How does "Spousal Rollover" help you in tax-planning?

In King Group's most recent Newsletter, they cited an article written by Mr. John Mill, a Succession Tax Counsel called "Spousal Rollover - the Most Valuable Tax Plan?" Mr. Mill did a fantastic job outlining the benefits in tax planning with regards to spousal rollovers. Please see below for the article:

Much of the world’s wealth is created through capital gains. A capital gain is the increase in the value of an asset over time. The taxation of capital gains has two “top secret” wealth building features:

1)  Tax is deferred so that the compounding train stays on track;

2)  Only ½ of the increase in value is subject to tax – the other ½ of the increase in value is tax free.

But all good things come to an end – capital gains are harvested on the sale of the asset or the death of the owner. The tax on death arises as a result of a “deemed disposition”. When we say “deemed” we mean that there is no actual sale; instead CRA pretends there is a sale and then demands “pay up buster, or else!!”.  This somewhat insensitive demand creates two problems:

1)   The compounding train is knocked off the track;

2)   The lack of cash to satisfy CRA’s demand creates a liquidity problem.

Fortunately, if there is a surviving spouse, the Income Tax Act provides an automatic solution called a “spousal rollover”. A rollover means that the property can be gifted to the spouse and the tax will once again be deferred: the compounding train continues to chug along, and CRA ceases and desists with its demands.

When you consider that: there can be a multi-decade lag in the life span of spouses, and that this rollover applies automatically to everyone — the spousal rollover probably is the most valuable tax plan of all time. Whether or not that is true it is clear that spousal roll-overs are an important part of the succession planning tool kit. The purpose of this post is to take a quick jog through the key points of spousal rollovers so they may be more firmly held in mind.

The most important point is that the spousal rollover provisions are very generous and interpreted very broadly to include rather than exclude transactions. It is not often that CRA will raise issues with spousal rollovers. One famous case was the Supreme Court case of Lipson. In that case the lower income spouse used a spousal rollover to attribute losses to a higher income spouse, the Supreme Court found this to be a reversal of the purpose of the attribution rule and therefore abusive.

Spousal rollovers apply to gifts during lifetime and bequests on death. The difference is that any income generated during the life of the spouse making the gift is attributed back to them — attribution of income ends on the death of the spouse making the gift.

The definition of “spouse” is very wide including common-law and former spouses.

All depreciable and non-depreciable capital property is automatically rolled over to the spouse unless they elect out of the rollover. There is no form for such an election, instead you the election is made by reporting the disposition on the tax return of spouse who made the gift. This results in tax to pay; however the spouse receiving the gift gets an increase in the adjusted cost base of the asset meaning there will be less tax to pay when they sell or die.

In determining the extent to which it may be beneficial to elect out of the rollover and trigger tax in order to increase the adjusted cost base, the succession planner would consider whether the deceased has:

• personal credits and low marginal tax rates;
• net capital losses or non-capital losses that would otherwise expire;
• a capital gains deduction for qualified farm property or qualified small business corporation shares;
• donation credits or carry forward amounts; or
• alternative minimum tax credits carried forward from prior years

In addition to capital properties there are other properties including: inventories, resource properties, and registered plans (RRSPs, RRIFs) that qualify for spousal rollover treatment. The spousal rollover applies to almost any form of transfer to a spouse: court order; disclaimer; release; or surrender; and, may apply to jointly held property if each spouse rolls over their own interest in the property.

The spousal rollover can be to a “spousal trust”. The topic of spousal trusts will be the subject of a future post as there are many considerations, but the following discussion covers the basics.

Spousal trusts settled during the life of the gift giving spouse are taxed at the top marginal rate; whereas testamentary trusts made as a consequence of death are taxed at graduated rates resulting in a tax savings of about $15,000 per year. Also the 21 year deemed disposition rule does not apply to qualified spousal trusts. Once again over a potential multi-decade span a qualified spousal trust can be very valuable.

CRA has a set three conditions for a qualified spousal trust. These conditions seem confusing at first but they are really straightforward if you consider that these conditions are designed to mimic what would happen if the spouse owned the property without a trust:

   

• The first condition is that the property must “vest indefeasibly” within 36 months. A lot of confusion is caused by the fancy phrase “vest indefeasibly” but it simply means: there cannot be any future condition that would cause you to lose the property. In other words you can’t say: “… this property goes to my spouse until my daughter graduates from school”. If you think of normal property ownership the “vesting indefeasibly” concept is perfectly simple: you would never buy a car that is yours until a daughter graduates — it just wouldn't make any sense.
• Secondly all of the income must go to the spouse during their life. Once again this is what would happen if the spouse owned the property. Once the spouse receives this income they could do anything with it including giving it away.
• Thirdly none of the capital can be distributed to anyone other than the spouse during their lifetime. If you owned a bank account you would expect that the money in that account could be given away by someone else.

An important ‘heads up” for business succession planning is that a shareholder agreement requiring a partner to purchase and pay for shares directly from the estate instead of from the surviving spouse results in no rollover and potential loss of that spouses’ capital gain.

An important limitation of the spousal rollover is that you must be a Canadian resident to qualify. This means non-residents do not qualify; however, the Canada/US tax treaty extends Canadian spousal rollover privileges to US residents with Canadian spouses.