Tax – Page 3 – Doug Carroll

Using the preferred beneficiary election with new qualified disability trusts

At issue

Testamentary trusts may come into being at and as a result of a person’s death. Commonly this is done using a Will, less often using an insurance or RRSP/RRIF beneficiary designation, and occasionally as a result of a court order.

For decades the tax benefit of such trusts has been their entitlement to use graduated tax brackets, as opposed to top bracket treatment for inter vivos trusts. As of 2016, testamentary trusts no longer have this preference, except for the first 36 months of an estate and for certain trusts for disabled beneficiaries. In the former case of an estate, there are limited opportunities to engage in meaningful tax planning.

On the other hand, trustees can and must act strategically on behalf of disabled beneficiaries. In the first place, there is a positive obligation to file an election to preserve those graduated brackets, and only one trust can be so-elected. This can complicate how a parent approaches trust drafting in isolation, let alone where multiple contributors may be contemplated.

As well, trustees need to be certain how existing trust tax rules for disabled beneficiaries may be affected. At the head of that list is the continuing use of the preferred beneficiary election.

Income Tax Act (ITA) Canada – 104(14) — Preferred beneficiary election

The term “preferred beneficiary” is a defined term in the ITA, and for present purposes includes someone who has a mental or physical impairment that entitles the person to claim the disability tax credit.

Section 104(14) sets forth that: “Where a trust and a preferred beneficiary under the trust … elect in respect of the particular year … such part of the accumulating income of the trust … shall be included in computing the income of the preferred beneficiary for the beneficiary’s taxation year”.

The effect of the election is that some or all of the trust income is allocated to the beneficiary. Tax is calculated based on the beneficiary’s graduated rates, and the trust pays that tax. The net income remains in the trust under the care and control of the trustee.

ITA 122(3) — Qualified disability trust (QDT)

As noted, testamentary trust usage of graduated tax brackets is now very limited. However, where the QDT definition is met, a trust remains entitled to use graduated brackets to calculate its taxable income. To qualify, a joint election must be filed by the trust and a beneficiary of the trust who, by reason of mental or physical impairment, is entitled to claim the disability tax credit.

Importantly, the electing beneficiary cannot “jointly elect with any other trust, for a taxation year of the other trust that ends in the beneficiary year, to be a qualified disability trust.” To the point, there may be only one QDT for a given person in any taxation year.

2015-0605111E5 (E) — Qualified Disability Trusts – Preferred beneficiary election

The taxpayer described a hypothetical situation in which an individual with a disability has four grandparents and each grandparent establishes under his/her will a trust for the individual. It is acknowledged that only one of the trusts could be a QDT for the 2016 and subsequent tax years. The inquiry goes on to ask whether the trustees of the additional three testamentary trusts created for the benefit of the same individual can make a preferred beneficiary election for each additional trust.

In response, the CRA author confirms that there have been no changes to the preferred beneficiary election rules as a result of the changes to the rules applicable to testamentary trusts, including the introduction of the QDT.

Both the QDT and preferred beneficiary election are elective provisions, and those elections are not mutually exclusive. As such, the trustees together with the disabled beneficiary can choose which joint election will be made, if any, and it is indeed possible for a trust that has made a joint election to be a QDT to also make a preferred beneficiary election.

Practice points

As of 2016, most testamentary trusts cannot use graduated tax brackets, but the new qualified disability trust preserves that treatment for disabled beneficiaries.
For existing trusts, additional tax filing obligations are required to assure QDT treatment, which fortunately may be coordinated with the preferred beneficiary election.
For families in the preparatory stages, they should confirm with legal counsel that appropriate powers and permissions have been explicitly drafted into trusts and other planning documents.

When to revise your Will

Do new rules for trust taxation warrant a review?

For some people, even the thought of creating a Will casts a pall over their mood. Yes, a Will deals with a person’s death, but the broader process of estate planning is about caring for the most important people in your life, and having an up-to-date Will is central in that process.

But how do you know if you are really “up to date”?

While there’s no black-and-white answer to that question, there are principles that can be used as a guide. And within that inquiry, recent changes to the taxation of trusts may be sufficient to prompt a review and potentially a revision.

When to have a Will

Estate planning is about taking care of yourself now and in the future, and taking care of the people around you – now, in the future and when you are no longer there.

Sometimes the need for a Will is obvious: There is a significant other or a child, or a house or business with employees. Consider though a parent forced to deal with the intestacy of a twenty-something child, or an unanticipated large insurance payout or court award from an accidental death.

In my opinion, everyone who is legally capable of executing a Will should do so.

Having a Will provides certainty, not just about who will receive what, but also because it allows for tailored planning of when an inheritance will be distributed, and how the process will be managed. In this last respect, there is little ability to manage tax concerns without having worked through the issues ahead of time and having executed a Will designed to manage remaining contingencies.

When to review your Will

What then may prompt the review of a Will? (And when I say “prompt,” I am suggesting that a call to your lawyer may be in order to ask whether there is a need to discuss implications.) I would put it into the following three categories, in order of priority:

Changes to the people

This includes you, a dependent, a Will beneficiary, an immediate family member (whether or not a beneficiary), an executor, or a trustee or guardian
Beginning or end of a close personal relationship, whether or not legally married
A birth, adoption, death, mental capacity concern or significant health event
Immigration, emigration or change in citizenship
A change in liability exposure, such as a bankruptcy, being joined in a lawsuit, signing a guarantee or starting a business

Changes to the property

Sale of a large asset, especially if it is the subject of a specific Will bequest
A windfall, such as an inheritance, court award or lottery prize
A theft, loss or consumption, including a marked decline in or withdrawal from an investment account, especially for an RRSP/RRIF plan where a beneficiary designation factored into inclusion or exclusion of beneficiaries in a Will
Ownership change or transfer, including loans or gifts to Will beneficiaries, a change to bank signing authority, or addition of a joint owner on investments or real estate
Cancellation or loss of life insurance (for example, on retirement from employment) where the plan proceeds or a beneficiary designation factored into Will planning

Passage of time

Even if you and the property have remained effectively the same, the legal landscape may have shifted beneath you. It is difficult to say exactly how much time would be appropriate, but I would suggest no more than five years. The principal sources of law are as follows:

Case law – Judicial decisions where the strategies, circumstances and facts may have relevance to your situation and planning decisions
Provincial law – Changing legal entitlements and administrative processes, for example, Ontario creating a more stringent estate-administration tax-reporting regime and Alberta now treating a marriage as not revoking a pre-existing Will
Federal law – Mainly changes to tax legislation that could have an impact on drafting Wills and on the administration of estates and trusts

Trust tax changes

First proposed in the 2013 Federal Budget and passed into law in 2014, as of the beginning of 2016, testamentary trusts have lost most of their previous tax preferences.

A testamentary trust is created under a person’s Will. Up to the end of 2015, such a trust was entitled to graduated-tax-bracket treatment, similar to an individual’s personal tax treatment. Though taxable from its first dollar of income, the trust would initially be subject to the lowest combined federal-provincial rate then work its way up through the tax brackets. As of 2016, the top federal-provincial rate – near or exceeding 50% in most provinces – applies throughout.

There are two key exceptions to the new rules, bringing two new acronyms into the lexicon:

Graduated rate estate (GRE) – For the first 36 months of a deceased’s estate, graduated tax brackets will remain available. However, the rules are complex, and if not carefully navigated, the preferential treatment may be lost
Qualified disability trust (QDT) – Ongoing graduated-tax-bracket treatment may be available to a testamentary trust with a beneficiary who is qualified for the disability tax credit

In the past, an estate-planning lawyer may have recommended the creation of one or more testamentary trusts and drafted the Will accordingly. Today, those trusts may have little or no benefit and may turn out to be an impediment to efficient estate administration. For those who have benefited from what was good planning in the past, it may be time to call the lawyer and discuss appropriate planning in this new environment.

Are Alberta trusts still worth it? – Mounting changes may make them uneconomical

There was a time when the creation of trusts in the province of Alberta was practically an industry unto itself. I can attest from personal experience when I was in private law practice a decade or so back that Alberta firms advertised directly to their Ontario colleagues.

From then up to last year, among the provinces Alberta clearly had the lowest top bracket tax rate at 39%, being 29% federal and 10% provincial. At times that has ranged from 5% to over 15% better than elsewhere in the country.

The expectation was that the trust’s residence for tax purposes would follow that of the trustee. This came under scrutiny in 2012 in Fundy Settlement with the Supreme Court of Canada ruling that residency is determined based on the location of the trust’s central management and control. In that case, that meant Canada rather than Barbados. The Newfoundland Supreme Court considered that case in Discovery Trust earlier this year, upholding a trust’s contention that it was resident in Alberta.

Still, even if a trust is properly established, managed and documented, is it still worth the effort to have it taxed in Alberta?

Changes to testamentary trusts

Inter vivos trusts have long been taxed at the highest combined federal-provincial tax rate, but testamentary trusts could take advantage of graduated brackets. Potentially this benefit could be multiplied for someone who was a beneficiary out of more than one Will.

After this year, with the exception of the first 36 months of an estate and trusts for qualified disabled beneficiaries, testamentary trusts will also be taxed at the highest bracket.

This obviously takes the shine off using testamentary trusts for tax purposes (let alone multiples), though where it is expected that a given beneficiary will be at top bracket in another province, a 39% tax rate may still seem useful — so long as the rate remains at that level.

Alberta rate changes

Even before the election of a majority NDP government in Alberta earlier this year, the incumbent Progressive Conservatives had proposed adding another tax bracket. This became moot once the election was called.

After winning a majority in May, the NDP moved swiftly to carry out a number of election promises before the summer. This included the addition of 4 provincial brackets, 3 of them above the federal bracket ($138,586 in 2015): 12% at $125,000, 13% at $150,000, 14% at $200,000 and 15% at $300,000. The rates are effective October 1, so there is a pro-rata calculation based on the addition applying for 1/4 of the year in 2015. For the top bracket, that means 11.25% for 2015, and then 15% hereafter.

Combined with the 29% federal bracket, that makes for a top combined rate of 44%, the same as Saskatchewan and slightly above the Newfoundland top rate of 43.3%. Alberta is no longer the obvious choice.

Liberals election platform

At time of writing, the Liberals have just won a majority in the federal election. A key plank in their tax platform was to reduce a middle federal bracket from 22% to 20.5%, and to add a top bracket for income over $200,000 at the rate of 33%.

With a majority mandate, it can be expected that these tax changes will be put in place, certainly for 2016. That will raise all provincial combined top rates by that same 4% increment. In Alberta’s case, that will take it to 48% in 2016.

This series of changes make for a significantly different tax proposition for testamentary trusts than would have been contemplated no more than three years ago, particularly for trusts resident in Alberta. Those who have drafted their Wills intending to take advantage of the tax differential should take another look and decide if their plans still make sense. For existing trusts, legal and tax advice is recommended if a variation of the trust is desirable or even possible.