Alter Ego Trusts and Charitable Remainder Trusts
by Arthur Drache
At a recent conference of the Canadian Association of Life Underwriters, a question was posed to the CRA about the use of alter ego trusts as a functioning charitable remainder trust. An alter ego trust is an inter vivos trust created after 1999 by a taxpayer who had attained 65 years of age at the time the trust was created4, under which (i) the taxpayer is entitled to receive all of the income of the trust arising before the taxpayer's death, and (ii) no person except the taxpayer can, before the taxpayer's death, receive or otherwise obtain the use of any of the income or capital of the trust.
One major attraction is that property can be transferred into an alter ego trust without a deemed realization.
Charitable remainder trusts ("CRTs") have been used in Canada for many years, despite the fact there are no specific rules in the Income Tax Act dealing with such trusts. As written by the CRA in its Registered Charities Newsletter #27:
"A charitable remainder trust involves transferring property to a trust whereby the donor or beneficiary retains a life or income interest in the trust but an irrevocable gift of the residual interest is made to a registered charity. A registered charity can issue an official donation receipt for the fair market value of the residual interest at the time that the residual interest vests in the charity".
In that Charities Newsletter and in Interpretation Bulletin IT-226R, the CRA provides a number of requirements that must be satisfied for there to be a gift of a residual interest. These requirements include an irrevocable transfer of the property, vesting of the property in the charity at the time of transfer, and no ability to encroach on capital for the life tenant.
The CRA takes the position that a gift to a CRT results in a taxable disposition of the entire property. However, the CRA takes the additional view that the donor can elect under subsection 118.1(6) for the proceeds of disposition to be not greater than the FMV of the property and not less than the ACB of the property. In other words, the donor does not have to recognize a gain on the transfer if he or she elects at the ACB of the property. The donation receipt would also be equal to the elected amount. If the fair market value of the residual interest of the property is less than the elected amount, the donation receipt, in the CRA's view, cannot be greater than the value of the residual interest.
The CRA at the CALU conference made the following observations.
"With the above as background, the provisions in the Income Tax Act for alter ego trusts and joint partner trusts could effectively allow for a CRT if the alter ego beneficiary or the joint partner beneficiaries (as the case may be) do not have any capital encroachment rights and the other requirements for a CRT have been satisfied. As the rules in the Income Tax Act provide for an automatic rollover of certain properties to these trusts (unless the transferor elects out of the rollover rules), the rule in subsection 118.1(6) would not be needed to avoid any gain on the transfer. "
The question posed to the CRA was this. If an individual transferred property to an alter ego trust as described in the above, can the CRA confirm that there would be no recognition of a gain on the transfer of the property and a donation receipt could be issued by the registered charity beneficiary equal to the value of the charity's residual interest?
· Unless an election is made to the contrary, an individual may transfer property to an alter ego trust on a tax-deferred basis under subsection 73(1) of the Act provided the transfer is made in the circumstances described in subsections 73(1.01) and 73(1.02) of the Act.
· Consequently, where an individual transfers property to an alter ego trust there would generally be no recognition of a capital gain. Consistent with IT-226R, where a gift is made to a registered charity of a residual interest in an alter ego trust, and there is no right to encroach on the trust's capital for the benefit of the settlor, an official donation receipt could be issued by the registered charity beneficiary in an amount equal to the value of the charity's residual interest at the time the particular interest vests, provided the fair market value of that interest can otherwise reasonably be established at that time.
· It should be noted, however, that any accrued capital gains with respect to the trust's capital property as at the end of the day in which the settlor of the trust dies, would be taxed in the trust, pursuant to subsection 104(4) of the Act for that year. This factor would be relevant in establishing a reasonable estimate of the value of the residual interest in the trust to the charity at the time the trust is created.
Thus, it seems clear that one can use all or part of an alter ego trust to create a charitable remainder trust though of course the question of the immediate value of the gift remains, something which has always bedevilled CRTs in Canada where despite literally years of negation with the CRA (we recall meeting on this topic more than ten years ago) no clear cut valuation rules, most notably what discount rate applies to the deferred gift has ever been legislated. This on one reason why CRTs have never achieved the same popularity in Canada as they have in the United States where they are considered a routine charitable transaction.
The CRA's comments at the CALU conference shows a certain openness of mind but readers should be cautious. Doing this sort of transaction without good legal, accounting and actuarial help might be akin to a do-it-yourself appendectomy.