The 2014 Federal Budget proposes to introduce a number of significant changes to the taxation of trusts and estates which will fundamentally change the landscape of estate planning. The Department of Finance (the “Department”) proposed these changes to eliminate the preferential treatment of testamentary trusts over certain inter vivos trusts, citing concerns about tax fairness and neutrality.
Generally speaking a trust is a legal arrangement under which one person (the trustee) holds property for the benefit of another person (the beneficiary). There are two categories of testamentary trusts. The first is a trust created under the terms of a will and the second is an estate which arises on the death of an individual and involves a legal representative administering the final affairs and property of the individual. Trusts and estates are considered individual taxpayers under the Income Tax Act (Canada) (the “Tax Act”) and are taxable on any income earned by the trust and estate which is not paid or made payable in the year to the trust’s beneficiaries.
Inter vivos trusts created after June 18, 1971 pay income tax at the highest marginal tax rate applicable to individuals on all of their income. In contrast, prior to the implementation of the new rules announced in this year’s Budget, taxable income earned in a testamentary trust or a grandfathered inter vivos trust has been subject to the same graduated tax rates available to individuals.
The Department first contemplated changes to the taxation of trusts and estates in the 2013 Budget. The Department expressed concerns with the differential treatment of trusts under the existing tax rules and the potential for taxpayers to intentionally delay the administration and distribution of assets forming part of the deceased’s estate in order to maintain access to the graduated tax rates. On June 3, 2013, the Department announced its “Consultation on Eliminating Graduated Rate Taxation of Trusts and Certain Estates” (the “Consultation”). Despite contrary submissions from, among others, the Society of Trust and Estate Practitioners (STEP) Canada, the Wills, Estates and Trusts Section of the Canadian Bar Association and the Conference for Advanced Life Underwriting (CALU), the Department proposed to eliminate the preferential tax treatment afforded to testamentary trusts and grandfathered inter vivos trusts by the imposition of flat top-rate taxation, subject to two important exceptions:
- Graduated rates will apply for the first 36 months of an estate that arises on and as a consequence of an individual’s death; and,
- Graduated tax rates will continue to apply in respect of testamentary trusts for the benefit of disabled individuals who are eligible for the Disability Tax Credit.
The assumption underlying the first exception is that 36 months is a reasonable and sufficient period of time to complete the administration of an estate. While this time period may be adequate for relatively simple estates, cases involving litigation or complex cross-border issues may take significantly longer to resolve. It is uncertain whether the legislation will provide executors with an ability to apply for an extension under such circumstances. A distinction might be made between cases in which the evidence suggests that a taxpayer has acted intentionally to delay administration of an estate in an effort to maintain access to the graduated tax rates and those cases in which the administration has been delayed for legitimate reasons.
During the consultation period, concerns were raised regarding the role of testamentary trusts in allowing disabled individuals to access income-tested benefits such as provincial social assistance benefits. Fortunately, the proposed new rules create an exception so that the graduated rates will continue to be provided for those testamentary trusts with individuals who are eligible for the Disability Tax Credit as beneficiaries. Further details concerning the scope of this exception will be released within the coming months. It would be preferable if this exception was integrated with the provincial rules for disability benefits to ensure that individuals receiving such benefits are not disadvantaged, not all of whom are eligible for the Disability Tax Credit.
Unfortunately, taxing all income accumulated in a testamentary trust at the highest marginal rate discourages effective estate planning. The new rules defeat the trust as a vehicle to accumulate income for the provision of the trust’s beneficiaries in the future. Trustees may be compelled to accelerate the distribution of trust income to beneficiaries in order to avoid paying tax at the top marginal rate. Under the proposed rules, there is no incentive to accumulate income in the trust even if doing so is in the best interests of the beneficiaries. This is particularly relevant for minor or otherwise vulnerable beneficiaries.
In addition to taxing testamentary trusts at the highest marginal rate applicable to individuals, the new rules also propose to eliminate the following benefits previously enjoyed by testamentary trusts:
- exemption from income tax installment rules;
- exemption from the requirement to have a calendar taxation year;
- exemption in computing alternative minimum tax;
- preferential treatment under Part XII.2;
- the ability to automatically qualify as a personal trust; and
- ability to make investment tax credits available to a trust’s beneficiaries.
Despite the fact that testamentary trusts and estates no longer offer the same tax benefits, there are still many reasons why a testamentary trust may be useful in estate planning. One benefit of a testamentary trust is that the trustee maintains control over both the timing and amount of distributions to the trust’s beneficiaries. This level of control is particularly relevant when providing for minors, spendthrift or incapacitated beneficiaries, or those struggling with addictions. If income in the trust is made payable to a beneficiary in a low income tax bracket, the trust can still deduct the income which will be taxed at the beneficiary’s lower tax rate. Testamentary trusts remain valuable estate planning tools in blended families where the primary goal is often to preserve the inheritance such that the surviving spouse or partner is provided for during his or her lifetime but the remaining assets pass to the children after the first to die spouse’s death.
The opportunity for income splitting with the primary beneficiary’s own children and grandchildren is an important tax benefit that testamentary trusts continue to provide, and one which tax planners may wish to consider for the benefit of the family as a whole. A testamentary trust could be implemented where the testator wishes to benefit his or her adult child and grandchildren (or potential grandchildren). The discretionary beneficiaries of the testamentary trust would include the adult child and his or her children. The adult child could be appointed as trustee and thereby control the distribution of trust income and property to the minor beneficiaries. The opportunity for income splitting among the adult child and minor beneficiaries has the potential for significant tax savings. The attribution rules that restrict the potential for income splitting with inter vivos trusts do not apply to testamentary trusts. Income that the trustee (adult child) chooses to distribute to, or for the benefit of, the minor beneficiaries will be taxed in the hands of those minor beneficiaries at the lowest marginal rate (assuming no or very low taxable income) and after using available basic personal exemptions. Income paid or payable for the benefit of minor beneficiaries would be deductible by the trust. This use of the testamentary trust in this way allows the adult child (trustee) to use no or low tax dollars to pay for annual expenses for the benefit of the minor beneficiaries. In contrast, if the testator’s adult child was the sole beneficiary of the trust or received the inheritance directly, the distribution or earning of income to the adult child would be taxed at his or her marginal rate (almost certainly higher than the marginal rate of a minor beneficiary) and the adult child would then be left to use after-tax dollars to pay for his or her children’s expenses.
The Department’s proposal to eliminate graduated personal tax rates for testamentary trusts may be an inappropriate response to concerns regarding the preferential tax treatment of testamentary trusts under the existing rules. Although the proposed new rules for testamentary trusts limit some of the traditional planning opportunities, the testamentary trust continues to offer many tax and non tax advantages and is likely to remain a valuable estate planning tool.