Time is running out for advisors to make representations to the federal government on its proposal to eliminate the graduated tax rates currently available to testamentary trusts and estates.
A trust is not a legal entity but rather a type of legal relationship in which one person, the trustee, holds property for the benefit of someone else, the beneficiary. A testamentary trust is created when someone dies, generally through his or her will. An estate arises when someone dies and his or her legal representative takes control of administering the individual’s property.
Both a trust and an estate are considered individuals for tax purposes and must pay taxes on their taxable income that is not distributed out to the trust’s or estate’s beneficiaries. Trusts and estates are entitled to a deduction for income either paid out or made payable to its beneficiaries. The trust’s beneficiaries then include any income received or made payable to them in their own personal incomes and pay taxes at their own, personal graduated tax rates on that income.
Under existing tax laws, testamentary trusts and estates also pay taxes at graduated rates such that if the trust decides to retain its income in a given year instead of making its income payable to its beneficiaries, it pays taxes on that income at graduated tax rates.
This tax treatment is very different from the treatment accorded to inter vivos trusts, which are created during an individual’s lifetime, as these are taxed on any retained income at the highest marginal tax rate. Taxing inter vivos trusts at this flat, highest tax rate generally limits the tax planning effectiveness of such trusts, which “promotes fairness and neutrality in the tax system, and protects the Government’s revenue base.”
On the other hand, permitting testamentary trusts to pay taxes at graduated rates allows the trusts’ beneficiaries effectively to gain access to more than one set of graduated rates. As the federal government wrote, “This tax treatment raises questions of both tax fairness and neutrality in comparison to the treatment of beneficiaries of ordinary inter vivos trusts and taxpayers receiving equivalent income directly.”
As a result, this past June the federal government followed up on its 2013 budget promise to launch a formal consultation on proposed measures to eliminate the tax benefits that could potentially arise from having testamentary trusts and estates taxed at graduated rates.
The feds highlighted three specific tax-planning opportunities associated with the graduated tax rates available to testamentary trusts in the discussion paper released in June. The first was the use of multiple testamentary trusts in an individual’s will for post-mortem income-splitting. The second, was the action by some estates’ legal representatives to keep an estate open to avail it of the graduated rates artificially and unnecessarily. The third potential abusive activity was the use of testamentary trusts in respect of beneficiaries who might otherwise lose some of their old-age security benefits as a result of having the trust’s income paid out directly to the them and taxed in their hands.
The consultation paper describes the government’s intention to tax testamentary trusts at the highest marginal tax rate. It would also apply such a rate to estates 36 months after the individual’s date of death.
No grandfathering is being proposed with both proposals applying equally to existing as well as new trusts and estates starting with the 2016 and later taxation years.
The Department of Finance Canada is welcoming the public’s comments on the matter until Dec. 2. Submissions can e-mailed to trusts-fiducies@fin.gc.ca.