Which Trust Is Best to Avoid Inheritance Tax in Canada?

Can a Trust Reduce “Death Taxes” for High-Net-Worth Canadians?

Yes, trusts can be used strategically to help defer and plan for taxes at death for higher-net-worth families.

A trust in Canada isn’t specifically for avoiding an inheritance tax but rather to help to minimize the taxes that result because of a deemed disposition on death.

Written By Tiffany Woodfield, Financial Advisor, TEP®, CRPC®, CIM®

Key Insights

• Canada does not have an inheritance tax.
• Taxes at death can significantly reduce what beneficiaries receive.
• Trusts can help manage taxes, probate, control, and privacy.
• Trusts do not eliminate taxes entirely.
• Alter Ego and Joint Partner Trusts may allow tax-deferred transfers of wealth.
• Family trusts and estate freezes can shift future growth to the next generation when structured properly.
• Most trusts in Canada are taxed at the highest marginal tax rate on income retained within the trust, which can make ongoing tax planning important.
• Income retained within a trust is generally taxed at the highest marginal tax rate.
• When managing a trust, ongoing tax planning is critical. 
• Most trusts in Canada are subject to the 21-year deemed disposition rule, which generally treats the trust as having sold and immediately reacquired its capital assets at fair market value every 21 years.
• Trusts add complexity, costs, and annual filings. 

Is There an Inheritance Tax in Canada?

Canadians often think that there is an inheritance tax in Canada. 

This is likely because we are exposed to a lot of American news and hear about estate taxes. In Canada, we have what is called a deemed disposition. After you die, the government treats your estate as though everything were sold at fair market value immediately before death.

The deemed disposition reduces the estate’s value before the inheritance is distributed.

In other words, the final income tax return after death is where the government can take a large portion of the deceased’s estate before anyone gets an inheritance. 

For example, registered accounts like RRSPs and RRIFs will be taxed. Capital gains on secondary properties will also be taxed, as will capital gains on non-registered accounts. 

The taxes the estate must pay before anyone receives their inheritance are not called an inheritance tax, but they will reduce the size of the inheritance. 

Which Taxes Apply When a Canadian Dies?

As a Canadian resident, when you die, you’re considered to have disposed of all of your capital assets immediately before death. 

It’s like you sold everything at its current market value, and any resulting capital gains will be subject to taxes. For example, say you bought an investment for $100,000, and over the years it has grown to $500,000. The $400,000 difference is a capital gain and is subject to tax. 

In addition to this federal deemed disposition tax, most provinces also charge an administration fee or probate based on the value of your assets that are passed through your will. 

As you can see, death in Canada is a major taxable event even though we don’t have an “inheritance tax” per se.  

This is because the estate of the deceased is responsible for paying the taxes before any distributions are made.  This results in a smaller inheritance for beneficiaries.

Capital Gains Tax on Deemed Dispositions

As explained above, this is a federal tax that applies to capital assets that have increased in value and created a capital gain. Even though you haven’t actually sold anything, it is as if you sold it immediately prior to death. Without proper planning, this can significantly reduce your estate and cause liquidity problems. 

Even large estates may be forced to sell assets to cover taxes. 

Taxes on RRSPs and RRIFs at Death

When you pass away with either an RRSP or RRIF, the money that is in the registered account comes into taxable income and needs to be reported on your final tax return. 

Let’s say that you are the surviving spouse, and when you pass away, you have an RRIF worth $500,000. The full amount of $500,000 will be added to your final tax return and subject to tax.  

At a 52% tax rate, this could mean losing more than $250K right off the top. 

There are opportunities to defer this tax with a spousal rollover or if you have a qualified dependent, but in most cases, upon the surviving spouse’s death, there is a significant tax hit. 

Probate Fees and Estate Administration Tax

Probate and estate administration tax varies based on which province you live in. Probate fees are generally a % of the value of your estate that passes through the will. The probate process confirms the validity of your will so your assets can be distributed.

Assets that pass outside of the will, such as registered accounts, items held JWROS, or in trust, don’t have probate applied as long as they aren’t passed through the will. 

Which Types of Trusts Are Commonly Used in Canadian Estate Planning?

Testamentary Trusts

A testamentary trust is created as a result of the death of an individual. 

An estate, even if someone dies intestate, is still a testamentary trust. A trust that is created from a will is also a testamentary trust.  An insurance trust, even if created separate from the will, is a testamentary trust if funded on death.

Living Trust

A living trust is a trust created during the settlor’s lifetime.

These trusts are taxed at the highest marginal rate, and in most cases the transfer of property is at fair market value (FMV). Exceptions such as an Alter-Ego or Joint Partner trust exist.

Alter Ego and Joint Partner Trusts

An Alter Ego Trust is a type of living trust.

It is set up for the sole benefit of the settlor during their lifetime. The settlor refers to the person who set up the trust. There are certain rules to be followed to open this type of trust. For example, the settlor must be at least 65 years old. 

If these requirements are satisfied, assets can be transferred into the trust at FMV, which means the transfer doesn’t trigger a taxable event as with a normal trust. With most intervivos trusts (living trusts), when you fund them, if the assets you are putting into the trust have increased in value, then you will be subject to capital gains tax

A Joint Partner Trust is similar to an Alter Ego Trust except only the partner who contributes the capital property must be at least 65 years of age, and both partners are entitled to the benefit of the trust. Property is transferred on a tax-deferred basis.

Family Trusts in Advanced Planning

Family trusts are useful in advanced planning but require careful planning and guidance before setup.  

Some of the expanded Tax on Split Income (TOSI) rules limit the income splitting benefits of using a family trust. However, you may still be able to multiply your access to the Lifetime Capital Gains Exemption (LCGE) with other family members, which represents significant tax savings.  

It is important, when considering a family trust, to weigh the tax and non-tax benefits of various strategies so that the ultimate solution fits your overall objectives.

Resources: 

• LCGE Explained
• TOSI Rules

Estate Freeze

An estate freeze can be an excellent planning tool. 

In simple terms, an estate freeze locks in the current value of an owner’s estate, often by freezing the value of corporate shares. Any future growth can then be shifted to the next generation, such as children or grandchildren. 

This allows the increase in value after the freeze to accrue to the people who would otherwise inherit the property at death, while the original owner’s taxable value remains fixed.

When Does a Trust Create New Risks?

A trust can be a powerful estate planning tool, but it is not always the simplest or most tax-efficient solution. 

In some cases, the tax savings may be limited, while the added complexity, annual filing requirements, professional fees, and administrative responsibilities can outweigh the benefit.

A trust works best when it is created for a clear purpose and properly aligned with your wishes. It can provide flexibility, control, and structure around how assets are managed and distributed. 

However, Canadian tax rules have reduced some of the traditional income-splitting advantages of trusts, so the non-tax reasons for using one are often just as important as the tax planning opportunities.

Before setting up a trust, you need to be comfortable with the extra planning involved. 

This may include legal advice, tax advice, annual trust filings, trustee duties, record-keeping, and ongoing professional support. One common mistake is creating a trust without fully understanding how it will be funded, managed, taxed, and eventually wound down.

Another important consideration is taxation. 

Income retained in most trusts is taxed at the highest marginal tax rate, not at an individual’s personal graduated rates. In many cases, it may be more efficient to allocate or distribute income to beneficiaries so that it is taxed in their hands, but this must be planned carefully to avoid attribution rules, tax-on-split-income rules, or other unintended consequences.

The 21-Year Rule Explained

In Canada, most trusts are subject to the 21-year rule. 

Every 21 years, the trust is generally deemed to have sold and immediately reacquired its capital property at fair market value. Even though no actual sale has taken place. This rule is designed to prevent capital gains from being deferred indefinitely within a trust.

Without proper planning before the 21-year anniversary, the trust could face a significant taxable event. 

This can create a cash flow problem because tax may be owing even if the trust has not sold any assets or received cash to pay the bill.

Case Study: How a Joint Partner Trust Can Create a Smoother Transition for a Younger Spouse

Peter is a Canadian resident, age 65, and is married to Joanne, who is 54. 

Peter had built significant wealth and held approximately $4 million of non-registered investments in his own name. As part of his estate planning, Peter wanted to reduce probate exposure and create a smoother plan for Joanne if he became incapacitated or passed away.

After receiving legal and tax advice, Peter created a Joint Partner Trust. 

Because he was 65 and a Canadian resident, he could generally transfer qualifying capital property into the trust on a tax-deferred basis, provided the trust met the required rules. The trust allowed Peter and Joanne to benefit from the assets during their lifetimes, while the remaining property would be distributed according to the trust terms after the later of their deaths.

For Peter, the goal was not to eliminate tax entirely. 

The trust helped maintain control, provide for Joanne, improve privacy, and reduce the amount of property passing through his will. It could lower probate fees and make estate administration easier for his family.

However, the trust still required careful planning. 

Peter needed to consider legal costs, annual filings, trustee responsibilities, and future tax consequences. While probate may be reduced with a Joint Partner Trust, tax is generally deferred rather than eliminated, often until the death of the surviving spouse or partner.

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