The following excerpt is from Douglas Gray and John Budd's The Canadian Guide to Will & Estate Planning, published by McGraw-Hill Professional.
Taxes Arising on Death
We said earlier (tongue in cheek) that, from a tax viewpoint, the U.S. is a good place to live, and Canada is a great place to die. But is this really true? Is Canada really so much better than the U.S. from an estate planning viewpoint because of the absence of estate taxes in Canada?
As outlined below, the situation is not as rosy as it might seem because of the income taxes that can arise in a person's final income tax return for the year of death.
For most people, the greatest tax exposure exists with respect to the cash and investments which are sitting within an RRSP or RRIF. Generally speaking, the full value of these "registered" accounts at the time of death must be reported as "income" in the person's final income tax return. The amount of income tax actually payable will depend on the deceased's marginal income tax rate in his or her final income tax return. (However, there are a few important exceptions, such as when the RRSP or RRIF is transferred to a surviving spouse.)
Other assets can also attract tax in your estate. For example, if you own a vacation home that has appreciated in value, a taxable capital gain may eventually have to be reported by your executors in your final income tax return, because of the "deemed disposition" on death. Similarly, if you have a portfolio of marketable securities, some of the long-held stocks may have increased significantly in value. Such accrued but unrealized gains as of the time of death will give rise to income tax in your final income tax return, unless there are large enough offsetting deductions or tax credits, such as charitable donations.
Estimating the Future Capital Gains Taxes in Your Estate
For estate planning purposes, you need to think about the capital gains taxes that will be imposed on your estate in the future. Tax rates change from year-to-year, and it is anybody's guess what the income tax rates will be a year from now, let alone in five, 10 or 20 years. Estate planning is a long-term proposition, and there is no way of knowing how long we will live.
Therefore, for purposes of estimating the amount of capital gains tax that could be payable by your estate in the future, it is probably best to err on the high side.
For someone with an annual taxable income over $75,000, the effective rate of income tax (federal and provincial combined) on a $100 capital gain is currently in the range of 20 to 26 per cent, depending on the province of residence.
Therefore, for estate planning purposes, we recommend that you use a capital gains tax rate of 25 per cent in estimating the taxes that could be payable by your estate in the future.
Deemed Disposition for Capital Gains Purposes
Since we don't have a gift tax, you may be wondering if it is possible to avoid capital gains tax on death by giving away your assets during your lifetime. Unfortunately, a gift of assets during your lifetime is treated for capital gains purposes in much the same way as assets that are deemed to have been disposed of at the time of death. If you transfer an asset to another person (other than your spouse) by way of gift, you are considered for income tax purposes to have received proceeds of disposition equal to the fair market value of the property, even though you receive nothing in return. Because of this rule, any gift of property that has appreciated in value to someone other than your spouse will force you to recognize a capital gain in your income tax return. Here is an example of how a "paper transaction" can have undesirable tax consequences:
PLANNING TO PROTECT ● Giving Gifts of Equal Value-Or Not?
Graham and Robert are the best of friends and each of them has a daughter who is getting married. Graham is going to give his daughter Marjorie and her husband-to-be $25,000 cash to help them save for a house. Not to be outdone, Robert is going to give his daughter Joan $25,000 worth of shares of Microsoft Inc., which he bought in the early 1990s for only $1,000.
Graham's gift will be tax-free (since we do not have any gift tax), but Robert will have to report a capital gain in his tax return. Because he is transferring "property" rather than cash, he will be considered to have disposed of the Microsoft shares for proceeds of disposition equal to the current fair market value of the stock. Since his adjusted cost base (his cost) is only $1,000, he must report a $24,000 capital gain. Since 50 per cent is taxable, the income tax could be about $5,500 assuming that Robert is in the top income tax bracket.
Income Tax on RRSPs and RRIFs
If a Registered Retirement Savings Plan (RRSP) is in existence at the time of death, the full value of the RRSP must be reported in the deceased's final income tax return. An exception to this is where investments held in a RRSP or RRIF account have dropped in value after the date of the person's death until when such investments are transferred to the beneficiaries. In such cases, the amount of the drop in value can be claimed as a deduction in the deceased's final income tax return against the year of death RRSP/RRIF income inclusion.
Another very important exception to the rule regarding the full value of RRSP/RRIF accounts being included in the deceased's year of death taxable income is where the deceased was survived by a spouse, and the RRSP is transferred to the spouse. In that case, the income tax will merely be postponed, since taxes will be payable by the spouse as funds are withdrawn from the RRSP in the form of an annuity or as payments under a Registered Retirement Income Fund (RRIF). Any amount remaining in a RRSP or RRIF at the time of the spouse's death would be subject to income tax at the time of the spouse's death.
YOUR PRIMARY TAX PLANNING GOALS
The primary tax planning objectives that should be an integral part of your estate planning are: Tax Deferral It makes sense to defer (postpone) capital gains taxation for as many years as possible, by taking advantage of any rollovers that are available, such as the spousal rollover, or the farm property rollover.
Minimize Taxes Arising on Death
You should minimize the future capital gains taxation on death, by taking advantage of whatever exemptions are available, such as the principal residence exemption, and the lifetime capital gains exemption for shares of a small business corporation.
Minimize or Eliminate Your Exposure to Foreign Estate Taxes
If you own assets outside of Canada, or if any of your intended beneficiaries reside in a country which imposes an estate or inheritance tax, you should explore ways of reducing or eliminating the exposure to foreign estate or inheritance taxes that could be payable on your death. For example, consider setting up a Canadian investment holding company to hold your investment portfolio, if it includes U.S. stocks or bonds.
Achieve Current Income Tax Savings
You may achieve some current income tax savings at the same time as you restructure your affairs to achieve future estate planning objectives. For example, there might be some income tax savings resulting from the formation of an income splitting family trust that is part of your overall estate plan. Any tax savings that you realize during your lifetime should mean that you will have a larger net worth in the future, and a larger estate for your family.
Avoid Unnecessary Complexity, and Retain Flexibility
Ensure that any plans which you implement are sound from a financial and legal viewpoint, and flexible enough to be adapted to your changing circumstances and future changes in the tax laws. Don't embark on a complex tax planning strategy, unless you fully understand what is involved, and you are prepared to live with the complexity.
YOUR GENERAL ESTATE PLANNING OBJECTIVES
Before delving into tax planning objectives, keep in mind that any tax planning strategies that you may be thinking of implementing should always be tested against your more general objectives, to ensure that they are not at cross purposes.
Excerpt of The Canadian Guide to Will & Estate Planning is courtesy of Douglas Gray and John Budd Copyright © 2011