There was an almost-audible collective 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.
This June, the federal government published a consultation paper on the issue, 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 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.
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 will now be attached to such characterization
- Investment tax credits – These credits will no longer be allowed to be transferred to beneficiaries, and therefore may only be used to calculate the trust’s own income
- Tax administration – Extended time periods for certain refunds, assessments and filings will no longer be available
The proposals will not affect capital property rollover rules for spousal and common-law partner trusts, but, otherwise, it appears that the changes will encompass these trusts.
For disabled and minor-age beneficiaries, income will still be able to be taxed to qualified beneficiaries while being retained in the trust. Again, it appears from the proposals that income taxed to the trust itself will be subject to flat top-rate taxation in addition to the other implications listed above.
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 canvassed and undertaken. Apart from the confusion and complication this could introduce, there is obviously a cost. Practically, inaction may be the default result, or if a testator is now incapable, no corrective action would be possible anyway.
And this also affects surrounding estate-planning measures. 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 will limit or eliminate manoeuvering options.
Existing trusts that were funded based on the premise of graduated rates will now be subject to top-rate taxation. Where a trust is settled in whole or part for a frail beneficiary (e.g., gambling problems, substance abuse, etc.) who falls short of being disabled, trust capital may be eroded sooner than anticipated. Where there are multiple beneficiaries in a trust, it may now be necessary to isolate disabled and minor beneficiaries from others. In either case, drafted trust provisions may no longer be appropriate, particularly calculations based on distinctions between income beneficiaries and capital beneficiaries. In fact, investment policies and past investment decisions may not be optimal in hindsight, and may not comport with continuing needs under the new regime. In all cases, a court application for the variation of a trust is neither simple nor inexpensive.
Wish to comment?
The government has invited public comment. Submissions may be sent in paper to the Department of Finance in Ottawa or via e-mail to trusts-fiducies@fin.gc.ca.
The consultation period is open until December 2, 2013.