Trust taxation – Doug Carroll

Is this the end for testamentary trusts? – Government consultation begins

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.

In-trust accounts: Achieving tax efficiency with children’s savings

Known as in-trust, in-trust-for, or simply ITF, parents may often hold investment accounts earmarked for a minor child’s needs. While historically these trust accounts have been most commonly associated with education planning, they need not be constrained to that purpose alone. In particular, there are tax benefits that may be gained.

However, to take effective advantage in this broader sense, greater formality is necessary. By carefully documenting and monitoring the arrangement, a family will be better able to calculate the tax benefits and obtain more certainty that those benefits will indeed be realized.

An informal trust?

Parents may view an ITF as an informal way to isolate savings, but there must truly be a trust relationship in order for the tax benefits to be realized. To paraphrase Yoda of Star Wars fame, a trust either “is or is not,” so the use of the term “informal trust” is something of a misnomer. Thus, it must be clear what the property is, who will benefit from that property, and that there is a discernible intention to transfer ownership of that property into this new relationship.

The principal benefit to be gained is to have as much of the income as possible taxed in the child’s low tax bracket. Absent the trust, all income will generally be taxed in the parent’s hands. With the trust in place

interest and dividends will still be attributed back and taxed to the parent,
income-on-income (so-called second-generation income) will be taxed to the child, and
realized capital gains will be taxed to the child.

Follow the money

It is important to understand that a taxpayer must be able to prove entitlement to a tax benefit, not for the Canada Revenue Agency (CRA) to disprove it. Logistically, this presents some challenges when an ITF is employed.

In the classic ITF, all income is initially reported as that of the parent, being that it is that person’s Social Insurance Number that is on file with the investment company. In order to transfer taxation into the child’s hands, a note will have to be attached with the parent’s annual income tax return. In turn, a tax return should be filed on behalf of the child. Often there will be no tax due from the child given the basic personal exemption, but it is a good idea to nonetheless file the return to demonstrate you are in compliance with CRA filing rules.

Likewise, good recordkeeping is critical to being able to distinguish the types of income generated, in order to allocate the tax liability to the correct party. This can be especially complicated if the investment account is a combination of parent-sourced funds and the child’s own money, the latter being included because investment companies will not generally enter into contracts with minors. To the extent that these are commingled, it may become difficult – if not impossible as rebalancing and second-generation income come into play – to know what is whose, recalling once more that the onus is on the taxpayer vis-à-vis the CRA.

It may be preferable to use at least two accounts, both of which will be ITFs in form, though in substance their source funds differ. The first account will be the child’s own money; for example, from the Canada Child Tax Benefit, the Universal Child Care Benefit or an inheritance. The ITF format is an administrative convenience, and all income of whatever sort is to be taxed to the child.

The second account will be the true trust arrangement whereby the parent-sourced funds are gifted from the parent to be invested for the child. The above-mentioned tax-filing procedure would apply to this account. Ideally, each year the second-generation income would be shuttled over to the first account, thereafter completely clear of being attributed back to the parent..

A role for corporate class

This is a situation where corporate class mutual funds may offer some value. Such funds do not distribute interest and foreign income, two of the income types that are subject to immediate attribution. Of the two types of income that are distributed, Canadian-eligible dividends will still be attributable (at first generation) to a parent under an ITF, but capital gains distributions will be taxed to the child.

Strategic use of trusts: Managing for tax advantage

The settlement of a trust is a simple step that opens the door to sophisticated wealth planning opportunities.

In last month’s issue, we touched on the requirements for a trust to come into existence, and canvassed some of the most common ways trusts may be characterized for tax purposes.

Ultimately though, reducing trust taxes is but an intermediate step toward the ultimate purpose of providing optimal benefit to beneficiaries. Following are some further ways that a trustee’s careful decision-making can deliver that value to those beneficiaries.

Income splitting

As a starting point, if settled through a person’s Will, a trust will obtain testamentary treatment, meaning access to graduated tax rates for income reporting. This obviously compares favourably with the top marginal tax rates that apply to inter vivos trusts (those settled during lifetime). In effect, the deceased person continues to be somewhat present from a tax perspective.

It is actually possible to multiply this benefit by establishing multiple trusts, though within limits dictated by the Income Tax Act. Essentially, only one such trust may be created for each beneficiary designated under a Will. Still, that’s a side-by-side graduated tax rate vehicle for each person a testator wishes to benefit out of an estate.

In addition and as discussed in last month’s article, CRA has acknowledged that separate testamentary trusts may be established out of life insurance proceeds and RRSP/RRIF receipts.

Selecting the year-end

The year-end of a testamentary trust may be elected as any day in the full year following the relevant death. A trustee may use this election to strategically delay income recognition, as beneficiaries must report an income distribution from a trust in the beneficiary’s tax year in which the trust’s year-end falls.

To illustrate, if a beneficiary receives an income distribution in February Yr 1 from a testamentary trust with a January 31 year-end, that income is deemed to be received on January 31, Yr 2, with the tax due with the filing of the beneficiary’s Yr 2 T1 return in April Yr 3.

Income sprinkling

Beyond initial creation of the trust, there is an art and science to year-to-year trust tax management. For example, a trustee could selectively distribute annual trust income among beneficiaries to reduce the long-term total tax bill for all beneficiaries. This could be particularly effective when beneficiaries have little or no income from other sources, so that their basic personal amount credit and low bracket rates might be accessed when otherwise left unused.

This practice, called ‘income sprinkling’, could be effective in the short-term, but the trustee would have to remain vigilant to carry out the even-hand duty among beneficiaries over the long-term.

Allocations and elections

A very useful tool for a trustee to tax-manage a trust, whether inter vivos or testamentary, is to employ elections for allocating tax liability on income. Subject to the trust terms and the Income Tax Act, income may be retained in the trust or paid out to a beneficiary, with associated taxes either paid by the trust, the beneficiary or both. The table below illustrates how this may operate:

Taxed to Trust, Allocated to Trust

This is full retention of both income and tax liability in the trust. One possible application would be a testamentary trust where the beneficiary is at top marginal tax rate and does not need immediate cash.

From a non-tax motivated view, spendthrift and/or creditor protection trusts may be designed this way.

Taxed to Beneficiary, Allocated to Trust

In limited circumstances, tax liability may be elected to a beneficiary, while income remains in the trust, such as under the “preferred beneficiary election” for a disabled beneficiary.

At a minimum, enough income would be allocated to use the beneficiary’s basic personal credit, effectively eliminating the tax on that income.

Taxed to Trust, Allocated to Beneficiary

Where the beneficiary needs or must be paid the income, it may be possible to elect to tax the income in the trust.

For example, a qualifying spousal trust, inter vivos or testamentary, is required by the ITA to pay annual income to the spouse beneficiary. The tax election decision would rest mainly on whether the spouse or trust has the lower tax rate.

Taxed to Beneficiary, Allocated to Beneficiary

The usual treatment of income is that it is distributed to income beneficiaries as it is earned annually, and the tax liability follows.

As well, even if a trustee could act more strategically, he/she may decide that tax benefits of retaining income are nominal or outweighed by other considerations, and therefore a full distribution may be the best approach.

A final thought on probate

While not a serious cost issue in provinces like Quebec and Alberta, probate taxes or fees can be as much as 1.5% of incremental estate value, with no cap on the upper end. Probate avoidance is thus a common goal in estate planning, but it should not be pursued at all costs as it may in fact be a net negative benefit.

The simplified example in the following chart shows how an incremental $1,000 inheritance fares if it flows directly to a high tax rate spouse or incurs probate tax to flow to that spouse as beneficiary of a testamentary trust. The difference in values at the end of the first year is small, but by the end of the second year the trust option begins to show the benefit of graduated tax bracket treatment (as the probate tax only applies once), and that gap will widen in following years.

TABLE

Direct Estate/trust

A) Value of benefit $ 1,000.00 $1,000.00

B) Incremental probate tax (using 1.5%) n/a 15.00

C) Net funds to invest 1,000.00 985.00

D) Annual income (using 5% interest) 50.00 49.25

E) Tax (using spouse 40%, trust 20%) 20.00 9.85

F) Net income 30.00 39.40

G) Value at year-end [ C + F ] $ 1,030.00 $ 1,024.40

H) Value at 2nd year-end $ 1,060.90 $ 1,065.38