Income Taxes at Death
In Canada, claims arising on the death of a spouse are not many, nor is there much jurisprudence dealing therewith. But claims arising on marriage breakdown are not uncommon and a frequently litigated issue is whether, for the purpose of computing a spouse’s Net Family Property (NFP), property owned by him or her should be valued at its after tax amount in the spouse’s hands. For a time after the enactment of the Family Law Act (FLA), cases were all over the place on this point, some suggesting that income tax costs of disposition should be taken into account (with or without a discount for the likelihood of the disposition taking place relatively soon), while others suggested that in the absence of a clear indication that property would be sold by the owner spouse, no tax costs should be taken into account on the grounds that such a calculation was too speculative.
When the valuation date is one day before the death of the deceased spouse, the argument that income tax costs should be taken into account is more compelling than in the case of marriage breakdown. As the Income Tax Act (ITA) deems that the deceased spouse immediately before death:
a) Disposed of all of his or her capital property at fair market value; and
b) Collapsed all of his or her RRSPs and RRIFs,
there is really nothing speculative about it when the owner spouse incurs the tax costs in disposing of capital property or of collapsing his or her RRSPs or RRIFs or, for that matter, about the quantum. An issue remains as to whether the calculation of the deceased spouse’s NFP should assume optimal tax planning. For instance, in the context of a marriage ending in separation, it is held that the owner spouse should take into account one-half of his or her available lifetime capital gains deduction in order to minimize the notional tax costs of disposition.
The question of taking into account the income tax liability arising from a deemed disposition of capital property and a deemed collapse of RRSPs and RRIFs on the death of the deceased spouse depends on whether the income taxes are to be factored into the valuation of the property in question or whether they simply represent a liability of the owner spouse which will entitle him or her to a deduction in calculating his or her NFP.
Considering that the disposition of capital property and the collapse of RRSPs and RRIFs owned by the deceased spouse are deemed to have taken place immediately before death, and considering that the valuation date is the day before the deceased spouse’s death, it can be argued that on the valuation date there is no tax liability on account of deemed dispositions of capital property or deemed collapses of RRSPs and RRIFs. Actually, if it is a valuation issue, it can be argued that the value of property is the after-tax value to the owner and it does not matter whether the valuation date is one day before or one day after the deceased spouse’s death. Owing to the choice of valuation date, it would be seen that the funeral, burial and all other expenses arising after, and consequent to a spouse’s death, would not reduce his or her NFP.
Income Tax Issues
Besides the manner in which income taxes affect the computation of a spouse’s NFP, there are other important income tax issues which need to be addressed:
1) If capital property is transferred to a surviving spouse due to an equalization claim, does such a transfer qualify for “rollover” treatment under s. 70(6) of the ITA? In that event, how does that tax deferral affect the computation of the deceased spouse’s NFP?
2) When a court orders that the surviving spouse is to have a life interest in capital property owned by the deceased spouse, does such a transfer qualify for rollover treatment under s. 248(9.1) of the ITA, because the life interest is a “testamentary spousal trust”?
3) If a surviving spouse files an election to make an equalization claim, any life interest left to him or her under the deceased spouse’s will collapses. This leads to an acceleration of taxes and a shortening of the time period within which to file the tax return for the deceased spouse’s year of death. If the surviving spouse obtains an order for a late filing of an election to make an equalization claim, interest and late filing penalties will arise under the ITA. The question is who should bear the burden of those added costs?
Transfers of Property for an Equalization Claim
If a court orders that capital property of the deceased spouse be transferred to the surviving spouse absolutely to meet the latter’s equalization claim; to determine whether the property can roll over to the surviving spouse at the deceased spouse’s tax cost pursuant to s. 70(6) of the ITA, the key issue is whether or not that transfer can be characterized as having been made as a consequence of the death of the deceased spouse.
According to subsection 248(23.1) of the Income Tax Act, the answer is “yes” for a transfer of capital property made “as a consequence of the laws of a province relating to a spouses’ interests in respect of property as a result of marriage.”
It is not clear from this provision, whether or not a property transfer made pursuant to a settlement without a court order will qualify for rollover treatment. The most recent pronouncement from the Canada Revenue Agency (CRA) is that the rollover will be available if the surviving spouse files an election in favour of equalization within the time limit given in the Family Law Act, whether the ultimate transfer of property takes place by court order, or by agreement between the surviving spouse and the deceased spouse’s personal representative(s).
If the income tax liability that arises by virtue of the deceased spouse’s death in calculating his or her NFP is taken into account, an unusual calculation known as iteration is needed to determine the NFP, the amount of the equalization claim, and the deceased spouse’s ultimate tax liability. Let’s simply assume that the deceased spouse had a nil net worth at marriage, then the calculations would proceed as follows:
1) Find out the value of the deceased’s estate.
2) Subtract the taxes so as to determine the deceased’s NFP.
3) Find out the surviving spouse’s equalization claim.
4) Assume a transfer to the surviving spouse of capital property having a value equal to equalization claim.
5) Re-calculate taxes due after taking into account rollover of capital property transferred.
6) Subtract revised taxes so as to obtain the deceased’s revised NFP.
7) Start again from step 3.
Through such iteration an accurate figure for the equalization claim would be obtained along with a sum for the deceased spouse’s taxes.