Tax Factor 2013-07

July 2013

The 2013-07 issue of the Tax Factor is available for download. In this issue, we cover:

Federal government releases proposed measures affecting the taxation of testamentary trusts
Restricted farm losses - 2013 update

Federal government releases proposed measures affecting the taxation of testamentary trusts

In the recent 2013-05 issue of the Tax Factor, the article titled “Death and Taxes: Potential Changes to the Taxation of Testamentary Trustsdiscussed 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 [email protected]. We will review these emails and consider your comments in our submission to the federal government.

Restricted farm losses - 2013 update

As we first reported in our 2013 Federal Budget Report, the Finance Minister announced changes in the 2013 budget that will impact the tax treatment of farm losses. Given the importance of these rules to many of our clients in the agricultural industry, we wanted to provide some more information on this change.

Under current law, the restricted farm loss rules apply to limit farm losses when a taxpayer’s chief source of income for a taxation year is neither farming, nor a combination of farming and some other source of income. As reported in the 2012-05 issue of the Tax Factor, the longstanding interpretation of these rules was successfully challenged at the Supreme Court of Canada in 2012 in Craig vs. the Queen. Based on this 2012 decision, a full deduction of farming losses would be permitted where a taxpayer places significant emphasis on both farming and non-farming sources of income, even if farming is subordinate to the other source of income. This decision overrode the interpretation of the restricted farm losses tax rules as set forth in the Moldowan case, which was also a Supreme Court of Canada decision, and which established the longstanding precedent in 1977. We cautioned that the government may be prompted to change the legislation relating to restricted farm losses rather than let the decision in the Craig case stand. Unfortunately, the federal budget tabled on March 21, 2013 introduced such changes.

In the budget documents, the government states that: “To restore the intended policy of the restricted farm loss rules, Budget 2013 proposes … to codify the chief source of income test as interpreted in Moldowan. This amendment will clarify that a taxpayer’s other sources of income must be subordinate to farming in order for farming losses to be fully deductible against income from those other sources.”

The judgment in Moldowan states that there are three categories of farmers contemplated in the Income Tax Act (ITA)

  1. .A taxpayer for whom farming may reasonably be expected to provide the bulk of income or be the centre of work routine. Such a taxpayer, who looks to farming for his livelihood, can deduct the full loss in those years in which he sustains a farming loss.
  2. The taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood but carries on farming as a sideline business. Such a taxpayer is entitled to deduct farming losses on a restricted basis.
  3. The taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood and who carries on some farming activities as a hobby. The losses sustained by such a taxpayer on his non-business farming are not deductible at all.
In determining whether a farmer falls into the first category, where farm losses are fully deductible, the Moldowan case cites such factors as:
  • farming is the taxpayer’s major occupation;
  • other sources of funds, such as income from investments or income from a side-line employment or business, may also exist;
  • the quantum of farming income is relevant but it is not alone decisive;
  • the criteria indicative of ‘chief source’ can distinguish whether or not the farming interest is auxiliary;
  • a taxpayer who has farmed all of their life does not become disentitled to full farm loss deductions simply because he comes into an inheritance; and
  • a taxpayer who commits their energies and capital to farming as a main expectation of income is able to deduct the full impact of start-up costs.

Based on the comments made in the budget document and similar comments on the Canada Revenue Agency’s website about the Moldowan case, it would appear that the government’s intention is that the factors from the Moldowan case should become the guiding principles in interpreting the restricted farm loss provisions in the ITA.

However, the only proposed change to the wording of the restricted farm loss provision in the ITA for the first category of farmers is to add the word ‘subordinate’ to describe the other source of income where farming is carried on as a chief source of income in combination with a subordinate source of income. Keep in mind that subordinate means something that is of lower rank, or of lesser importance, and in the context of the Moldowan decision, does not necessarily mean that the quantum of the subordinate source of income must be less than farming, although on a stand-alone basis (without the context of Moldowan) it could be interpreted that way. It is unfortunate that the proposed changes could not more clearly support the family farm, where in order to finance the high capital costs associated with farming, many farmers, and in particular young farmers, continue to rely on off-farm income. In this regard, the Canadian Federation of Agriculture has referred to the following data in recent discussions with the government:

  • Young farmers earn, on average, less than half of their family income from the farm and more from non-farm sources than do other farms;
  • 22,527 farm operators under 35 years old still cite other occupations as their major source of income (2006 Census of Agriculture); and
  • 14,765 farm operators under 40 years old work more than 40 hours off-farm (2006 Census of Agriculture).

Where ‘subordinate’ is interpreted as the lower source of income, it will severely limit the ability of new farmers to finance start-up businesses and expansions through off-farm income, as the loss from the farming operations may not be fully deductible against other sources of income. Taken in the context of the factors outlined in the Moldowan decision, these farm losses will not necessarily be restricted. However, the proposed changes will create more uncertainty for many farmers as demonstrated by the numbers above, rather than recognizing the role of off-farm income in supporting the family farm.

In the 2013 federal budget, the government also proposed to increase the limit of annual deductible restricted farm losses to $17,500, up from $8,750, effective for taxation years that end on or after March 21, 2013. However, this change will do little to help those farmers most affected by the uncertainty in the restricted farm loss rules.

If you have questions regarding the deduction of current or future farm losses, please contact your BDO advisor.

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The information in this publication is current as of July 1, 2013.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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