The 2014 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.
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 and not paid or made payable in the year to the trust's beneficiaries.
Inter vivos trusts created after June 18, 1971, pay federal 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 concern 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 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 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
- the 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 spouse's death.
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. One of the government's main objectives was to mitigate the perceived abuses occurring where multiple testamentary trusts are created upon death, each with access to its own set of graduated rates. Concerns regarding the use of multiple testamentary trusts could have been addressed under the existing provision, in subsection 104(2), which provides a means for the Minister to deal with such abuse by taxing several designated trusts as one in cases where the income of the trusts accrues to the same beneficiary or group of beneficiaries. Under the proposed new rules, trustees are forced to decide between paying income to the beneficiaries and retaining income in the trust taxed at the highest marginal rate. As a result, trustees may be compelled to pay income to vulnerable beneficiaries even in cases where it is contrary to the best interests of such beneficiaries.
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