The federal government’s recent announcement that it is interested in reviewing the tax treatment of testamentary trusts could have significant consequences for estate planning, tax experts say, and highlights the value of having wills and estate plans periodically reviewed.
“We now have a signal that there is a potential tax change [affecting wills and estate planning] on the horizon,” says Michael Friedman, partner with Toronto-based law firm McMillan LLP. “It’s more important than ever to look at your will again.”
Testamentary trusts, which are trusts that are created through a will when a person dies, currently are taxed at graduated tax rates, the same rates that apply to individual taxpayers. (In contrast, inter vivos trusts, set up during someone’s lifetime, are taxed at the highest personal tax rate.) Testamentary trusts can allow the beneficiary to have access to more than one set of graduated rates and, in effect, achieve income-splitting.
The 2013 federal budget indicated that the Department of Finance Canada is concerned “with the potential growth in the tax-motivated use of testamentary trusts” and that Finance Canada will be releasing a consultation paper asking for comments about the possible elimination of the tax benefits arising from the taxing of testamentary trusts at graduated rates.
The government appears to be concerned about the tax-motivated use of multiple testamentary trusts to gain access to a multiple set of graduated rates.
“You can see where this can become abusive,” says Doug Carroll, vice president of tax and estate planning with Invesco Canada Ltd. in Toronto. For a beneficiary, a testamentary trust could provide up to around $17,000 of tax relief a year, if the income being generated out of the testamentary trust is large enough.
However, Carroll and other tax experts hope that the government will take a cautious approach to making any changes to the current tax treatment of testamentary trusts. These experts argue that for most individuals, testamentary trusts are used primarily for estate-planning purposes, with the tax benefit being a secondary consideration.
ELIMINATION IS PUNITIVE
“The whole point of setting up a trust is to make sure the property you are passing on ends up in the right hands, and under the conditions and restrictions you want,” Carroll says. “Once that’s taken care of, there are potentially some tax benefits that you can get because of these graduated tax rates; although, when you do the math, for most people, there isn’t the expectation of a huge benefit.”
Eliminating the use of graduated rates for testamentary trusts entirely, some tax experts argue, would be particularly punitive in cases in which the beneficiary is disabled or incapable of managing his or her own affairs. For example, income not paid out from the trust to the beneficiary would accumulate in the trust and be taxed at the highest rate. However, any amount of income paid out from the trust to the beneficiary could unfavourably affect the beneficiary’s eligibility to receive government support payments.
Tax experts argue there probably are ways to address the government’s apparent policy concern without entirely eliminating the use of the graduated rates for testamentary trusts. Possible options, Friedman suggests, might involve somehow aligning the rates used to tax a testamentary trust with the beneficiary’s individual tax rate or limiting access to multiple sets of graduated rates.
The fact Finance Canada is contemplating making a change to the use of graduated rates on testamentary trusts is likely to have an influence on estate planning, as there will be uncertainty about what changes, if any, are made and what the timing of those changes will be.
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