Michael Goldberg, Tax Partner, Minden Gross LLP, MERITAS law firms worldwide and founder of "Tax Talk with Michael Goldberg", a quarterly conference call about current, relevant and real life tax situations for professional advisors who serve high net worth clients.
Part I of this series of articles reviewed some of the basic tax requirements for using trusts to split income, and Part II discussed a number of tax planning opportunities that can be accessible through the use of inter vivos trusts. The focus of this third instalment of the series will be traditional testamentary trust income splitting planning and the upheaval to trusts, wills, and estates practices caused by the December 16, 2014 enactment of Bill C-43, Economic Action Plan 2014 Act, No. 2 ("Bill C-43").
Testamentary Trust Planning
Income splitting is also a benefit that can be enjoyed when planning involves "testamentary trusts", which are trusts formed upon or as a consequence of the death of an individual and which have not received property contributions by anyone other than the deceased individual,1 and include a deceased's estate and trusts formed under the terms of a deceased's will. However, these trusts serve numerous other non-tax purposes.
By law, a deceased's assets will be dealt with by his administrators under his will or, if there is no valid will, under the provincial rules that govern an intestacy. The vehicle for holding the assets will be a form of trust that is referred to as an estate. Assuming the deceased's last wishes are governed by a will, the will would normally instruct his administrators on how to satisfy the obligations he owed and how to dispose of the property he owned at the time of his death. In this way the estate serves a number of practical purposes, including providing a vehicle to collect taxes owing by the deceased at the time of his death and while the assets remain within the estate.
Eventually, the estate should be fully administered and the property may be distributed outright to the deceased's beneficiaries or the terms of the will might create and fund other trusts that, if properly structured, should be testamentary trusts for purposes of the Act. For example, a spousal trust will often be used to maintain control over a deceased's assets for the benefit of her spouse, while the spouse is alive, so as to maintain the spouse's lifestyle and also to protect and preserve family assets for distribution to the deceased's children, grandchildren, and so on. Also, the deceased's will might give rise to more traditional family trusts, insurance trusts, or protective trusts such as Henson trusts that can be created for disabled beneficiaries or spendthrift trusts.
Although well beyond the scope of this article, there are many good US tax and non-tax reasons to form trusts for US beneficiaries that are either created prior to the death of an individual and funded out of a Canadian estate or, depending on the US adviser one engages, even created in the will itself.
Traditional Canadian Income Tax Advantages of Using Testamentary Trusts
There has traditionally been a number of Canadian income tax advantages associated with the use of testamentary trusts.
First, a bequest left to a properly drafted spousal trust will defer death taxes until the death of the surviving spouse. This could also have been the case if the property had been bequeathed outright to the surviving spouse and held by the survivor until his death. However, by leaving the property in the trust, it is possible for the deceased, through her executors or trustees, to ensure control over the estate property to make sure that it is not used in a manner contrary to the deceased's wishes and/or that it is preserved for the benefit of the surviving spouse and future generations.2
Second, as was the case with non-testamentary trusts, properly drafted testamentary trusts can allow the income of a trust to be taxed in the hands of the beneficiaries at their marginal rates.
Finally, the taxation of testamentary trusts differ in a number of other favourable ways from the taxation of ordinary inter vivos trusts ("Pure Testamentary Trust Tax Benefits"). Probably the most significant of these tax differences is that testamentary trusts have traditionally been taxed at graduated rates as though they were a separate individual.3 The annual tax savings available to a testamentary trust varies by province but can be significant. In this regard, the chart below shows the 2015 testamentary trust savings on the first $135,0004 of income on a province-by-province basis,5 as compared to a situation where that same $135,000 of income had been taxed at the top marginal rate in each particular province.
* All figures rounded. ** 2015 Budget not yet released.
As illustrated, based on the assumptions in the chart, 2015 savings will range from a low of about $10,750 in Alberta to a high of about $26,500 in New Brunswick. In addition, since British Columbia, New Brunswick, Nova Scotia, and the Yukon all have marginal provincial tax rates that exceed the top federal tax bracket, 2015 testamentary trust benefits may be even greater than those shown in the chart.
A Whole New World—The End of Testamentary Trust Planning?
In 2013 the Department of Finance proposed to eliminate most Pure Testamentary Trust Tax Benefits, including the benefits of unlimited access to graduated tax rates for testamentary trusts. In particular, beginning in 2016 it was proposed that the graduated tax rate advantage would only be permitted for a maximum of the first 36 months of an estate. In addition, following that 36-month period the proposals were intended to strip testamentary trusts of their other unique benefits by eliminating exemptions from income tax installment rules, rules requiring ordinary trusts to have a calendar taxation year, and the alternative minimum tax rules. In addition, while in the past testamentary trusts were not subject to tax under Part XII.2 of the Act, which applies to ensure non-resident beneficiaries of trusts do not avoid tax on certain types of Canadian income, this preferential tax treatment was to be eliminated. Also, rules that would automatically qualify testamentary trusts as personal trusts and which would allow trusts to make investment tax credits available to beneficiaries were to be eliminated (collectively, all of these benefits, including the graduated rate benefit, are referred to herein as "Traditional Testamentary Trust Benefits").
Notwithstanding much critical commentary, the 2014 Budget announced plans to implement the proposals, and draft legislation was released on August 29, 2014. The draft legislation, which contained no grandfathering provisions, not only proposed to implement the proposals but went far beyond the original proposals in ways that will broadly and generally negatively impact traditional testamentary and other non-testamentary trust planning.6 Despite additional submissions having been made to the Department of Finance by, among others, the Joint Committee and STEP, with very few substantive changes from the draft legislation, Bill C-43 was introduced for first reading on October 23, 2014. On December 16, 2014, Bill C-43 was enacted as the law of the land, though the implementation of the provisions of Bill C-43 relating to testamentary spousal trusts as well as to other trusts and particularly to "lifetime trusts" (these are self-benefit trusts, alter ego trusts, and joint partner trusts) will generally be delayed until 2016.
Although there is no way to adequately address the legislative changes in in Bill C-43 in this series of articles,7 some of the more critical changes that will impact testamentary spousal trusts and lifetime trusts are highlighted below.
- Testamentary spousal trusts and lifetime trusts will all now have deemed year-ends on the date of death of the individual or last spouse or common law partner to die, as the case may be.8
- The income earned by a trust subject to the new deemed disposition rules for its taxation year that ends on the deemed year end will be deemed to be that of the deceased trust beneficiary and not the income of the trust.9
- Access to many traditional testamentary tax planning practices such as planning involving subsections 164(6) and 112(3.2),10 certain beneficial charitable planning opportunities,11 preferential charitable donation tax rates,12 and all of the Traditional Testamentary Trust Benefits will only be available to trusts that qualify as graduated rate estates ("GREs").13
- Pursuant to new subsection 104(13.3), the ability to make designations under subsection 104(13.1) and (13.2) will be restricted to situations where any trust—including testamentary spousal trusts and lifetime trusts—has unused losses.
Another significant problem with Bill C-43 is that it was enacted without provisions that would "grandfather" situations where wills can no longer be changed (e.g., because the maker of the will is dead or incapacitated). Consequently, in these situations it may not be possible to take any steps to address the legislative changes, which could give rise to adverse tax results and, in some situations, potentially lead to unnecessary litigation.
We understand that lobbying bodies and practitioners continue to make presentations and submissions to the Department of Finance, the Minister of Finance, and whoever might be willing to listen in hopes of causing the Department of Finance to fix Bill C-43 before it comes into force in 2016. Stay tuned to find out if they will be successful.
In the meantime, what are practitioners to do? Unfortunately, the most that can be said is that all advisers should consider whether it is appropriate to contact some or all of their will clients to encourage them to review their wills in 2015. As well, since the changes enacted in Bill C-43 will impact lifetime trust planning, advisers who employ such trusts should also consider encouraging their clients to review whether those trusts will continue to meet their client's planning needs in the future.
Unfortunately, solutions to problems caused by Bill C-43 will not always be straightforward and, as mentioned earlier, it remains unclear whether changes could still be made to the legislation before its January 1, 2016 effective date. As a result, the whole exercise may prove to be an unsatisfactory one.
Assuming Bill C-43 does come into force on January 1, 2016, and results in the elimination of most of the Pure Testamentary Trust Tax Benefits, leaving only modest ongoing tax benefits akin to those available to ordinary inter vivos trusts, or in some cases even potentially leading to significant tax problems, is there a future for testamentary and lifetime trusts? In situations where such trusts are implemented with proper care and attention to details and the non-tax benefits warrant their use, the answer certainly appears to be yes.
1 The term "testamentary trust" is defined in much greater detail in subsection 108(1) of the Income Tax Act (Canada) (the "Act"). Unless otherwise noted all statutory references are to the Act.
2 Similar results apply to inter vivos spousal trusts but, creating such trusts while a person is alive gives rise to tax and non-tax issues that are beyond the scope of this article.
3 As was discussed in Part II of this series of articles, rules in subsections 104(13.1) and (13.2) might also have been used to designate amounts paid by a trust to a beneficiary as being taxable only in the trust, which could have given rise to a number of income splitting benefits, including allowing designated amounts paid out to beneficiaries to still enjoy the testamentary trust's graduated tax rates. However, due to the enactment of Bill C-43, effective for the 2016 and subsequent taxation years, the ability to utilize the designations provided under these provisions will be restricted so that designations can only be made to permit trusts to use up losses.
4 This figure was chosen to approximate the top federal tax rate in 2015. As at the date of writing this article Manitoba, Newfoundland and Labrador, and Prince Edward Island had not yet released their 2015 budgets, so rates used in the chart continue to be 2014 tax rates.
5 Because not all credits available to individuals are available to testamentary trusts, the tax savings associated with a testamentary trust's graduated rates is a bit lower than for individuals.
6 To be fair the draft legislation contained a few beneficial provisions. In particular, the proposals (now law) will make it easier for certain testamentary trusts to make use of charitable donation credits and will allow some relief from the rules that will otherwise limit access to testamentary graduated rates for certain testamentary trusts formed to benefit disabled individuals who are eligible for the disability tax credit.
7 For those interested in further reading on the proposed changes see, for example, Ross, A. M. (2014, October). Proposed Tax Legislation Affects Trusts and Donations on Death. Conference for Advanced Life Underwriting. CALU, North York, ON.
8 See new paragraph 104(13.4)(a).
9 This rule may result in significant inequitable results where the deceased beneficiary's heirs are different from the residuary beneficiaries of the trust. It should be noted that the estate will continue to have liability for this taxable income pursuant to subsection 104(13.4). The interaction of these rules with trustee fiduciary obligations has been discussed by Elena Hoffstein and Pearl E. Schusheim in the following presentation: Hoffstein, E., & Schusheim, P. E. (2014, November 18). New Testamentary Trust Rules. Jewish Community Foundation Professional Advisory Committee Seminar. Lipa Green Centre, Tamari Family Hall, Toronto, ON. There also appear to be technical drafting errors in the rules that, unless corrected, would appear to cause the last-to die spouse's estate to be taxed on income rather than capital account. It can only be hoped that this is unintended and will be corrected (on February 3, 2015, Joan Jung of Minden Gross LLP made a submission to the Department of Finance in connection with this matter).
10 Planning involving subsection 164(6) would traditionally be used to carry capital losses realized in the first taxation year of an estate back to the deceased's terminal taxation year to offset against capital gains in that taxation year. Often such capital losses are realized in connection with the redemption of shares, which itself may give rise to taxable dividends in the estate. Where capital losses would otherwise have been realized on shares on which capital dividends have been paid those losses can be restricted pursuant to a number of provisions in section 112. Subsection 112(3.2) provides estates with important exceptions to these stop-loss rules. From January 1, 2016 onward these beneficial provisions will only be available to GREs.
11 Including those briefly discussed in footnote 5 above.
12 For example, the "zero" inclusion rate for taxable capital gains in paragraph 38(a.1).
13 A deceased person is only able to have one GRE, which is that person's estate. Only that GRE can benefit from the 36 month period of access to testamentary graduated rates and the other Traditional Testamentary Trust Benefits. Although based on informal discussions with the Department of Finance we understand that multiple will structures involving identical trustees in each will should generally not result in a person having more than one estate, it appears that no other testamentary trusts, including insurance trusts, would qualify as GREs. At the end of 2015 for current testamentary trusts or at the end of the 36-month period of existence of the GRE, whichever is later, a year-end will occur pursuant to new subsection 249(4.1).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.