Category: Invesco Fundamentals

Testamentary trusts: Tax cutter, practice builder

Rules in the Income Tax Act (Canada) governing trusts enable beneficiaries under a Will to receive their entitlements in a tax-advantaged manner. 

For financial advisors – apart from enhancing after-tax investment returns – trusts can be an effective means for bridging over to the next generation of clients. 

This month’s column reviews the nature of trusts, variations for using them to reduce taxes and some of the key creation criteria to be aware of.

Key elements of trusts

A trust is a taxable entity but it is not a legal entity. Rather, a trust is a property relationship among three elements:

Settlor – The original property owner who creates the trust

Trustee – The new legal owner and manager of the trust property

Beneficiary – The new beneficial owner for whom the property is managed  

While there can be only one settlor, there is no limit on the number of beneficiaries. Likewise, there is no limit on the number of trustees, though for practical reasons one trustee is usually sufficient, with perhaps two or three named in complex situations requiring specialized skills. 

Why use trusts?

Property may be placed in trust for a number of reasons, including: 

Protective care 

Creditor protection

Business planning, and

Tax advantage, particularly in managing an estate 

Tax advantages of testamentary trusts

One of the main distinctions among trusts is between those created during a person’s lifetime (inter vivos trusts) and those created at death (testamentary trusts). There are little or no tax benefits to using inter vivos trusts.

All trusts are separate taxpayers from their beneficiaries. This separation can be particularly valuable for testamentary trusts as they are entitled to marginal tax bracket treatment similar to individuals, though they cannot claim personal tax credits available only to natural persons. 

As an example, if a beneficiary in the top tax bracket receives an inheritance directly, almost half the related income will be lost to taxes. By comparison, a testamentary trust set up for that beneficiary will pay less tax on every dollar earned up to the top bracket level, currently at $126,264 in 2009. Even at more modest levels, if the combined income of the trust and beneficiaries exceeds even the lowest tax bracket threshold, the door is open for an opportunity to save taxes.  

Tax-cutting strategies

Income splitting – The main strategy is effected by the settling of the trust itself, with the creation of a new taxpayer being the trust.

Spousal trusts – Tax-free spousal rollovers of capital property can be extended to one or more spousal trusts.

Income sprinkling – Selective distribution of trust income among beneficiaries can reduce the total tax bill for all beneficiaries.

Multiple trusts – The testator can create at least as many trusts as there are beneficiaries – more if life insurance is in place.

Long-term tax savings – Trusts can be effective tax-management vehicles for up to 21 years or more.

Obtaining the benefits

While a formal written trust document is not needed in all cases, to obtain the most desirable tax benefits, a well-considered estate planning process and clearly drafted Will are essential.

ED: Significant changes to trust taxation occurred in 2015, eliminating many of the tax-reduction benefits discussed here.

Understanding RESPs: An education in itself

A registered education savings plan (RESP) offers tremendous opportunity to house education funding in a tax-beneficial vehicle. However, unless you are dealing with them on a regular basis, RESPs can be confusing.  

From eligibility criteria to grant support qualification to withdrawal procedures, the rules are stringent and potentially unforgiving if you’re not careful.  

Planning for education can be a moving target

In fact, for most parents, the bridge from first knowledge to first withdrawal is measured in years or even decades. Consider my friends’ daughter who will begin university in September 2009. Since she was born in 1990, 

Either or both of the annual and lifetime contribution limits have been raised on five occasions

The Canada Education Savings Grant has been modified as to both amounts and carryforwards, and the companion Canada Learning Bond has been introduced

Withdrawal commencement and plan durations have been extended and qualifying program definitions have been revised; and 

Further benefits lie ahead for her younger siblings through the newly available Quebec Education Savings Incentive, the family being in Quebec, obviously (Note that Alberta also provides provincial support through the Alberta Centennial Education Savings Grant) 

Though these changes have injected a degree of havoc in the parents’ planning, the havoc has certainly been welcome in terms of enhanced savings growth. The challenge now, as they commented to me recently, is to shift gears to learn and manoeuvre a new set of rules (new to them, that is) governing the drawdown of those funds. 

But it’s not just parents who are challenged.  

We’re here to help you figure it all out

Even conscientious advisors can be hard-pressed to maintain top-of-mind awareness.  Understanding RESPs can be an education in itself, and an advisor’s desire and need to keep current could be very time-consuming – and that’s even before considering all the “acronyms” you must keep track of.

To provide some assistance we have developed a new RESP InfoCard that complements the text treatment in our RESP InfoPage. This back-to-back format tool provides quick reference to key information like age and time constraints, up-to-date financial data and technical rule compliance.

And of course, if you are looking for clarification or expansion on these and other tax and estate issues, our InfoService team is always available to you at the end of the phone line or via e-mail.

Is my RRSP protected from creditors?

Given the events of the past year, it’s probably a question that comes up fairly often now for financial advisors, and there’s no simple answer. Whether your clients are asking you out of nervousness for their nest egg, their jobs or both, it’s an extremely topical issue. 

Last year’s amendments to the federal bankruptcy law gave RRSP/RRIFs a similar level of protection to their registered pension plan cousins. Short of bankruptcy, however, the question needs to be framed in terms of the type of plan being held, whether it is lifetime or estate protection at issue and concurrently what province or territory one resides in.

Expected creditor exposure

The chart below summarizes expected treatment.

 Why is the creditor claiming?

Certain conditions and classes of creditors may override technical compliance with the rules, even for insurance-based plans. If a creditor can show a fraudulent conveyance or preference, impugned transactions may be reversible. It depends on the province or territory whether intent is a necessary component of the action, or if prejudice to the claimant is sufficient,.

It is also possible that matrimonial property, support orders and dependants’ relief claims could impress a trust upon RRSP/RRIF assets. As well, CRA has been successful in actions taken against registered plans.  

Where any of these complications are present, legal advice should be sought out before making any moves.