Punitive Impact of Proposed Changes to Taxation of Testamentary Trusts
June 13, 2013
By Catherine D.A. Watson Coles, QC, at McInnes Cooper
On June 3, 2013, the Federal Department of Finance released its consultation paper on the taxation of testamentary trusts, and of pre-1971 grandfathered inter-vivos trusts. The proposed changes will substantially limit the tax planning options available to Canadians upon death – with a punitive impact on many families. The most significant proposed change will see the tax rate applicable to income earned in all such trusts increase from the individual graduated rate, to the top marginal rate. The changes will reduce or eliminate a number of very simple tax planning opportunities, including:
- Death of a Spouse. Planning using a testamentary spousal trust for tax purposes will be eliminated, with a punitive tax effect to a family on the death of the first spouse.
- Bequests to Adult Children. The income splitting opportunities created when a parent leaves a bequest to an adult child in a testamentary trust will also be eliminated.
- Minor Beneficiaries. Tax on income earned in a trust benefitting a minor will increase – and the money for the minor will decrease – even though a parent’s only choice is to use a trust.
- Disabled Beneficiaries. Similarly, tax on income earned in a trust benefitting a disabled person will increase, and the money available to the disabled person will decrease – limiting the planning necessary to safeguard a disabled person’s entitlement to government benefits and programming and from undue influence.
In the consultation paper (Proposal), the Federal Department of Finance proposes a number of changes to the way in which the Canada Revenue Agency (CRA) will tax testamentary trusts and pre-1971 grandfathered inter-vivos trusts. These changes will reduce the tax planning opportunities associated with testamentary trusts, although the many non-tax reasons for using such trusts remain undisturbed. The key proposed changes are:
Top Marginal Tax Rate. The Government’s proposal to tax all testamentary trusts at the highest marginal tax rate is the most significant change in the Proposal. Under the current taxation regime, the same graduated tax rates that apply to individuals also applies to income earned in testamentary trusts. However, the Goverment proposes to apply the top marginal tax rate for income earned in all such existing trusts, and future testamentary trusts, beginning in the 2016 taxation year. The Government provides two bases for this change:
- Fairness. The current regime raises the question of fairness between the taxation of such trusts and the taxation of ordinary inter-vivos trusts.
- Usage. The extent to which taxpayers employ tax planning using the marginal rates to their benefit – in other words, the fact that Canadians actually avail themselves of the preferential tax treatment afforded to testamentary trusts – has heightened the Department of Finance’s concern.
3 year Administration Period. Under the Proposal, an estate will be allowed to retain graduated rate treatment for a three year administration period; after this three year period, income earned in an estate would also be taxed at the highest marginal rate. However, there are a multitude of reasons why an administration period of greater than three years may be necessary.
Related Measures. The Government has also proposed a number of related measures:
- Year End. All trusts will move to a Dec 31 year end.
- Tax Instalments. Trusts will be required to remit tax payments on an instalment basis.
- Exemptions Eliminated. The $40,000.00 exemption in the computation of Alternative Minimum Tax will no longer apply to trusts. In addition, testamentary trusts will no longer be exempt from Part XII.2 tax – the 36% tax rate applicable to capital gains where a trust with non-resident beneficiaries sells taxable Canadian property.
- Disqualified as Personal Trust. Testamentary trusts will no longer automatically qualify as personal trusts under the Income Tax Act.
- ITC. Investment Tax Credits will have to be recognized in the trust/estate, and not in the beneficiaries’ hands.
- Administrative Rules. Access to various administrative rules currently applicable to testamentary trusts will be substantially limited.
Click here to read the “Consultation on Eliminating Graduated Rate Taxation of Trusts and Certain Estates”.
PUNITIVE IMPACT OF PROPOSED CHANGES
If the Government implements the Proposal, it will reduce or eliminate a number of very simple tax planning opportunities – with a punitive effect on many families. For example:
Death of a Spouse. Currently, taxpayers can use a testamentary spousal trust so that the death of a spouse (including a common-law partner) has minimal tax impact. With a testamentary spousal trust, the deceased spouse’s assets transfer to a spousal trust on a rollover (that is, a tax-deferred) basis. Marginal tax rates apply to income earned in the testamentary spousal trust, meaning income-splitting can continue even after a spouse’s death. The tax result is therefore much the same as it was before the death of the spouse. Under the Proposal, planning using a testamentary spousal trust will no longer be possible, even though the rollover to such trusts remains undisturbed. There will be a punitive tax effect to a family on the death of the first spouse because the highest marginal rate of tax is applied to income earned in the spousal trust.
Bequests to Adult Children. Currently, a parent can leave bequests to adult children in testamentary trusts for their benefit. This planning tool allows continued income-splitting opportunities even after both parents’ deaths. Parents frequently use this technique to preserve as much of the family’s capital as possible within the family unit. The Government’s proposal will completely eliminate this planning opportunity.
Minor Beneficiaries. Practically, a parent has no choice but to leave a bequest to a minor child in a trust: the child is legally not capable of receiving the gift until he or she reaches the age of majority. Currently, income earned in such a trust is taxed at the graduated marginal rates, much as it would have been had it been taxed to the parent during his/her lifetime. Under the Proposal, however, all income earned in such a trust will be taxed at the highest marginal rate, except the income allocated out to the beneficiary. In effect, there is a punitive tax effect to a minor on the death of a parent – less money remains for the minor, and more money goes to the CRA. even though there is no tax-planning motivation behind the creation of the trust, and the parent has no choice but to create it.
Disabled Beneficiaries. Planning for a disabled beneficiary typically involves creating a trust to hold assets for his/her benefit. This planning is put in place for several reasons, typically involving:
- Government Benefits. The planning safeguards the beneficiary’s entitlement to government benefits and programming. These benefits are often necessary to the beneficiary’s medical health, well-being and quality of life; eligibility for them is governed by asset and income level.
- Protection from Undue Influence. Disabled beneficiaries are often vulnerable to caregivers and others, and more susceptible to pressure to give away as gifts the money that they control. Trust planning allows the planner to control the disabled person’s direct asset and income level, and also to preserve the capital for the disabled person’s benefit.
As in the case of a minor, the tax rate on income earned in such trusts will increase from the graduated individual rate to the top marginal rate. Again, this will leave less money available for the benefit of the disabled person – again, even though a testator has no real choice but to create such a trust – with a punitive effect on disabled beneficiaries.
In the Proposal, the Government emphasizes that the special rules under the Income Tax Act allowing income earned in trusts for minor or disabled beneficiaries to be taxed in the hands of those beneficiaries will not change. However, the result effect on such trusts remains deleterious because such beneficiaries will no longer be able to income split between themselves and the trusts.
PUBLIC INPUT AND PLANNING
These examples illustrate that the Proposal will substantially limit the planning available to Canadians upon death in a way that is punitive to many families. In attempting to address and eliminate the planning that most offends it, the Proposal eliminates planning opportunities that are not remotely offensive.
Canadians have until December 2, 2013 to provide the government with input on the Proposal. The consultation paper sets out how Canadians can provide this input.
Once the Government has instituted changes to the taxation of testamentary trusts – as it no doubt will – it will be incumbent on Canadians to review their estate planning. Significant planning opportunities involving testamentary trusts will remain, but many Canadians will need to make adjustments to their estate plans in light of the changes.
Please contact your McInnes Cooper lawyer or any member of our McInnes Cooper Estates and Trusts Team to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.
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