Canada’s Alternative to the Inheritance Tax
There is no inheritance tax or estate tax in Canada per se. With the exception of property passing to surviving spouses (or possibly dependents) upon death at tax cost, there is a notional or deemed disposition of capital property owned by the deceased immediately prior to death.
A deceased’s final tax return includes their income from normal sources as well as the taxable capital gains from deemed dispositions, and amounts in registered accounts (described in more detail below).
Tax obligations in the deceased’s final return are normally settled from the estate assets. The executors of the estate are responsible for filing the deceased’s final tax return and administering the payment of the deceased’s final tax liability, so the deceased’s tax liabilities are normally settled with the CRA before distributions of estate assets to beneficiaries under the will.
Although there is no actual inheritance tax, if requested by the executor of the estate, the CRA will issue a clearance certificate that confirms the deceased’s taxes payable so the residual assets of the estate can be distributed to its beneficiaries without potential exposure of additional tax reassessment liability to the executor.
Taxation of Registered Assets
Canada designates certain retirement accounts as registered, which means they accumulate value on a tax-deferred basis. Registered accounts include:
- Registered Retirement Savings Plans (RRSP) and Registered Retirement Income Funds
- Locked-In Retirement Account
- Tax-Free Savings Account (TFSA)
- Registered Education Savings Plan
Where there is no eligible beneficiary, as explained below, all except the TFSA create a tax liability for the account owner at death. The fair market value of such accounts are included in the deceased’s final year’s income.
The income is taxed incrementally at different tax rates. The highest marginal tax rate in 2017 for residents of Ontario on income over $220,000 is 53.53%.
The deceased may have designated one or more eligible beneficiaries to receive the registered accounts. Eligible beneficiaries include:
- Common-law partner
- Financially dependent child/grandchild under age 18
- Financially dependent infirm child/grandchild of any age
- A trust for any of the above
Taxes on registered investment assets inherited by eligible beneficiaries are deferred until the eligible beneficiary either sells the investments or dies, at which point the registered assets are taxed as ordinary income in the beneficiary’s hands.
Absent planning for this tax, some or all of the registered accounts may need to be liquidated in order to pay the terminal taxes (which are similar in nature to an inheritance tax in other countries). Planning may include an investment in a life insurance policy in an amount that is estimated to be equal to the expected tax balance arising upon death.
It is noteworthy that a registered account with a designated beneficiary transfers outside of the will. This could create unanticipated complexities because the tax liability of the terminal return applies to the estate whereas the asset flows at full value to the designated beneficiary. This can result in a beneficiary receiving assets, but the tax obligation related to those assets still being an obligation of the estate. This circumstance can be mitigated with proper financial advice and planning.
Taxation of Non-Registered Assets and Other Capital Property
Non-registered accounts include brokerage investments, or directly held investments in such as shares and mutual funds. Other capital property includes assets held to earn income such as investment in rental property and personal use assets.
For tax purposes, non-registered assets and other capital property are deemed disposed of (and reacquired) at fair market value upon the death of the asset holder and result in capital gains.
Capital gains arising on the notional disposition of such assets are generally calculated as the fair market value of the asset arising on the deemed disposition less its original cost. Fifty percent of the capital gains are subject to tax at the incremental tax rates mentioned earlier.
Certain assets might be able to be sheltered from the tax arising on deemed capital gains. For example, shares of qualifying Canadian controlled private corporations that carry on active business may qualify for the lifetime capital gains exemption of $835,714. In addition, the capital gain arising on a deemed disposition of a principal residence may also be sheltered from taxation by the principal residence exemption.
Tax on assets that are passed upon death to surviving spouses, common-law partners or trusts are deferred until the earlier of the death of the survivor spouse or sale of assets. The Income Tax Act allows for a tax-free rollover to the surviving spouse common law partner or spouse at their tax cost. The assets can include real estate, business assets, non-registered investment assets, cars and other personal belongings.
There are elections available to trigger gains on assets passing to surviving spouses if such planning makes sense to take advantage of the incremental tax brackets of the deceased.
Rights and Things Return
There is an election available to report certain income that is accrued but unpaid on a separate income tax return in the year of death. Examples of such income includes unclipped coupons or declared but unpaid dividends. This election is often beneficial as it permits the executor to take advantage of another set of incremental tax rates and certain non-refundable credits.
Ontario Estate Administration Tax
Ontario levies a tax similar to an inheritance tax on certain types of assets such as real property, bank and investment accounts. This tax is levied in connection with the probate process that involves the court affirming the legitimacy of the will. This Ontario tax currently does not exceed 1.5% of the fair market value of assets subject to probate. Certain types of assets are not subject to probate tax in and of themselves such as shares and debts of private corporations. However, if the estate assets are co-mingled with other assets subject to probate, then the entire estate becomes taxable. Appropriate planning can avoid the administration of this inheritance tax.
Where an individual is an investor in a private corporation, there are planning strategies available to avoid double tax. The first level of tax occurs with the deemed disposition arising on death being included in their income as described above. The second level of tax occurs if and when the corporation is wound up; the recipients of the corporation’s assets will at that time recognize a taxable dividend to the extent the amount distributed exceeds the stated capital of the shares. As a result, the increase in the value in the corporation’s assets will be taxed twice, once on the deceased’s deemed disposition, and again when assets are distributed. Strategies may be available to mitigate this double-tax exposure and their implementation is time sensitive. A qualified advisor should be consulted when planning these tax strategies.
Although Canada does not have an official inheritance tax or estate tax, there is a tax liability that typically arises upon the death of a taxpayer or the second to die of spouses and common law partners. During their lifetime, Canadians can actively plan their tax strategies to reduce taxes arising on death. These estate-planning strategies may include gifting, implementing estate freezes using private company shares or using intervivos trusts. A qualified advisor should be consulted when planning tax strategies.