Back in March, the Canadian government had indicated that they were looking into changing the graduated tax rates applied to testamentary trusts. Trusts have always been a tool for tax and estate planning, and although their use will likely not diminish, this overhaul will drastically alter the way in which these types of trusts are taxed.
On June 3rd, 2013 the Canadian department of Finance formally released documentation proposing changes to the way federal tax would apply to many of the trusts estate planners use on a regular basis.
In general terms, a trust is an entity that holds property for the benefit of one or more individuals called beneficiaries and the assets are typically controlled by a trustee, who administers them according to the provisions of the trust. An estate however is created upon the death of an individual and is administered by a representative who manages the affairs and property of the deceased. In both cases trusts and estates are considered to be taxpayers and must declare and pay tax on their realized income.
Although most trusts are taxpayers on their own, many trusts can choose whether to keep the income or pay it directly to the beneficiary. In the event the income, or a portion thereof, is payable directly to the beneficiary, the trust no longer has the obligation to pay taxes on that portion of income. Rather, it is the beneficiary who includes such amounts as part of their own income and gets taxed at their personal marginal rate.
However, in the event that the trust keeps the income, then it is the trust that files and pays tax, not the beneficiary. The tax rate imposed on such a trust will be determined by the type of trust, i.e. was it a testamentary trust, inter vivos trust or grandfathered inter vivos trust.
Testamentary trusts are created as a consequence of death and can only hold the assets of the deceased individual. This type of trust can typically fall into one of two categories; an estate or a trust that is created by will.
An inter vivos trust is one that is created today while you are alive. It can own assets and be administered based on the provisions of the trust for the beneficiaries. This isn’t very different from a grandfathered inter vivos trust which is an inter vivos trust that was created before June 18, 1971 and has certain restrictions on their activities.
Under today’s rules, testamentary trusts, which include estates, and grandfathered inter vivos trusts pay federal tax at their own graduated rates based on the amount of realized income. These rates are the same as those for individuals, (Year 2013: 15% on the first $43,561 of taxable income, 22% on the next $43,562 of taxable income (on the portion of taxable income over $43,561 up to $87,123), 26% on the next $47,931 of taxable income (on the portion of taxable income over $87,123 up to $135,054), and 29% on taxable income over $135,054). Inter vivos trusts on the other hand are automatically taxed at the highest marginal federal rate of 29%, regardless of the amount of income. As a result, inter vivos trusts are not used for tax planning reasons, but rather have a separate use altogether.
Splitting ones assets over multiple testamentary trusts allows the beneficiaries to take advantage of multiple graduated rates, which in essence would allow them to net more after tax income.
The government has raised concerns stating issues of fairness in the tax treatment of different types of trusts and executers having a tax-centered reason to prolong the administration of estates. Essentially this means that the government is tired of these rules negatively impacting their tax revenues.
The proposed changes would eliminate the marginal tax rates for testamentary and grandfathered inter vivos trusts. These trusts would therefore receive the same treatment as inter vivos trusts and automatically be taxed at the highest marginal rate. This would also apply to estates where the administration exceeds 36 months following the individual’s date of death, after which the highest marginal rate would be applied.
There are however certain trusts that are exempt from these rules. The government is proposing that the high marginal tax rates not necessarily be applied to trusts for the disabled and for minor children. They will continue to let these types of trusts, subject to anti-avoidance rules, to benefit from the current Income Tax Act rules allowing the income to be taxed in the hands of the beneficiary under their own marginal rate, despite having been accumulated in the trust. This is referred to as the preferred beneficiary election rules, which should be untouched by the proposed changes. Additionally the new rules would not alter the roll over provisions that extend to spousal and common law partner trusts.
It is the government’s hope that these new rules will instill a level of fairness across the board and assist in providing incentives for estate trustees to speed up the settlement of estates. Unfortunately for estate and tax planners, these rules would greatly diminish the beneficial use of testamentary trusts for tax planning purposes.
The information contained herein is for informational purposes only, and is not legal advice or a substitute for legal counsel. It is not intended to be attorney advertising or solicitation. If you have a legal question, please consult with a licensed attorney.