Our wealth and private client services group recently worked successfully with the Department of Finance (Finance) to find a solution to a change in the law that resulted in unfair treatment of disabled Canadians.
More particularly, the changes made in 2016 to the definition of “principal residence” in the Income Tax Act (ITA) resulted in only three categories of trusts being eligible to claim the principal residence exemption (PRE) as of January 1, 2017:
- alter ego trusts, joint partner trusts, spousal trusts and self-benefit trusts;
- qualified disability trusts, but only if they are testamentary (i.e. created by will or otherwise as a consequence of someone’s death); and
- subject to certain conditions, inter vivos or testamentary trusts established for a minor child where one or more parents are deceased.
These changes caused inter vivos trusts established for disabled taxpayers in reliance on the previous tax rules to be disqualified from claiming the PRE for principal residences held in such trusts. Existing trusts of this type that could not distribute a residence to the beneficiary due to legal disability or practical concerns preventing the disabled beneficiary from holding property faced disastrous consequences. Such trusts would be deemed to dispose of the residence 21 years after their establishment pursuant to paragraph 104(4)(b) of the ITA and any resulting capital gain would be taxable to the trust.
The standard planning to avoid the consequences of the rule changes involves having the trust distribute the residence held by it to a beneficiary on a tax-deferred rollover basis, so that an individual beneficiary owns it personally on the twenty-first anniversary of the trust’s establishment. However, a disabled individual might not have legal capacity to hold property personally or to subsequently settle a self-benefit trust.
To provide general relief from the consequences of the changes, the 2016 ITA amendments provided transitional rules that allowed trusts holding a principal residence to claim the PRE on the accrued gain in the value of the residence up until December 31, 2016, based on a valuation of the residence on that same date. However, this would provide no relief for years after 2016. Therefore, this transitional relief, while helpful in some circumstances, would be insufficient to shelter the gain that would likely arise on many trusts’ twenty-first anniversaries where the standard planning discussed above cannot be implemented.
Our Vancouver wealth and private client services group brought this problem to the attention of Finance and discussed the related challenges faced by disabled Canadians and their families. As part of these discussions, legislative solutions to address the problem were discussed, resulting in Finance issuing a comfort letter on September 4, 2019.
The comfort letter states that Finance will recommend to the Minister of Finance that the ITA be amended to allow an inter vivos trust established for the benefit of an individual who qualifies for the DTC to be eligible to claim the PRE provided certain conditions are met. The proposed fix involves amending the definition of “principal residence” so that an inter vivos trust would be able to claim the PRE for a taxation year provided that the general designation requirements of a principal residence are met and the following conditions specific to the trust are fulfilled:
- a beneficiary of the trust is an individual resident in Canada during the year who is eligible to claim the DTC;
- the beneficiary is a child, spouse, common-law partner, or former spouse or common-law partner, of the settlor of the trust; and
- no person other than a beneficiary described above may, during the beneficiary’s lifetime, receive or otherwise obtain the use of any of the income or capital of the trust.
The proposed recommendation would apply retroactively to taxation years following 2016, and is a welcome change, as it corrects the resulting inequity arising from the 2017 changes that put disabled individuals at a disadvantage and restores their ability to claim the PRE for their own residences in appropriate circumstances.