On December 17, 2014, Bill C-43 received Royal Assent, ushering in a new era of estate planning with proposed changes to the Income Tax Act (the “Tax Act”). As long anticipated, testamentary trusts will generally be subject to flat top rate taxation at the highest marginal rate, rather than at graduated rates as is currently the case. Exceptions to this general rule are available for graduated rate estates (“GREs”) and qualified disability trusts (“QDTs”) where necessary criteria are met. The new rules will apply as of January 1, 2016.
Loss of Graduated Rates
Commencing in the 2016 tax year, existing and future testamentary trusts (other than GREs, discussed below) will be subject to the same rules as currently apply to inter vivos trusts. This means that non-GRE testamentary trusts will no longer be able to access a large number of benefits which previously applied, including:
- Ability to access graduated tax rates. Testamentary trusts will be subject to the highest federal tax rate, which is currently 29%. We anticipate the Provinces will align their tax legislation accordingly resulting in an effective combined tax rate approaching 50% in many Provinces.
- Exemption from remitting tax instalments.
- Exemption from Alternative Minimum Tax.
- Ability to allocate investment tax credits to beneficiaries.
- Ability to have a non-calendar year end.
- Extended period for filing a notice of objection to a tax assessment. Testamentary Trusts must now file the notice of objection within 90 days of receiving the notice of assessment.
- Relief from the application of the stop loss rules, which relief allows for certain loss carry-back post mortem planning to avoid double taxation. Where the deceased individual held private company shares and post-mortem loss carry back planning is desirable, it will be necessary in many cases to ensure the estate qualifies as a GRE.
- Increased flexibility in claiming tax credits associated with charitable donations on death.
For existing testamentary trusts which do not qualify as GREs, there will be a deemed year end on December 31, 2015, which may result in 2 fiscal periods in 2015. For planning purposes, it may be advisable to trigger income or gains in 2015 to make use of the last year graduated rates will be available.
Graduated Rate Estates
If an estate qualifies as a GRE, it may continue to access the above listed benefits for a limited time. An estate will be a GRE if:
- No more than 36 months have passed since the date of death,
- The estate is a testamentary trust under the Tax Act,
- The estate designates itself as a GRE in its first tax return that ends after 2015,
- No other estate of the individual designates itself as a GRE, and
- The deceased individual’s SIN is provided.
Only an “estate” is eligible to qualify as a GRE. Generally speaking, a person’s estate exists during the period of time that the executor needs to deal with the deceased’s assets before distributing them to beneficiaries or a trust created under the Will. Therefore, it appears that individual testamentary trusts, even where established under a Will, would not qualify as GREs. As a planning point, it is not uncommon for individuals to utilize a combination of vehicles – such as multiple Wills (which are commonly used to deal with multijurisdictional assets or to facilitate administration of estate assets without requiring Court proceedings) or insurance trusts. Such planning should be reviewed in light of the new rules as it may be necessary for these vehicles to qualify as a GRE, and modifications to current planning may be required to ensure that there is one single estate that is eligible to make the GRE designation.
Further, estates which take over 36 months to administer will face a loss of GRE status and a deemed year end when the 36 month threshold is reached. Estates in existence as of January 1, 2016 may qualify as GREs provided all of the above conditions are met.
Qualified Disability Trusts
Another exception to the taxation of testamentary estates at the top marginal rate can be found in the QDT regime. In order for a trust to be a QDT:
- The trust must be a testamentary trust under the Tax Act,
- The trust must be resident in Canada for the particular year,
- The trust must jointly elect with one or more beneficiaries (the “electing beneficiary”) who is named under the Will or beneficiary designation,
- The electing beneficiary must qualify for the disability tax credit, and
- The electing beneficiary cannot have made that joint election with any other trust. As there is a limit of only one QDT per beneficiary, all other trusts established for the beneficiary of a QDT will be taxed at the highest marginal rate.
It is crucial to ensure proper timing for making the QDT election, as there does not appear to be any relief for late election. We expect this may cause some practical difficulties, as many individuals with disabilities who lack mental capacity may not have court appointed guardians and, accordingly, will be unable to file the joint election until such a guardian is appointed.
The tax relief granted to QDTs is not absolute. QDTs are subject to a recovery tax triggered in a year where (i) the trust ceases to qualify as a QDT, or (ii) a capital distribution is made to a non-electing beneficiary. This tax is intended to “recover” tax savings obtained by the QDT due to the application of graduated rates in prior years. The recovery tax is calculated by determining the amount that would have been payable if the income of the trust which is never ultimately distributed to the electing beneficiary had been taxed at the highest marginal rate.
These new rules represent a significant change for taxpayers and their advisors. Everyone should be encouraged to review their estate planning before 2016 to ensure that it is still appropriate and will achieve the intended objectives.