Estate, trust and tax planners have long favoured testamentary trusts as vehicles to pass along assets to beneficiaries or heirs. A testamentary trust is generally a trust or estate that is created the day a person dies. Commonly, these trusts are established in a testator’s will.
A significant benefit to testamentary trusts had been that income earned and retained in the trust received the same graduated rate of income tax as an individual tax payer. Unfortunately, under the terms of Bill C-43, after January 1, 2016, all income retained in the trust will now be taxed at the highest rate of tax applicable in the province in which the trust is resident.
There will be two exceptions to this new rule – The Graduated Rate Estate (GRE) and a Qualified Disability Trust (QDT).
Graduated Rate Estate
Anyone who has ever acted as an executor can tell you that it can take a considerable length of time to settle the estate. How much time is reasonable? Under the new legislation, the government is telling us that the appropriate amount of time for an estate to be settled is 36 months. To support this, they point to statistics that suggest the majority of estates are wound up by then. As a result, for the first 36 months, the estate trustee can elect for that period that an estate (a deceased can have more than one estate) will be classed as a Graduated Rate Estate (GRE) and during this period will be subject to graduated rates of tax as it would have been under the old system. If at the end of this period, the estate still exists, it will now be taxed at the top rate.
The important points to consider are:
The legislation goes even further because only GREs can utilize certain planning techniques available when a person dies including:
Even though testamentary trusts have lost their preferred tax treatment, they will still present significant estate planning benefits for situations involving spendthrifts, special needs beneficiaries and blended families among others.
Qualified Disability Trust
A QDT is a testamentary trust that will continue to enjoy graduated rates of tax. The basic conditions of a QDT are as follows:
The rules surrounding the Qualified Disability Trust are complicated so if you are preparing your Will with a disabled dependent in mind, please make sure to obtain professional help.
Life Interest Trusts
Appearing in the final version of Bill C-43 without prior warning was a change in the manner in which life interest trusts, specifically spousal trusts, alter ego trusts and joint partner trusts will be taxed when the income beneficiary dies. When an income beneficiary (or second death in the case of a joint partner trust) dies, the trust is deemed to have disposed of all its capital assets at fair market value. The income from this deemed disposition has, up to now, been taxed in the trust. As of January 1, 2016, deaths occurring after that date will see the capital gains taxed in the deceased beneficiary’s terminal tax return and not in the trust.
This simple change can have significant implications if the deceased beneficiary’s estate does not have significant assets and the beneficiaries of the deceased’s estate are different from the remainder beneficiaries of the life interest trust. An example will illustrate this best. Assume we are dealing with a spousal trust created by Bob for the benefit of his wife, Jill. Both are in second marriages and have kids from the first marriage. The spousal trust provides that when Jill dies the assets go to Bob’s kids (he created the trust to provide for Jill while she is alive but wants his kids to ultimately benefit). This new provision will tax Jill so that the assets in her estate must fund the tax liability, which means her kids get less from her estate (assuming they are her beneficiaries). In contrast, Bob’s kids get more assets because the assets in the spousal trust are not reduced by the tax liability on them. Although there is joint liability for the tax with the spousal trust, if Jill’s estate has the money to fund the tax, the legislation does not appear to mandate that CRA go after the spousal trust to pay the tax for Jill’s estate or that Jill’s estate can get reimbursed from the spousal trust for the tax paid.
Another significant implication will be felt by post mortem estate plans (also discussed above in respect of GREs), such as private company share redemptions that depend on netting capital losses against capital gains. With the new legislation, capital gains which arise from the deemed disposition will be reported by the deceased, but the capital loss created by the redemption will be realized in the trust.
A similar issue exists in respect of any donations made by the life interest trust. Since the trust will not have income, the donation credits may not be able to be used to reduce tax.
The good news is that on November 16th, Finance sent a letter to various industry groups, including the main insurance lobbying group, CALU, indicating that they have heard the concerns raised by the tax community and are willing to continue to discuss specific recommendations to address these concerns. However, amended legislation has not been introduced and these rules will still apply beginning in 2016.
Any planning that has been implemented in the past using these vehicles should be reviewed. There may be required revisions or additional planning to deal with situations that are affected negatively by these new changes.
All the changes discussed here take effect after 2015 and it is important to note that there is no grandfathering of existing trusts or trusts created in existing Wills. If you have concerns that you may be affected by this new legislation regarding the taxation of trusts, it is important that you discuss your situation with a qualified professional advisor.
305 Lakeshore Road E, Suite 3
Toll free: 1.866.811.2711