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Tax Traps & Tips: The Alter Ego Trust: A Tax-Effective Tool to Protect Your Testamentary Wishes
Beyond Numbers · February 2002

By Garri Terzian, CGA, Manager, Taxation, Deloitte & Touche LLP, Vancouver

Alter Ego Trusts

The Wills Variation Act provides disgruntled children, spouses, and common law spouses standing to challenge a will if they feel they have not been justly provided for. However, assets of the deceased distributed pursuant to the terms of an alter ego trust are unlikely to be challenged under the Wills Variation Act.

Protecting one's wishes after death is one of the many significant benefits of an alter ego trust. Another benefit is that assets passing pursuant to the terms of the alter ego trust are not subject to probate fees, unlike those passing on the death of an individual under a will. (Probate fees, depending on the province of residence, can be as high as $15,000 on every $1 million of estate assets.) Furthermore, avoiding probate means the assets of the deceased are not publicised.

How is the alter ego trust different from other trusts?

Before the introduction of alter ego trusts, other inter vivos trusts were available to address the above concerns. The problem with these other inter vivos trusts was that the transfer of property to the trusts generally occurred at fair market value, triggering income taxes prematurely.

An individual can generally contribute capital property to an alter ego trust tax-free.

An alter ego trust is defined in the Income Tax Act as a trust created after 1999 by an individual who is at least 65 years old, for the individual's exclusive benefit. Until the individual's death, no other person may receive or otherwise obtain the use of trust income or capital.

There are several requirements for transferring capital property to alter ego trusts on a tax-deferred basis:

• The tax deferred transfer of assets only applies to capital property (not inventory including raw land, goodwill, or resource property).
  
  
• Non-depreciable capital property is transferred at its adjusted cost base. Depreciable property is transferred at its undepreciated capital cost.
  
  
• Both the settlor and the alter ego trust must be a resident of Canada.
  
  
• The transfer will automatically occur on a tax-deferred basis unless the transferor elects to have the transfer take place at fair market value. Note that the election is an all-or-nothing election. The transferor cannot choose a value between cost and fair market value.
  
  
• The rollover occurs regardless of whether property is given or sold to the alter ego trust.

Trust income is paid or payable to the income beneficiary throughout his or her lifetime and is therefore taxed at the individual's marginal tax rates. The transferor has access to the trust income and control of the trust capital prior to death.

An alter ego trust will have its first deemed disposition on the death of the individual who created the trust. However, the alter ego trust can make an election in its first taxation year to be subject to the 21-year deemed disposition rule, such that the first deemed disposition will occur 21 years after the trust is created, rather than on the death of the settlor.

There will be a deemed disposition at fair market value of the assets in the trust if and when the transferor should leave Canada. The resulting gain and CCA recapture will be subject to departure tax, and since an alter ego trust is an inter vivos trust, the gain and recapture will be taxed at the highest marginal tax rate.

Key Points to Remember:

• On the date of deemed dispositionwhether upon death, emigration of the settlor, or on the 21-year anniversary of the trustany accrued capital gains and CCA recapture will be taxed in the trust in the province in which the trust is resident. Therefore, the alter ego trust may be set up in province with a lower tax rate than that of the province where the settlor resides. Depending on the provinces involved, income taxes upon death may be reduced by as much as about 10%.
  
  
• If the deceased had losses while the trust had gains, or vice versa, these losses and gains cannot be offset. Thus, if the taxpayer is expected to be in a low marginal tax bracket or to have unused losses at the date of death, it may not be tax efficient to separate the properties into an alter ego trust subject to tax at the top rate. If a power of encroachment has been retained, it might be beneficial to review the trust assets from time to time and return assets to the individual if a better overall tax result would be achieved by the taxation of that asset in his or her hands.
  
  
• Prudent planning might dictate a search for assets with potential losses in the individual's hands that could be rolled into the trust and used against gains resulting from the deemed disposition.
  
  
• Real estate transfers may be subject to land transfer tax in certain provinces.
  
  
• Although the use of an alter ego trust avoids probate fees, there will be a loss of graduated tax rates otherwise available to a testamentary trust after death. Therefore, if the individual does not wish to have the assets distributed immediately after his or her death, the cost and benefit should be analysed between probate fees avoided and tax savings lost from a testamentary trust.
  
  
• Since no person except for the settlor may receive or otherwise obtain the use of any of the trust's capital (or income) during the settlor's lifetime, the settlor's capital interest in the trust may be attacked by the taxpayer's creditors. If this is a concern, the settlor should have only an income interest in the trust to protect trust assets from creditors.
  
  
• The $500,000 capital gains exemption is not available to an alter ego trust with respect to gains on property arising on the deemed disposition on the date of death. The deemed disposition on death occurs at the end of the day of death, which means that any capital gain is not attributed back to the settlor because he or she is deceased. The situation is different for a capital gain realised during the lifetime of the settlor. In that case, the $500,000 capital gains exemption is available to the alter ego trust on realised qualified capital gains. Extreme caution should be exercised if qualified small business corporation shares or qualified farm property are to be transferred to an alter ego trust.

Before the introduction of the alter ego trust, the transfer of assets to a trust could cause adverse tax consequences. With an alter ego trust, the transfer can now be achieved on a tax-free basis. However, due to the potential pitfalls, professional advice should be sought before entering into any such arrangement.

Web Works: What's New

by Rita Mikusch, ICABC Webmaster

New Pop-Up Poll Question

The new question for the Pop-Up Poll is: "When do you expect BC's economy to recover?" It will be available on the ICABC website (www.ica.bc.ca) until the end of February 2002, so sign in now and tell us what you think!

In case you haven't yet seen our new Pop-Up Poll, it's available on the homepage of the ICABC website. It's easiest to access it by clicking on the black and white ICABC logo in the top left-hand corner of the screen. Once you've clicked on the logo and arrived at the homepage, you'll see a blue circle in the middle of the page that contains the current Pop-Up Poll question. Simply click on it to give us your input.

If you have any suggestions for future Pop-Up Poll questions, please email them to me at mikusch@ica.bc.ca. We'll be changing them approximately every six weeks.

Firms Listing Now Online

The listing of BC CA firms is now on the ICABC site. You'll find it under "Who We Are" in the ICABC section.

On the firms listing page, you'll see a map of BC. By clicking on the region of the province in which you'd like to find a CA firm, you'll be taken to a search engine that will help you narrow your search by company name or city.

The firms listing will be updated quarterly; however, in special cases, should your firm's contact information change between those times, we will be able to update the list manually.

Member Benefits

Have you checked out the "CA Discounts and Deals" available under "Member Benefits" in the ICABC section of the website? You'll find a whole range of opportunities here: hotel, travel, and car rental discounts; special deals on certain mobile phones, restaurants, and office supplies; and great offers on really important things like Arts Club Theatre tickets and Canucks hockey tickets!

Be sure to check it out regularly for the latest offers. Some of these deals are time limited and only available for a short period of time.

Women CA Group

The Women CA Group now has its own page on the ICABC website, featuring contact information, current events, and news on past events. Look for it under "CA Issues" in the CA Advisor section of the site. For more information on the Women CA Group, contact Laurinla Ma at laurinla@wdmca.com or Evelyn Lee at elee@johnsenarcher.bc.ca.

Future Upgrades and Revisions

Do you have any ideas for upgrades or revisions to the ICABC website? Email them to me at mikusch@ica.bc.ca.