In October 2014, the Federal Government tabled a Notice of Ways and Means Motion to implement changes to the Income Tax Act (‘ITA’) proposed in the 2014 Federal Budget. The government first disclosed its concern about perceived abuses of the tax treatment of testamentary trusts in the 2013 Federal Budget.
The proposed changes affect testamentary trusts and grandfathered inter-vivos trusts.1 Testamentary trusts are an estate planning tool that arise upon the death of an individual. The assets are held by a trustee for the benefit of beneficiaries, this is in contrast to an inter-vivos trust that is established during the lifetime of the individual.
Under the current regime, inter-vivos trusts are taxed at the top marginal tax rate. Depending on the province of resident of the trust, this can be as high as 50 per cent. Testamentary trusts, however, are taxed under the same progressive graduated personal tax rate as an individual tax payer. The result for 2014 is lower tax rates on the first $200,000 of trust income. This could mean savings of over $20,000 depending on the province of residence.
The proposed legislation, which will come into effect 1 January 2016, will eliminate the graduated tax rate regime. All testamentary trust income will now be taxed the same as inter-vivos trusts; at the top marginal rate. The proposed changes, however, allow for two exceptions:2 (1) the Graduate Rate Estate (GRE)3 and (2) the Qualified Disability Trust (QDT).4
The Graduated Rate Estate
For the first 36 months, the estate will have access to marginal tax brackets. To be eligible the following requirements must be met:
- the estate must arise as a consequence of a an individual’s death (a testamentary trust);
- no more than 36 months have passed since the date of death of the individual;
- the estate must designate itself as the GRE of the individual in its tax return for the first taxation year ended after 31 December 2015; and
- there can be only one estate designated as the GRE of the individual for the year.
At the end of the 36 month period, the estate will cease to be a GRE. Under the new rules, all existing estates and testamentary trusts must select a December 31 fiscal year end. When the estate ceases to be a GRE, it will be required to select a December 31 fiscal year end for the first year after it ceases to be a GRE.
Qualified Disability Trusts
The second exception to the proposed rules is for Qualified Disability Trusts (‘QDT’). QDT’s are testamentary trusts created for benefit of individuals that suffer from disabilities. The trusts, sometimes referred to as “Henson Trusts”, will continue to take advantage of graduated rates. To qualify for the QDT exception, the estate must meet the following requirements:
- each beneficiary of the trust qualifies for the Disability Tax Credit (DTC) in his or her taxation year in which the trust year ends;
- the estate must jointly elect with at least one beneficiary on its income return for the year;
- each electing beneficiary must be an individual named as beneficiary by the individual creating the trust;
- no electing beneficiary may jointly elect for his or her taxation year, any other trust to be a QDT; and
- subsection 122(2) must not apply to the trust for the year (cannot be an inter vivos-trust).
This is beneficial for Canadians with severe disabilities who qualify for the DTC (see article: The Disability Tax Credit – Do you qualify? [LINK]). However, thousands of Canadians that suffer from disabilities but do not qualify for the DTC will lose the benefit of using testamentary trusts. There are still other tax credits or deductions that can result in benefits for these individuals such as the refundable medical tax expense supplement and Ontario trillium benefits among others.
Other changes for the treatment of testamentary trusts
Effective 1 January 2016, testamentary trusts will lose access to the following benefits:
- the exemption from remitting tax installments;
- the exemption from Part XII.2 tax (trust income allocated to a non-resident beneficiary);
- the $40,000 basic exemption when computing the Alternative Minimum Tax; and
- a number of tax administration rules that otherwise would only apply to individual tax payers.
Despite losing many of the tax advantages currently provided for testamentary trusts, there are still benefits to establishing this type of legal arrangement;5 especially if you are planning for the future needs of an individual suffering from a severe disability and qualifying for the Disability Tax Credit. Establishing a testamentary trust is complex. At Siskinds we understand these complexities and can help you navigate the rules.
1 Certain trusts created before 18 June 1971
2 See revisions to subsection 122(1) of the ITA.
3 Defined in subsection 248(1) of the ITA.
4 Defined in subsection 122(3) of the ITA.
5 Such as preservation of inhertence, flexibility in how payments are structured for your beneficiary in terms of timing and the amount of distribution.