There was an collective, almost-audible gasp from the estate-planning community when Finance Minister Jim Flaherty announced in the 2013 Federal Budget that testamentary trusts would be placed under the tax microscope. While not technically “the end” for such trusts, the budget brought into question whether the key benefit of graduated tax bracket treatment would remain available to them and to grandfathered pre-1971 inter vivos trusts.
In June 2013, the government published a consultation paper on the issue (the consultation period closed December 2, 2013), soliciting input from all interested individuals and organizations. As proposed, these changes have the potential to:
- fundamentally change future estate-planning processes and decisions,
- force existing plans to be reconsidered and possibly reconstructed, and
- disrupt existing trusts that may have been in place for years or even decades.
Key benefit: Graduated tax brackets
A testamentary trust comes into being on a person’s death, with the trust terms generally provided for in the person’s Will. In fact, an estate itself is a testamentary trust, irrespective of whether a Will exists or what may be stated in it. There’s more on estates below within the summary of proposed changes (see “Challenged to respond”).
A trust is subject to the combined federal-provincial tax rates where it’s determined to be resident. As compared with an inter vivos trust (one created during one’s lifetime) that is taxed at the top marginal tax rate, a testamentary trust is entitled to use graduated tax brackets. Though it cannot claim tax credits available to an actual human being, a testamentary trust can thus experience a tax-rate reduction of 20% or more in some cases.
Proposed changes
Put simply, the proposals would subject these trusts to flat top-rate taxation. In the case of estates, graduated treatment would be allowed for up to 36 months, after which flat top-rate taxation would apply. The measures would apply to existing and new arrangements for the 2016 and later taxation years.
A number of further implications flow from this change:
- Tax instalments – Instead of being allowed to pay taxes at year-end, quarterly tax instalments would be required
- Alternative minimum tax calculation – As is the case for existing inter vivos trusts, the $40,000 exemption would no longer apply
- Year-end – Rather than being able to choose its year-end, such trusts would be subject to a calendar year-end
- Distributions to non-residents – The exemption from part XII-2 distribution tax would no longer apply
- Tax-deferred distributions – Rather than being automatically a “personal trust” that may transfer assets at cost base to beneficiaries, conditions would attach to such characterization
- Investment tax credits – These credits would no longer be allowed to be transferred to beneficiaries, and therefore could only be used to calculate the trust’s own income
- Tax administration – Extended time periods for certain refunds, assessments and filings would no longer be available
The proposals would not affect capital property rollover rules for spousal and common-law partner trusts, but otherwise the changes would apply to the operation of these trusts.
For disabled and minor-age beneficiaries, income would still be able to be taxed to qualified beneficiaries while being retained in the trust, though the trust itself would be subject to flat top-rate taxation.
The fallout
The government’s stated concern is that beneficiaries of these impugned trusts may access more than one set of graduated tax rates, raising questions of “tax fairness and neutrality.” With respect to grandfathered pre-1971 inter vivos trusts, I agree that tax planning undertaken almost half a century ago should not continue to provide tax benefits indefinitely. However, in the case of testamentary trusts – where you must die for the wheels to be set in motion – we need to tread far more carefully.
Accepting that the system may be open to abuse by some, there is a much broader swath of the population who, by no fault of their own, find themselves in a vulnerable position due to the death of a key household provider. Juxtaposed with “tax fairness,” life itself has not been fair to these widows or widowers, orphans and other dependants. There are valid personal and public policy reasons for the “neutrality” of the tax system to give way in such circumstances.
Challenged to respond
Wills prepared under the prevailing rules may need to be redrafted, and other planning avenues may need to be considered. Apart from the confusion and complication this could introduce, there is also a cost. Practically, inaction may be the default result; or if a testator is now incapable, no corrective action would be possible anyway.
Surrounding estate-planning measures would also be affected. For example, the quantum of life insurance may now be out of sync — whether those proceeds are intended to flow through a testamentary trust or directly to a beneficiary — on the assumption of existing tax treatment applying to other assets flowing through a testamentary trust. As with wills, there is the potential for confusion and complication, and a very real possibility that insurability would limit or eliminate manoeuvring options.