Taxes on trusts: Top rate for estates?

Testamentary trusts

In June, Finance Canada released a consultation paper outlining its proposals to eliminate the use of graduated-rate taxation for testamentary trusts and certain estates. The consultation period ends Dec. 2.

Testamentary trusts, which are created through a will upon the death of an individual, currently are taxed at graduated tax rates – at the same rates that apply to individual taxpayers. By contrast, inter vivos trusts, which are set up during someone’s lifetime, are taxed at the top individual tax rate.

Testamentary trusts can be used to allow the beneficiary to have access to more than one set of graduated rates and, in effect, achieve income-splitting.

The federal government first indicated in its budget tabled in March that it is concerned with what it believes is the tax-motivated use of multiple testamentary trusts. Tax authorities contend that some taxpayers use these trusts to gain access to a multiple set of graduated rates and also use tax-motivated delays when completing the administration of estates to prolong access to the lower, graduated tax rates.

According to the recent consultation paper: “The tax benefits of tax planning of this nature raise questions of fairness, and negatively affect government tax revenue.”

In the paper, Finance Canada is proposing to apply flat, top-rate taxation to testamentary trusts created by wills as soon as these trusts arise (on death), and to certain grandfathered inter vivos trusts that were created before June 18, 1971, which are currently still taxed at graduated rates.

In addition, Finance Canada is proposing to apply flat, top-rate taxation to an individual’s estate, which is included in the definition of a trust under the Income Tax Act (ITA), after a reasonable period of administration. The government is defining that as 36 months following the individual’s death. Thus, an estate would have access to graduated rates for up to the first 36 months of administration, after which it would be taxed at the top rate.

Overly restrictive

Ottawa is proposing to start applying the new rules in the 2016 taxation year.

In reaction to the consultation paper, tax practitioners say the proposals to eliminate the use of graduated rates for testamentary trusts are not well considered. They argue that most people set up trusts in their wills for a variety of valid and sensible tax and estate planning reasons unrelated to the access to the graduated rates, or with the rates as a secondary consideration only.

“These [proposed] rules are overly restrictive for the problem they’re trying to solve,” says Pamela Cross, a partner and regional leader of the tax group in the Ottawa office of law firm Borden Ladner Gervais LLP.

Tax practitioners are arguing that eliminating the use of graduated rates for testamentary trusts would be unfair and potentially punitive in some cases. In particular, they say, there are cases in which the beneficiary is unable to manage his or her own affairs, such as a disabled child or a child with a substance abuse problem.

If the government’s proposals were to be enacted into law, assets left in trust for these types of beneficiaries would be taxed at the top rate on the first dollar earned.

The only way to avoid this top rate would be to have assets flow out from the estate directly to the beneficiary, who may have little or no income and, therefore, be in a lower tax bracket.

“That’s unfair,” says Cross. “That puts that beneficiary at an economic disadvantage when the purpose [of creating the trust] is not tax planning but to protect the beneficiary. By limiting access to graduated rates, you’re affecting the ability of people to plan properly.”

Although there are provisions in the ITA that allow for the suspension or lessening of the effects of the top rate in a case in which a testamentary trust has been created for a disabled beneficiary, tax practitioners say, those provisions would apply only in limited cases.

Tax practitioners also believe that the proposed three-year window to administer estates is inadequate, says Michael Friedman, a tax lawyer and partner with McMillan LLP in Toronto, particularly if the estate is complex or if legal challenges arise: “Thirty-six months sounds like a lot of time on the surface, but it can run by very quickly.”

Tax practitioners also doubt that the government can realize a significant amount of tax revenue from the proposed changes, arguing that only the very wealthy could derive significant tax savings from setting up multiple trusts for the primary purpose of gaining access to a multiple set of graduated rates.

Disadvantaged

“There is no doubt that planning is being done to use testamentary trusts to access graduated rates and thus achieve income-splitting,” wrote Kim Moody, a partner with Moodys LLP in Calgary, in an article posted on the firm’s website. “However, it is not clear this is a huge ‘problem’.”

Tax practitioners expect that financial services industry organizations will be responding to Finance Canada’s request for submissions.

They are hopeful that the government can be persuaded to amend the proposals to address some of the industry’s concerns regarding the scope of the proposed changes.

Says Tim Cestnick, president and CEO of Toronto-based WaterStreet Group Inc.: “To just blindly eliminate the graduated rate on testamentary trusts is not carefully considering the needs of a lot of beneficiaries who might be disadvantaged by the decision.”

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