1. Definition of Principal Residence
The rules in the Income Tax Act permit transfers of capital property between spouses (either during lifetime or on death) to take place without triggering capital gains or losses. The following discussion with respect to absolute gifts to a spouse in a will applies equally to a transfer of property to a spouse during his or her lifetime. The Federal government has passed the Modernization of Benefits and Obligations Act (the "MBO Act"). The MBO Act extends benefits and obligations under several federal statutes, including the Income Tax Act to all couples, including same sex couples that have been living together in a conjugal relationship for at least one year. The changes to the Income Tax Act as a result of the MBO ACT came into effect in 2001 taxation year. For all intents and purposes, same sex couples who have been living in a conjugal relationship for at least one year will be treated as "spouses" for all purposes of the Income Tax Act, including spousal rollovers that are discussed below.
There have been some cases that have considered the definition of a "conjugal relationship". These are primarily family law cases but they throw light on how this phrase would be applied in the context of the Income Tax Act. A conjugal relationship does not require cohabitation under the same roof. A court would consider a variety of factors including:
1. Whether the parties shared sexual intimacy;
2. Whether they prepared meals, maintained premises or performed domestic chores together;
3. Whether the parties had joint financial arrangements;
4. The attitude of the parties towards their children; and
5. How the parties are viewed by friends and family.
(a) Absolute Gift to Spouse
All capital property owned by an individual taxpayer is deemed to have been disposed of on death for tax purposes. The rule provides that the capital property is disposed of for proceeds equal to the fair market value of the property at the time of death. The estate is deemed to have acquired the property at an adjusted cost base equal to the deemed proceeds of disposition. Therefore, if there are any accrued gains they will be triggered and capital gains will be payable by the estate in the terminal return. Capital gains can be deferred if capital property is left to a spouse in a will. There is a provision in the Income Tax Act which will automatically defer the capital gain if a spouse becomes absolutely entitled to the capital property either as a result of the will provisions or the provincial intestacy laws, if there is no will. The deceased spouse is deemed to have disposed of the property for proceeds of disposition equal to the adjusted cost base (ACB) of the property and the surviving spouse is deemed to have acquired the property at an ACB equal to that of the deceased spouse. Capital property includes depreciable property and eligible capital property. The depreciable property is deemed to have been disposed of for proceeds equal to the depreciated capital cost of the property to the deceased and the estate is deemed to have acquired it at the same amount. The estate is also deemed to have acquired the property at the original cost of the deceased for purposes of capital gains and recapture. Where a testator has capital property with significant accrued gains and plans to leave some property to s spouse and other property to other individuals, the spousal rollover may be an important factor to consider.
(b) Buy-Sell Agreements
If the testator owns shares of a private company which are subject to a buy-sell agreement, special care should be taken. The spousal rollover is only available if the spouse is absolutely entitled to the capital property as a consequence of the death of the deceased spouse and if the property vests in the spouse absolutely within 36 months after the death of the deceased spouse. Where a buy-sell agreement requires the estate to sell shares to a third party, the requirement for vesting in the surviving spouse may not be met and the spousal rollover may not be available. Where the tax plan contemplates both the existence of a buy-sell agreement and the availability of the spousal rollover on death, it is wise to draft the buy-sell provisions so that the purchaser is bound to purchase the shares but the estate is not obliged to sell them.
(c) Electing Out of the Spousal Rollover
It is possible for the personal representatives of the estate to elect out of the automatic spousal rollover. There may be cases where it makes sense to trigger a capital gaining connection with the deemed disposition of property on death. Since the spousal rollover will take place automatically if property is left in a will to a spouse, or a qualifying spousal trust, or if a spouse inherits the property under the intestacy provisions, it is important to consider whether to elect to trigger the gain. For example, if there are capital losses of the deceased which need to be used up, or if the enhanced capital gains exemptions is available to shelter the gain, it may be preferable to trigger the gain on death and permit the surviving spouse to acquire the property at the increased ACB. The election must be made on an asset-by-asset basis and results in the disposition of the property elected upon at proceeds of disposition equal to fair market value at death. It is not possible to trigger only a portion of the accrued gain in respect of an individual property. With respect to shares, each share is considered a separate asset and one could elect on some shares without electing on all of the shares.
(d) Qualifying Spouse Trust
A tax free rollover is also available if capital property is left to a "qualified spouse trust" ("QST"), therefore, it is not necessary to leave property directly to a spouse in order to defer the capital gain until the death of the surviving spouse. Where the testator wishes to permit the surviving spouse to use the capital property but wants to ensure that it is available to others at the death of the surviving spouse, a qualifying spouse trust will accomplish that objective while also permitting a tax deferral. To be eligible for the rollover to QST several requirements must be met:
- The QST must be created by the will of the deceased spouse or by a court order in respect of the estate of the deceased spouse pursuant to dependants' relief legislation;
- The spouse of the deceased must be entitled to receive all of the income from the trust during his or her life time;
- During the lifetime of the surviving spouse, no one other than the spouse may receive either income or capital from the trust;
- The deceased spouse must have been a resident of Canada immediately before death and the QST itself must be resident in Canada.
(e) Tainted Spouse Trust
Care must be taken in drafting the provisions of the QST. Where the surviving spouse's entitlement to income will cease on remarriage, such a provision has been held to taint the QST. Any provision which would permit anyone other than the spouse to become entitled to income or capital will taint the trust. For example, a provision permitting capital encroachment in favour of the spouse and children would taint the trust and prevent the estate from obtaining the tax deferral. A provision directing or permitting the debts of the estate (other than death duties or income taxes) to be paid out of the QST may also taint it. A power permitting the estate trustee to make loans to persons other than the spouse on non-commercial terms while the spouse is still alive may taint the trust even if the power is never exercised.
(f) Converting a Tainted Trust to QST Status
There are some steps that can be taken to ensure the tax deferral is available if the QST has been tainted. These steps include the use of disclaimers, renunciations and the exercise of a special election all of which are described below.
If a beneficiary disclaims an interest under a will before receiving any benefits, the disclaimer will void the gift altogether. In our example of a tainted spouse trust we mentioned a provision permitting capital encroachments in favour of the spouse and children. If the children disclaim all entitlement to capital encroachments during the spouse's lifetime, this will convert the trust to a QST, provided the other requirements are met. It is essential that the disclaimer be given before the beneficiary receives any benefit under the trust. If a benefit has been received and the beneficiary subsequently gives up all rights to capital encroachments, this will be considered a surrender of release of the trust interest and will constitute a disposition of the trust interest by the beneficiary. It will convert the tainted trust into a QST. It should be noted that minor is not capable of giving a valid disclaimer.
Where a disclaimer of an interest in a tainted trust would resulting some other than the spouse acquiring an interest, it is possible for the beneficiary to renounce the interest in favour of the spouse. This will act as an assignment of an interest in the trust to the spouse and cause the trust to be a QST and therefore, be eligible for the rollover. It will be a disposition of the interest in the trust by the renouncing beneficiary and there may be tax consequences flowing from this disposition that should be considered.
(i) 36 Month Vesting Rule
As mentioned earlier, in order to qualify as a QST, the property must vest in the QST within 36 months after the death of the deceased spouse. Care should be taken to ensure the disclaimer or renunciation takes effect prior to the expiration of the 36 month period following death.
(j) Direction to Pay Testamentary Expenses From Trust
If a QST has been tainted because the will directs that debts be paid out of the QST, a special election can be filed which has the effect of treating the trust as a QST and causes property of the trust in an amount equal to the debts paid by the trust to be subject to the deemed disposition rules. It is possible to choose specific properties on which the election is to be made. Those properties elected upon are deemed to have been disposed of for proceeds equal to the fair market value of the property which will trigger any accrued gains. If the fair market value of the property elected upon exceeds the value of the non-qualifying debts, only a portion of the accrued gain will be triggered.
(k) Rollover of Land Inventory and Resource Properties
It is also possible to transfer land inventory either directly to a spouse or to a QST and obtain a tax deferral advantage. The same requirements mentioned above apply. The deceased is deemed to have disposed of the property at proceeds equal to the lesser of cost or fair market value at death. This rollover is particularly advantageous asset not only defers the tax that would apply on death, it may also permit the conversion of what would be treated as an income gain on death (because the property was held as inventory by the deceased) to a capital gain, provided the surviving spouse or the QST holds the property on capital account. Resource property transferred to s spouse or QST is also eligible for rollover treatment.