Canada: Update On Taxation Of Estate Plans

On January 1, 2016, new tax rules relating to certain types of trusts come into force. These new rules will eliminate some of the advantages of using trusts established by Will ("testamentary trusts") for tax planning purposes and will impact existing trusts.

Testamentary Trusts to be Taxed at Top Marginal Rates

Currently, income of testamentary trusts is taxed at the same graduated rates of tax as individuals. Start­ing January 1, 2016, this income, if not paid out to a beneficiary, will be taxed at the highest marginal rate of tax (anticipated to be 53.53% in Ontario as of January 1, 2016). Two exceptions to this rule exist for: (i) graduated rate estates; and (ii) qualified disability trusts.

(i) Graduated Rate Estates

The executors of a deceased's estate can designate the estate to be a "graduated rate estate" ("GRE") for the first 36 months after death. By doing so, the estate can:

  • have estate income taxed at graduated rates for the first 36 months following the date of death;
  • use certain post-mortem planning techniques to reduce tax, such as loss carry backs; and
  • allocate the credits for charitable donations made by the Will against taxable income of the deceased in the year of death or the year prior, or allocate such credits against the estate income in any of the three years during which the estate is a GRE.

(ii) Qualified Disability Trust

Graduated tax rates will also apply to a "qualified disability trust" ("QDT"), which is defined as:

  • a testamentary trust;
  • resident in Canada throughout the year;
  • that names as a beneficiary a person who is eligible for the federal Disability Tax Credit; and
  • that, together with the eligible beneficiary, files a joint election to be a QDT.

An individual can only have one QDT. The benefit of having a QDT is that any annual income not paid to or for the eligible beneficiary can be taxed in the trust at graduated rates. However, the QDT will eventu­ally be required to pay a "recovery tax" when it is distributed to any beneficiary other than the eligible beneficiary. Tax will be payable on the accumulated income on which tax was originally paid at graduated rates, in an amount equal to the tax which would have been paid had such accumulated income been taxed at the top marginal rates in the year it was originally earned. This will apply to payments of accumu­lated income to any other beneficiary while the eligible beneficiary is alive or after the death of the eligible beneficiary. Essentially, a QDT will only act as a deferral of tax at the top rate for all income which has not been paid to or used for the benefit of the eligible beneficiary.

Taxation of Spousal Trusts

The new rules provide that a spousal trust (testamentary or inter vivos), an alter ego trust and a joint part­ner trust ("life trusts") are deemed to have a year-end at the end of the day on which the last person who was entitled to income for life (the "life beneficiary") dies. The current rules provide that the tax liability arising as a result of the deemed disposition of the capital assets on the death of the life beneficiary rests with the life trust. Therefore, it is essentially a tax on the assets which pass to the remaining capital beneficiaries of the life trust.

As of January 1, 2016, the estate of the life beneficiary will be liable for the tax on the deemed capital gains even though the estate of the life beneficiary is not entitled to any further assets out of the life trust. Essentially, the new rules result in a mismatch between the taxpayer responsible for the tax (the estate of the life beneficiary) and the taxpayer who owns the assets from which the tax liability arose (the life trust). The capital beneficiaries of the life trust will pay no capital gains tax on the assets they receive, while the beneficiaries of the life interest beneficiary's estate will pay the capital gains tax on the assets distributed to the capital beneficiaries of the life trust.

The Department of Finance has issued a letter in which it suggests that this provision will be amended so that this absurd result does not occur. In the meantime, it will apply to all existing life trusts as well as those established after January 1, 2016.

Loss of Graduated Rates for Minors

The loss of the graduated rates for trusts means that if a Will established trusts to protect the inheritance of minor beneficiaries, only amounts actually paid to or for the benefit of the minor can be taxed in the minor's hands, and at their graduated rates. Any income remaining in the trust at the end of the year will be taxed in the trust at the highest marginal rate. This also affects testamentary trusts currently being administered and not just those established after January 1, 2016.

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.

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