executor’s exercise of discretion with respect to selection and allocation extends beyond the 36 months following date of death, indefeasible vesting will not have occurred within the ITA’s required timeline and the Spousal Trust will be ineligible for the spousal rollover^[3].

Spousal Trust in the Context of an Intact Family

Intact families with high net worth – where corporate interests carry the bulk of the family’s wealth and typically, the bulk of the accrued capital gains – commonly utilize a particular succession strategy in the creation and management of the Spousal Trust. This strategy is both tax-driven and Family Law Act sensitive. To achieve maximum tax benefits and to minimize or even eliminate the risk of a challenge to the creation of the Spousal Trust, the testator shifts the decision making to the executor as to which assets of the estate will comprise the Spousal Trust.

To give effect to this strategy, the testator directs in the Will that the executor, who at the time of the testator’s death should have knowledge of the tax status of the various estate assets, shall settle a Spousal Trust with a prescribed amount, say $1.00. The settlement of the Spousal Trust is to be followed by the selection and allocation by the executor, at his or her discretion, of the specific assets to be transferred to the Spousal Trust. The intention is that the executor will select and allocate to the Spousal Trust, which had been created with $1.00, the assets with the greatest embedded capital gain. Therefore, the tax deferral will apply to most or all of the estate’s tax liability. Further to this step, the testator then directs the executor to settle a discretionary family trust with any of the remaining assets not yet allocated to the Spousal Trust, and typically, those assets which do not carry a significant tax liability. The discretionary family trust is created for the benefit of the survivor spouse and the common descendants of the spouses. The goals in using the strategy involving a Spousal Trust in conjunction with a family trust are to take advantage of the spousal rollover, and to ensure creditor protection for all estate assets while providing for all family members. This will promote family harmony and minimize the risk of dispute or litigation.

Spousal Trust in the Context of a Blended Family

Commonly, the testator in a blended family wishes to provide income and perhaps some capital for the survivor spouse, while maintaining some or most of the capital for the remaindermen beneficiaries, such as the testator’s children from a previous relationship. The testator achieves this goal by disallowing whole capital distribution providing for restricted, capped, capital encroachment in favour of the survivor spouse during his or her lifetime. This ensures preservation of capital cross-generationally.

To maximize the benefit of a Spousal Trust as a tool to protect assets from creditors of the survivor spouse, the survivor spouse should not be the appointed trustee. Creditors will then be unable to successfully argue that the survivor spouse is in control of the assets. In the context of a blended family where the survivor spouse and the remaindermen beneficiaries necessarily have adverse interests, the testator’s choice of the executor and trustee is often a source of contention and warrants careful discussion with the drafting lawyer.

To minimize the risk of the survivor spouse challenging the Spousal Trust, it is prudent to ensure that the drafting in the Spousal Trust includes an ousting of the even hand rule. It is also recommended to include trust language such as: “In connection with the foregoing authority to encroach on capital, I direct my Trustees to give primary consideration to the welfare of my Spouse and to ensuring that my Spouse continues to enjoy the same standard of living following my death as my Spouse enjoyed at the time of my death.”

The Spousal Trust in the blended family context enables the testator to provide for the lifetime financial needs of the survivor spouse, usually by way of unlimited access to income and limited access to capital. Upon the death of the survivor spouse, the remaindermen beneficiaries receive the balance of assets remaining in the Spousal Trust.

Tainted Spousal Trust

A Spousal Trust can be tainted by certain acts of the trustee or the language drafted in the Spousal Trust which are contrary to the ITA Requirements. A tainted Spousal Trust is ineligible for the spousal rollover or, if the tainting occurs some time after the establishment of the Spousal Trust, all previously deferred tax will immediately become payable. Some examples of such acts or drafting are:

1. Providing a loan to anyone other than the survivor spouse using Spousal Trust capital at a rate which is less than a commercial rate of interest;
2. Purchasing of a Life Insurance Policy with Spousal Trust capital on the life of the survivor spouse;
3. Limiting the distribution of income to the survivor spouse, thereby recapitalizing the Spousal Trust^[4];
4. Drafting an expanded definition of the Division Date^[5] of the Spousal Trust to include cohabitation or marriage of the survivor spouse as triggering events;
5. Paying of financial obligations which are not testamentary debts^[6] by the trustee, using Spousal Trust income or capital.

In essence, the outcome of any one of the above acts or drafting errors (among others), is that Spousal Trust funds, whether income or capital, flow to a person other than the survivor spouse, while the survivor spouse is alive. If that occurs or if pursuant to the drafting it is possible, the Spousal Trust is tainted.

It is sometimes possible to untaint a tainted Spousal Trust by implementing a series of steps as prescribed by the ITA^[7], such that the tainted Spousal Trust may regain its eligibility to the advantageous tax status.

Conclusion

There are many benefits to the use of a Spousal Trust in a family’s comprehensive, long-term estate planning, whether the family is intact or blended. The overarching goals when drafting a Spousal Trust are to avoid tainting of the Spousal Trust and to minimize the risk of litigation. The benefits of the Spousal Trust can be obtained with thoughtful planning and sophisticated drafting.

Happy New Year and to excellent drafting.

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[1] ITA section 70(6)

[2] Where spouses die within a short time span of each other, the survivorship clause avoids duplicating the probate process and paying of probate tax on the same estate twice.

[3] Subject to an application to CRA for an extension, by the executor.

[4] A written request by the survivor spouse to the trustee disclaiming a portion (or all) of the net income in any taxation year will not taint the Spousal Trust, so long as the request is initiated by the survivor spouse and the survivor spouse can enforce payment of said disclaimed income any time before his or her death.

[5] Division Date marks the termination of the Spousal Trust at which time the remaining balance of the capital is distributed to the remaindermen beneficiaries.

[6] Testamentary debts include funeral expenses, deceased spouse’s tax owing to CRA, any outstanding debts of the deceased testator which existed at date of death, probate tax, and trustee compensation.

[7] ITA section 70(7).