This article discusses a couple of recent cases – both involving estates - that raise interesting tax-related issues.  The first illustrates the insidious effect of “boilerplate” provisions in a will can have on qualifying spouse trust status.  The second shows that, while the attribution rules relating to spousal transfers stipulate that the transferor-spouse must report the gain on a subsequent disposition, this does not necessarily mean that the spouse is contractually responsible to defray the taxes. Originally published in CCH Tax Notes 570.   

Balaz – Rectification of a Spouse Trust Will

The first case, Balaz[1], involves a rectification order to a will in which a number of so-called boilerplate provisions were deleted, the objective being to create a qualifying spouse trust, so as to permit a rollover of assets into the trust.

Besides the requirement that, during his or her lifetime, the spouse must be entitled to all of the income of the trust, another key requirement for qualifying spouse trust status is that no person other than the spouse may, before the spouse’s death, receive or otherwise obtain the use of any of the income or capital of the trust.

As it relates to boilerplate provisions in a will, this requirement is discussed in Chapter 8 of our book, Tax and Family Business Succession Planning[2] as follows:

As the “no use” requirement must presumably be met under the terms of the trust, appropriate language should be inserted in the document. It therefore appears to be advisable to examine closely the powers given to trustees in a spouse trust in order to make sure . . . that the “boilerplate” does not trip over the “no use” requirement, e.g., by providing for a power to lend on any terms they see fit.[3]

Another example of boilerplate which could be problematic relates to provisions allowing the use of real estate, such as a home or vacation property, on non-commercial terms.[4]    

Both of these provisions were the subject of the Balaz rectification order.[5]  But the order involved a third provision which I found to be of interest: a standard corporate boilerplate provision allowing the trustees to incorporate and transfer assets of the estate into the corporation on such terms as they consider advisable, which was also struck out in the rectification order.[6]

The rationale for striking this clause stems from the fact that a corporation is a separate person - and the no-use requirement is that no person other than the spouse may, before the spouse’s death, receive or otherwise obtain the use of any of the income or capital of the trust.[7]     

The rectification order was granted on the grounds that it was the intention of the testator to create a qualifying spouse trust so as to defer death tax exposure[8].  Interestingly, the CRA did not oppose the order.[9]  It appears from the court proceedings that the issues emanated from the surviving spouse’s tax advisor, rather than adverse proceedings on the part of the CRA.

I am not aware of the CRA taking the position that a provision allowing the estate to form a corporation and transfer property thereto on such terms as the trustees see fit disqualifies spouse trust status.[10]  However, what is becoming increasingly obvious is that, from a technical standpoint, it is surprisingly easy to trip over the “no-use” requirement.  As another example, as discussed in Chapter 8 of our book, Question 14 of the 2008 APFF Round Table[11] may suggest that a spouse trust should contain a non-assignability clause.

 

Zeitler – The Attribution Rules Apply – But Who Pays the Tax?

The second case, Zeitler[12], was recently decided by the British Columbia Court of Appeal and dealt with the spousal attribution rules, which generally require the transferor-spouse to pay the tax on a subsequent disposition of a transferred property[13].  The Zeitler case dealt with whether - in spite of the attribution rules - there was nonetheless an implied term in the transfer agreement in question that the transferee-spouse should defray the tax. 

The case involved a wife’s purchase of two rental properties in the mid ‘80’s.  A couple of years after the purchase, the properties were transferred to the husband for fair market value consideration[14].  After the transfer, the wife had no further involvement with the properties.  The husband passed away intestate, such that the husband’s children would be entitled to most of the estate, but under the attribution rules, the wife would have to pay tax on a deemed disposition of the property, arising from the husband’s death.[15]

The court held that the operation of the attribution rules so as to tax the gain in the hands of the wife (i.e., transferor-spouse) was not determinative as to whether there was a contractual obligation for the transferee-spouse to defray these taxes[16].

The court further held that there was an implied term in the transfer agreement between the spouses that the husband – now his estate – would pay the taxes on a subsequent disposition.  Although a court should be reluctant to rewrite contracts, cases indicate that this can be done based on the presumed intention of the parties where the implied term must be necessary to give business efficacy to a contract.[17]  The judgment indicates that it seems to be “obvious that, if asked at the time they formed the contract which of them was to be responsible for the tax, both parties would have said that Mr. Zeitler would be responsible. He acquired both the legal and the beneficial interest in the property. He was entitled to the gain for his sole use.”[18]

These sorts of issues might arise, for example, on a second marriage for both spouses.  Suppose that the husband’s and wife’s assets are each to be left to children of their first marriages.  However, the husband agrees to fund the purchase of a luxury vacation property to be owned by the wife – and to be left to her children[19].  If the wife were to predecease the husband[20], the husband may assert that, based on Zeitler, there is an implied term that the wife’s estate – i.e., the children from her first marriage - should pay the taxes on the deemed disposition of the vacation property.

But when should there be such an implied term?[21]  In the Zeitler case itself, it appears that the transfer price was at or near the cost of the properties, so that the implied obligation of the transferee-spouse to pay tax in respect of the transferred properties did not have to take into account deferred tax liability existing at the time of the transfer.  Suppose, however, that this was not the case – i.e., there was deferred tax exposure at the time of the transfer.  Should there still be an implied term?  Does this depend on the magnitude of the deferred tax exposure relative to the total tax?  Should the implied term relate only to post-transfer appreciation?

While it may be said that the Zeitler case may add some uncertainty as to who must pay the tax when the attribution rules apply, the situations in which this may actually be in dispute may be fairly limited, in view of the fact that specific rules apply when spouses separate[22]. 

 

David Louis, tax partner, Minden Gross LLP, a member of MERITAS law firms worldwide. David's practice focuses on tax and estate planning for entrepreneurs and their corporations. dlouis@mindengross.com.  The author wishes to thank his tax partner at Minden Gross, Joan Jung, for originally pointing out these cases as well as her insights thereon.