Budget 2014 hits trust tax planning hard

1. The elimination of immigration trusts

The first planning technique being eliminated involves an “immigration trust,” which is a non-resident trust generally set up by wealthy immigrants moving to Canada to shelter investment income from Canadian taxation during their first five years of Canadian residency.

Under tax law, if a Canadian resident contributes property to a non-resident trust, the “deemed residence rules” could apply to treat the non-resident trust as resident in Canada and thus subject to Canadian taxation. These rules were designed to deter Canadians from setting up offshore trusts to avoid paying Canadian taxes.

Immigration trusts take advantage of the following exception to these rules: if the contributors to the trust are individuals who have been residents in Canada for less than a total of 60 months, the trust is not subject to Canadian taxation on its foreign-source income. As immigration trusts are often set up in tax haven jurisdictions in which no local taxes are imposed, it’s possible for the trust to escape taxation of its income altogether as there would be no taxes in either Canada or the foreign jurisdiction.

Unlike new immigrants, Canadian residents don’t have the opportunity to shelter foreign-source income from taxation for up to five years, so the government felt this raised “tax fairness, tax integrity and tax neutrality concerns.” Consequently, the 2014 federal budget proposes to remove the 60-month exemption from the deemed residence rules, effectively precluding the establishment of an immigration trust post-budget day.

Although you can debate whether or not this change is good tax policy, what I find particularly egregious is that for existing immigration trusts, 2014 will be the last year these trusts can avoid Canadian taxation. This seems like a harsh, retroactive change in tax policy that will negatively affect any immigration trust set up in the past five years. Take the case of a new immigrant who just spent thousands of dollars in legal and set up fees to establish such a trust in January. They will now only get one year’s benefit. This is clearly unfair and an inappropriate use of retroactive tax legislation.

2. The elimination of graduated tax rates for testamentary trusts

The second change was the elimination of graduated taxation rates for testamentary trusts. Starting in 2016, flat top-rate taxation at 29% federally would apply to testamentary trusts created by wills and to estates “after a reasonable period of administration” of 36 months. Consequently, the benefits of graduated rate taxation would generally be limited to the first three years of an estate as well as to testamentary trusts whose beneficiaries are eligible for the federal disability tax credit.

What seems particularly unfair is that this proposed rule puts the trustee in a difficult position, especially in cases in which the main benefit of the trust was non-tax related and was to allow the trustee to continue to control and manage the deceased’s estate and protect the money for the beneficiaries. Under the new system in which top-rate taxation will start applying to the trust in 2016, the trustee must now choose between either paying more taxes in the trust or paying out the income to beneficiaries, who may be in lower tax brackets but whom the trustee deems not to be capable of handling the income — whether because they’re minors, immature, or, in some cases, may have a substance abuse problem.

The new rule will also impact existing testamentary trusts that require income to be retained in the trust and now taxed at the top rate. The trustee could apply to court to vary the trust, but this will be expensive and usually requires the consent of all interested persons, including the applicable government representative for minors and other incapable persons as well as for future unborn beneficiaries.