In general, testamentary trusts arise when an individual dies leaving benefits to be distributed to certain persons over an extended period of time. Testamentary trusts are defined under the Income Tax Act (Canada) (the “Act”) as trusts that arise on or as a consequence of an individual’s death and, as such, are generally created by Will. They stand in contrast to inter vivos (Latin for “while living” or “while alive”) trusts, which are settled by an individual during his or her lifetime and generally subject to the terms of a trust agreement or indenture.
Under the Act, as it presently stands, estates, testamentary trusts and certain inter vivos trusts (created before June 18, 1971) pay federal income tax at the graduated tax rates applicable to individuals in respect of income that is taxed in the estate or trust and not allocated to a beneficiary. This is not the case for inter vivos trusts created after June 18, 1971, which pay federal income tax at the highest marginal tax rate applicable to individuals on all their income. For example, a testamentary trust resident in Ontario and created in 2012 that received $65,000 of interest income would only have been taxed at a combined federal and provincial tax rate of 31.15% for all such income above $42,707 (in addition to a combined base tax liability of $8,714, for a total federal and provincial income tax liability of approximately $15,658), while a similar inter vivos trust that received $65,000 of interest income would have been subject to taxation at the highest combined Ontario and federal tax rate of 47.97% on all such income, irrespective of any lower tax rates of its beneficiaries.
2013 Federal Budget Proposals Regarding Denying Graduated Rate Taxation for Testamentary Trusts and Estates
The Federal Government expressed concern in the 2013 Budget that the difference in tax treatment for different trusts raises questions of tax fairness and neutrality. The Government is also concerned about taxpayers delaying the administration and distribution of the assets forming part of a deceased’s estate, in order to continue the availability of graduated rates. Further, tax planning strategies that incorporate multiple testamentary trusts, in the Government’s view, are negatively impacting the Canadian tax base.
As a result of its concerns, the Federal Government announced in the 2013 Budget that it will consult with stakeholders on possible measures to eliminate the tax benefits that arise from taxing testamentary trusts, estates administered over long periods, and pre-June 18, 1971 grandfathered inter vivos trusts at graduated rates. In our view, it would be truly unfortunate if the Federal Government were to change the current tax treatment of testamentary trusts and certain estates, subjecting them to the treatment that was introduced on June 18, 1971 specifically for the purpose of discouraging the use of inter vivos trusts.
Under the Act, as it stands, an estate may be viewed as an extension of the deceased. This is both logical and practical. Estates can hold and distribute property in much the same manner as the deceased would have been able to had he or she been alive. Holding assets within an estate can also provide a measure of protection to certain beneficiaries, including from their creditors. Viewed as an extension of a deceased individual, a policy shift that seeks to impose the highest level of taxation on an estate that continues to provide for the deceased’s dependants is, therefore, in our respectful view, unduly punitive.
Moreover, ordinary graduated rate treatment may be only one of several reasons for testamentary trust usage. Such trusts, which accumulate income, may be established in Wills for beneficiaries who, although not under the age of majority, may nonetheless not be ready to manage the income the assets may generate. Testamentary trusts may also be used to protect spend-thrift or otherwise addicted family members from depleting their assets imprudently. In order to avoid being taxed at a punitive tax rate, trustees would feel compelled to pay out income to beneficiaries who are unable to or who should not be placed in a situation where they will need to manage money. Distributions to certain beneficiaries may also compromise their eligibility for government assistance to which they would otherwise have been entitled. Such a consequence would be truly unfair both to the deceased, who has sought to carefully and responsibly provide for his or her next-of-kin or dependants, and to the dependents themselves, who could now see an erosion of income that would have otherwise been accumulated to punitive taxation at the highest marginal rate.
To the extent the Federal Government is concerned about multiple testamentary trusts from one estate negatively impacting the Canadian tax base, subsection 104(2) of the Act, as it presently stands, was inserted in the Act to enable the Canada Revenue Agency to deny testamentary trusts the tax savings that artificially multiplying the number of trusts might otherwise provide. Accordingly, it is difficult to understand how introducing punitive rates for individuals’ estates will assist in creating tax fairness for those who, in a responsible manner, provide for their family members after their deaths.
Consultation on Eliminating Graduated Rate Taxation of Trusts and Certain Estates
On June 3, 2013, the Department of Finance announced its “Consultation on Eliminating Graduated Rate Taxation of Trusts and Certain Estates” (the “Consultation”). The Department has clarified, inter alia, that, despite the proposals announced in the 2013 Federal Budget, preferred beneficiary elections would still be available under the Act for eligible disabled persons, and that the Act’s existing rules for trusts established for minor beneficiaries would also continue to apply. The Department of Finance further confirmed that tax-deferred rollovers of assets to testamentary spousal trusts would be preserved. However, certain provisions of the Act and the Regulations under the Act related, in particular, to testamentary trusts and estates would be subject to consequential amendments as a result of the proposals announced in the 2013 Federal Budget. These consequential amendments would include,inter alia:
- an obligation for testamentary trusts and certain estates to pay income taxes in quarterly installments, as opposed to the current requirement that such trusts and estates pay any taxes owing for a taxation year within 90 days of the end of that year;
- a denial of the $40,000 exemption for alternative minimum tax that is presently available to testamentary trusts, certain estates and grandfathered inter vivos trusts;
- a requirement that testamentary trusts and certain estates adhere to calendar year taxation periods in the same manner as inter vivos trusts;
- the extension of the possible application of income taxation under Part XII.2 of the Act to testamentary trusts;
- a denial of the automatic qualification of testamentary trusts as “personal trusts” for the purposes of the Act;
- a requirement that testamentary trusts and certain estates recognize investment tax credits within the trust or estate, as opposed to making the credits available to beneficiaries in determining their own income tax liability for a taxation year; and
- the restriction of the application of certain administrative rules to testamentary trusts that are estates and not subject to flat taxation at the top applicable graduated rate in a particular taxation year. These rules extend the period in which, for example, objections to tax assessments may be made or refunds may be provided on account of the overpayments of taxes.
The Consultation is open to the public and submissions may be made by interested parties until December 2, 2013 either by e-mail to: [email protected], by fax to: 613-992-2036, or by post to: Trust Graduated Rates, Tax Legislation Division, Tax Policy Branch, Department of Finance, L’Esplanade Laurier, 17th Floor, East Tower, 140 O’Connor Street, Ottawa, Canada, K1A 0G5. It is expected that the Federal Government will consider the implementation of the proposals announced in the 2013 Federal Budget regarding the denial of graduated rate taxation to testamentary trusts and certain estates during and following the Consultation period.