In the recent 2013-05 issue of the Tax Factor, the article titled “Death and Taxes: Potential Changes to the Taxation of Testamentary Trusts” discussed the government’s intention to eliminate the tax benefits that arise from the taxation of trusts and certain estates at graduated rates, and the potential impact that this elimination may have on current post-mortem tax planning. At the time of publication, the government had not yet revealed any specific details on how it intended to accomplish this objective. And as a result, there were many unanswered questions. On June 3, 2013, the Department of Finance released its consultation document outlining the proposed measures to eliminate graduated rate taxation for trust and certain estates. This article discusses the key proposed changes and considers the potential tax impact of these changes.
Proposed measures revealed by the Department of Finance
If enacted into law, the proposed measures will see amendments to the Income Tax Act (ITA) that include the application of ‘flat top-rate taxation’ to grandfathered inter vivos trusts and trusts created by will. ‘Flat top-rate taxation’ refers to the flat income tax rate applicable to other trusts (i.e. ordinary inter vivos trusts, including family trusts) which is currently set at a federal rate of 29% plus provincial tax at the top rate. Flat top-rate taxation is also proposed to apply to estates (‘flat top-rate estates’) immediately after the 36-month period following the death of an individual. As a result, estates of deceased individuals will only be eligible to retain access to graduated rates for up to the first three years of the estate’s administration. It is proposed that these measures will apply to all existing and new arrangements for 2016 and subsequent taxation years.
It is worth pointing out that the proposed measures on graduated rates will not change the existing preferred beneficiary rules, the rules for spousal rollovers or the rules that apply to trusts for minor children. As well, the rollover rules that apply on the death of a spouse or common-law partner will remain unaffected by these proposed changes. For more information on these and other rules affecting trusts, read our Tax Bulletin titled Understanding Trusts.
It also bears noting that while the rollover rules on the death of a spouse or common- law partner remain undisturbed by the government’s proposals, passing these proposals into law may have a significant negative impact on the tax burden placed on a surviving spouse. Consider that currently on the death of a spouse (or common-law partner), assets may be rolled over to a testamentary spousal trust and income earned by the spousal trust would generally be taxed at the graduated marginal rates applicable to individuals. In this way, income splitting can essentially continue beyond the death of the spouse and the taxation would essentially be the same as it would have been during the deceased spouse’s lifetime. However, if the proposals noted above are legislated, the testamentary spousal trust would be subject to flat top-rate taxation, resulting in an increased tax burden to the surviving spouse. Similarly, if enacted, these proposals would see an increased tax burden placed on the beneficiaries of a trust established by will for the benefit of minor or disabled persons. Since flat top-rate taxation would very clearly result in there being less money in the trust available for the beneficiaries, there would be a punitive effect on the very people these trusts are meant to protect.
Proposed measures affecting other trust tax rules
As the basic premise of the consultation paper, the government believes that testamentary trusts and grandfathered inter vivos trusts should be subject to the same tax treatment as ordinary inter vivos trusts. Consequently, the government’s consultation paper also includes proposed amendments to a number of other related income tax rules. These proposed measures include:
Taxation year and fiscal period
Testamentary trusts are currently not subject to the same rules that require ordinary inter vivos trusts to use a calendar year reporting period for tax purposes. If passed, the proposed measures would see trusts created by will and flat top-rate estates be required to use a calendar taxation year, and that their fiscal periods end in the calendar year in which the periods began. This change may cause complications for estate and testamentary trust administration in certain circumstances.
Alternative minimum tax
Individuals, including trusts, are subject to the alternative minimum tax (AMT). In computing AMT, a $40,000 basic exemption is currently available to testamentary trusts and certain grandfathered inter vivos trusts. The measures in the consultation paper propose to deny this exemption to grandfathered inter vivos trusts, trusts created by will and flat top-rate estates. Although not a positive change, this change is consistent with the main proposal of doing away with graduated tax rates.
Income tax instalments
Under the current legislative rules, testamentary trusts are exempt from the requirement placed on individual taxpayers to pay a portion of their estimated tax liability for a taxation year by making tax instalments. The proposed measures aim to eliminate this exemption and extend the income tax instalment rules to trusts created by will and flat top-rate estates. Interestingly, while the current tax legislation does require that ordinary inter vivos trusts pay instalments, the Canada Revenue Agency (CRA) does not currently enforce this requirement. Since a legislative change is being suggested, it is possible that the CRA will start enforcing the requirement for inter vivos trusts.
Other proposed changes
The consultation paper also includes measures proposed to affect certain other rules in the ITA that are more technical in nature. These rules are fairly complex and reference should be made to the consultation paper for more details.
You should note that the timing of these additional proposed changes was not set out specifically, but we assume they would be made when the main change on graduated rates applies.
The government has extended an invitation for stakeholders to consult on these proposed measures by December 2, 2013. BDO intends to be amongst those providing a written submission to the Department of Finance on these proposed measures. We will continue to provide additional updates as more details become known.
As we indicated in our 2013-05 Tax Factor article, if you have any thoughts or comments that you’d like to share with respect to the elimination of the tax benefits associated with testamentary trusts, please email us at firstname.lastname@example.org. We will review these emails and consider your comments in our submission to the federal government.
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The information in this publication is current as of July 1, 2013.
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