Spousal Trust Trap: Waiving Entitlement to Income

Testamentary spousal trusts are often used as a tool in tax and estate planning, most notably for their income-splitting advantages. Although most practitioners in this area are aware of the conditions necessary to establish a testamentary spousal trust, many may be surprised to learn that a spouse's right to waive his or her entitlement to income from the trust could potentially cause the trust to lose its testamentary status.

One of the conditions necessary to the establishment of a valid spousal trust is that no person other than the spouse (or common-law partner) may, before the spouse's death, receive or otherwise obtain the use of any of the income or capital of the trust (paragraph 70(6)(b)). Typically, this condition is satisfied by providing in the trust deed that, prior to the death of the spouse, (1) all of the income of the trust must be paid to the spouse in the year in which it is earned, and (2) the capital of trust may be distributed to the spouse (and only to the spouse) at the discretion of the trustees. In some cases, however, the trust deed may contain language that provides that although the trust's income must be payable to the spouse, the spouse may waive his or her entitlement to the income, in which case the income remains taxable in the trust.

When a spouse exercises this right, the CRA's position is that the trust ceases to qualify as a testamentary trust as defined in subsection 108(1) (see CRA document no. 2005-0141181C6, October 7, 2005, which cites Greenberg Estate v. The Queen, [1997] 3 CTC 2859 (TCC)). In the CRA's view, any amount that becomes payable to the spouse is an asset of the spouse, and waiving the entitlement to an asset in favour of a trust is considered a contribution to the trust by someone other than the deceased, which is not permitted under the definition of "testamentary trust." If the testamentary status of a trust is compromised, the benefit of graduated marginal tax rates is lost and the trust is instead taxed as an inter vivos trust at the highest personal tax rate without the benefit of personal tax credits.

Given the potentially significant tax consequences, practitioners should be wary of providing spouses with the ability to waive their entitlements to income from spousal trusts. When dealing with existing trusts that already contain such language, keep in mind that the reason for providing a spouse with the right to waive his or her entitlement to income is presumably that the spouse is already taxable at the highest marginal rate and will thus prefer to have the trust's income taxed in the trust at graduated tax rates. There are at least two alternatives that could achieve this result without risk of a challenge by the CRA.

First, in a case where a spouse is the sole trustee of the spousal trust, the spouse can choose not to distribute the income in a particular year, and instead have that income taxed in the trust. The CRA has confirmed that this type of discretionary spousal trust does not compromise the spousal nature or the testamentary nature of the trust, provided that the spouse can demand payment of the accumulated income at any time prior to his or her death (see CRA document no. 2010-0376171E5, August 11, 2011).

Second, the trustees of the spousal trust can distribute all of the income of the trust to the spouse and then have the trust file a designation under subsection 104(13.1) to have the distributed income taxed in the trust (rather than in the hands of the spouse). This alternative has less risk and is likely to be the preferred choice, especially in cases where the spouse is not the sole trustee and the first alternative is therefore not available.

Nathan Wright
Cadesky & Associates LLP, Toronto

Canadian Tax Focus
Volume 3, Number 1, February 2013
©2013, Canadian Tax Foundation