Bill C-43, which received Royal Assent on December 16, 2014, introduces a new type of trust to benefit disabled individuals – the "qualified disability trust" ("QDT"). Accordingly, QDTs will apply to the 2016 and subsequent taxation years. The main benefit of a trust being designated as a QDT is that, despite the recent changes to the tax rules for testamentary trusts, a QDT will still be subject to graduated tax rates as opposed to being taxed at the top marginal rate.
In order to qualify as a QDT, a trust must meet the definition under subsection 122(3) of the Income Tax Act (Canada) ("Tax Act") which includes the following criteria:
- At the end of the taxation year, the trust must be a testamentary trust that arose on and as a consequence of a particular individual's death. This means that inter vivos trusts are excluded from qualifying as QDTs.
- The trust must be resident in Canada for the tax year. The mind and management of the trust must be in Canada in order to maintain this requirement.
- The trust must make a joint election with a "qualifying beneficiary" to be a QDT. To meet this requirement, a trust must include in its tax return for the trust year both (i) an election made jointly with one or more beneficiaries under the trust (referred to as the "electing beneficiaries") in prescribed form for the taxation year, and (ii) the social insurance number of each electing beneficiary.
- Electing beneficiaries must be "named" beneficiaries. This requirement means that each electing beneficiary must be an individual named as a beneficiary by the particular individual in the instrument under which the trust was created.
- Disability tax credit qualification. Each electing beneficiary must qualify for the disability tax credit under paragraphs 118.3(1)(a) and (b) of the Tax Act.
- Each electing beneficiary may only make one QDT election. An electing beneficiary that is a beneficiary of multiple trusts may only make the QDT election in regard to one of those trust.
There are several pitfalls that practitioners should be aware of when considering the use of a QDT:
- There is no relief for a late-filed election. If an election is not filed on time, the trust will not be a QDT for that taxation year and income taxed in the trust will be taxed at the top marginal rate.
- The QDT definition specifically requires that electing beneficiaries be named beneficiaries in the instrument under which the trust was created; however, this may not always be the case with a testamentary trust. Often testamentary trusts refer to "my issue" or "my children". Such references are not sufficient to meet the QDT definition. This is an issue, in particular, for individuals who are not yet born at the time a will is drafted or who become disabled later in life. A beneficiary who is not specifically named in the testamentary trust will not be able to benefit from the trust being a QDT.
- This tax credit, under paragraphs 118.3(1)(a) and (b) of the Tax Act, may not be available to all disabled individuals. For example, not all individuals who qualify for provincial disability benefits also qualify for the disability tax credit. Such individuals will not be able to benefit from the QDT designation.
- A QDT may be subject to a recovery tax under subsection 122(2) in respect of a previous year. The intent of the recovery tax is to claw-back tax savings for income taxed at graduated rates that is subsequently distributed as capital to a non-electing beneficiary. The formula for the calculation of the recovery tax is somewhat complicated, however, it effectively equals the amount of tax that would have been paid in a previous year if the trust had been subject to the highest marginal rate and taxable income for that year excluded amounts that were subsequently distributed as capital to the electing beneficiary.
A QDT will be subject to the recovery tax under the following circumstances: (i) none of the beneficiaries at the end of the trust year were an electing beneficiary for a preceding year, (ii) the trust ceased to be resident in Canada, or (iii) a capital distribution is made to a non-electing beneficiary. There are several issues to note regarding the recovery tax. The first condition applies to the year in which a qualifying beneficiary passes away and in such year, the recovery tax will apply. In addition, special attention must be paid to the administration of the trust to ensure that its mind and management are in Canada so that it does not become a non-resident trust, triggering the recovery tax under the second condition. Finally, if there will be multiple beneficiaries of the trust and not all such beneficiaries are disabled, then consideration should be given to the terms of the trust in allowing capital contributions to non-electing beneficiaries. One might consider setting aside a separate trust or trusts for such individuals so that capital can still be distributed to those beneficiaries without the concern of the recovery tax applying.
Below are some strategies that might be considered when planning for the use of a QDT:
- An electing beneficiary may only make the election with one trust for each taxation year. This is something that should be taken into account during planning. For example if both parents wills establish a testamentary Henson trust for their disabled child, the child will only be able to make the election for one of the two Henson trusts. So, for example, if each trust generates $25,000 in income each year ($50,000 total), only one of the trusts can be a QDT, so only $25,000 qualifies to be taxed at the graduated rates within the ADT. The other $25,000 will be taxed at the highest marginal rate.
- In making the joint election with an electing beneficiary to be a QDT, such election may be difficult to make in the case where an electing beneficiary does not have the capacity to make such an election. In such a case, a court appointed guardian may be required in order to successfully make the election.
- Life insurance trusts may be QDTs. As proceeds of life insurance may be significant, it would be prudent to consider whether such trust should be designated as the QDT
- If a spouse is eligible for the disability tax credit, it is possible for a testamentary spousal trust to qualify as a QDT.
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.