Estate Tax and Life Insurance Products in Canada
Life insurance is an attractive tool for dealing with estate tax planning because the proceeds received at death are generally not subject to tax. If you have, or are planning to purchase life insurance in Canada, you should be aware that the tax implications will depend on whether it is “exempt” from taxation of the accumulated income or “non-exempt.”
Policies issued before Dec. 2, 1982 fall under the “old rule” status. These policies are exempt from accrual taxation. Policies issued after Dec. 1, 1982, fall under the “new rules” and may be exempt or non-exempt.
To distinguish the exempt or non-exempt status of a policy, an exemption test must be administered by the insurance company on each anniversary date of the policy. A policy is considered exempt if its emphasis is “benefits on death.” Non-exempt policies are those policies that offer a substantial lifetime investment including annuity contracts. Exempt policies must meet current test requirements and must also meet prospective test requirements for future anniversaries. You can obtain information about the tax status of your life insurance policy from Life Guard Insurance Advisors.
While there is no true estate tax in Canada there are three potential taxes or pseudo-taxes that may be incurred at death (which many people refer to as estate tax):
- Estate Tax (Income Tax) Due to Deemed Disposition
- Provincial Probate Taxes
- U.S. Estate Tax (on your U.S. assets)
In the year of death, a final (terminal) tax return must be filed by the estate’s executor/liquidator that includes all income earned by the deceased up to the date of death. Also included in income for the estate tax is the net capital gain recognized under the deemed disposition rules.
The deemed disposition rules of the Income Tax Act treat all capital property owned by the deceased as if it was sold immediately prior to death. Thus, all unrecognized capital gains and losses are triggered at that point with the net capital gain (gains less losses) included in income.
The Income Tax Act does contain provisions to defer the tax owing under the deemed disposition rules if the asset is left to a surviving spouse or to a special trust for a spouse (spousal trust) created by the deceased’s Will. This provision allows the spouse or the spousal trust to take ownership of the asset at the deceased’s original cost. Hence, no tax is payable until either the spouse or the spousal trust sells the asset or until the surviving spouse dies. The tax is then payable based on the asset’s increase in value at that point in time.
A Special Note about RSPs and RIFs
In addition to the potentially significant tax liability from recognized capital gains, it is also necessary to deregister (i.e. collapse) any registered assets such as Retirement Savings Plans (RSPs) or Retirement Income Funds (RIFs) at the point of death. The full value of the RSP or RIF must be included on the deceased’s final (terminal) estate tax return. There are exceptions to this deregistration requirement if the RSP or RIF is left to the surviving spouse, a common law spouse and in some cases to a surviving child or grandchild.
An RSP or RIF can be transferred tax-free to a surviving spouse’s own plan. Also, the RSP or RIF can be transferred tax-free to a financially-dependent child or grandchild who is under age 18, or who is mentally or physically infirm, even if there is a surviving spouse. The registered funds must be used to purchase a term-certain annuity with a term not exceeding the child’s 18th year.
Life Insurance – a cost effective solution. Be sure to examine the cost of investing into a permanent life insurance policy as a way to deal with deemed disposition estate taxes at death. It often is the most cost effective way to protect your assets from government estate tax that will ultimately erode your estate.
Upon death, the executor of your estate will typically be required to file for probate with the provincial court. The estate’s executor must submit to the court the original Will and an inventory of the deceased’s assets. Upon acceptance of these documents by the court, letters of probate (called “Certificate of appointment of estate trustee with a Will” in Ontario) are issued. This document serves to verify that the submitted Will is a valid document and confirms the appointment of your executor.
With the executor’s submission to the court, he/she must also pay a probate tax (a major estate tax). This estate tax is based on the total value of the assets that flow through the Will. The rate charged varies between provinces with some provinces having a maximum fee. All provinces except for Alberta and Quebec levy potentially significant probate taxes.
Probate is not required for a notarial Will in the province of Quebec and for those that have other types of Wills drafted in Quebec the probate tax is very nominal.
In situations where the estate is extremely simple and does not require any involvement with a third party such as a financial institution, the Will may not need to be probated. As well, probate taxes can be reduced by using strategies such as the naming of beneficiaries, Joint Tenancy With Right Of Survivorship agreements and the use of living trusts.
In addition to the estate taxes payable in Canada, you may also be subject to a tax bill from the U.S. Government. Canadians that own U.S.-sourced assets such as real estate, corporate stocks and certain bonds and government debt are required to pay U.S. Estate Tax based on the market value of their U.S. assets at death. Any assets that are considered “U.S. situs” property (i.e. deemed to be located within the United States) will be subject to this tax. Most people do not realize that investing in the securities issued by a U.S. corporation such as IBM or Microsoft in their Canadian brokerage account may result in a U.S. Estate Tax liability for their estate.
While changes to the Canada-U.S. Tax Treaty have reduced the number of Canadians that may be subject to this Estate Tax, for many individuals with significant net worth, U.S. Estate Tax will still represent a significant tax burden to their estate. Potential methods of reducing the total cost of U.S. Estate Tax include the following:
- Use life insurance to cover the U.S. Estate Tax bill, allowing your total estate value to be maintained
- Sell your U.S. assets prior to death. This is the simplest method of avoiding the tax, but timing is everything with this strategy as the sale could result in an immediate Canadian tax liability
- Individuals with substantial U.S. holdings may wish to consider using a Canadian holding corporation since the assets would be owned by the Canadian corporation and not by the individual
- Reduce the value of your estate below the current threshold
- Hold Canadian mutual funds that invest in the U.S. market. While the fund may hold U.S. assets, it is considered a Canadian asset, and is not subject to U.S. Estate Tax
- Hold the asset in joint ownership. This may serve to defer the tax until the other tenant dies, assuming the surviving tenant can prove that he/she acquired their interest in the asset using their own capital
Take the next step and deal with Estate Tax…talk to us.
Life Guard Insurance Advisors are here to help recommend the solutions that are best for you. To learn more, please contact us to review your estate tax situation.