The Do’s and Don’ts of Testamentary Spousal Trusts

A testamentary spousal trust can be a powerful tool to support a surviving spouse while achieving tax deferral and preserving assets for the next generation. From a legal drafting or estate administration standpoint, it’s important to understand what the Income Tax Act (Canada) (“ITA“) requires for a trust to qualify as a testamentary spousal trust, and what tax advantages this structure offers.

What is a Testamentary Spousal Trust?

A testamentary spousal trust is a type of trust that arises on the death of an individual and is created by their will. It is established for the benefit of a surviving spouse or common-law partner and if it meets certain criteria under the ITA, can offer significant tax deferral opportunities, namely, the rollover of capital property to the trust on a tax-deferred basis.

Key Requirements Under the Income Tax Act

For a trust to qualify as a spousal trust and benefit from the rollover provisions in subsection 70(6) of the ITA, three main conditions must be met:

1. Created by Will or by Operation of Law on Death: The trust must arise as a consequence of the death of the individual—typically through their will or, in rare cases, under intestacy rules. It cannot be created inter vivos (during the lifetime of the deceased).
2. Surviving Spouse is Sole Beneficiary During their Lifetime: Under paragraph 70(6)(b), the surviving spouse or common-law partner must be entitled to all of the income of the trust that arises during their lifetime. This entitlement must be enforceable by the terms of the trust. Further, no person other than the surviving spouse or common-law partner may, before the death of the spouse or common-law partner, receive or otherwise obtain the use of any income or capital from the trust. This condition ensures that the surviving spouse or common-law partner has exclusive benefit from the trust during their lifetime.
3. Rollover of Capital Property: If the above conditions are met, the deceased is deemed to have disposed of capital property transferred to the trust at proceeds equal to the adjusted cost base (ACB)—resulting in no immediate capital gain. The trust then assumes the ACB, effectively deferring capital gains tax until the surviving spouse’s death or until the property is otherwise disposed of by the trust.

Tax Benefits of a Testamentary Spousal Trust

The main benefit of a testamentary spousal trust is the tax deferral of capital gains that would otherwise be triggered on death under subsection 70(5) of the ITA. Instead of capital property being deemed disposed of at fair market value (FMV) on the deceased’s death, the property can pass to the spousal trust at its ACB, and taxation is deferred until the surviving spouse dies.

This allows families to preserve wealth, particularly where there is an intention to ultimately benefit children or other beneficiaries, but with the surviving spouse’s needs being prioritized during their lifetime.

The Problem of “Tainting” a Spousal Trust

Even if a trust is properly structured under a will, it can lose its tax-advantaged status if it becomes “tainted.” Tainting occurs when the trust no longer meets the strict exclusivity requirements under subsection 70(6). According to the CRA’s Income Tax Folio S6-F4-C1, examples of tainting include provisions that allow someone other than the spouse to receive or benefit from income or capital during the spouse’s lifetime—even if only in exceptional circumstances.

This issue was front and center in Estate of Gordon Clark Terrill v. MNR (1987), where the Tax Court had to decide whether a clause allowing the trustees to encroach on capital for the benefit of the deceased’s son (before the spouse’s death) invalidated the trust’s eligibility for rollover. Although the court ultimately accepted extrinsic evidence supporting the interpretation that the son could not benefit until after the spouse’s death, the case underscores how ambiguous or overly discretionary clauses can risk tainting a trust and disqualifying it from the rollover provisions.

Final Thoughts

While the ITA provides clear rules for what constitutes a testamentary spousal trust, careful planning and drafting are essential to ensure those requirements are met. Whether you’re planning an estate or administering one, understanding these provisions helps ensure both compliance and the effective use of available tax deferrals. Contact the Wills and Estates lawyers at Mills & Mills LLP if you have questions or would like to learn more about testamentary spousal trusts.

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