Appropriate tax treatment

Saturday, 01 June 2013
Marni M K Whitaker discusses the Canadian government’s proposal to change the income tax rate applicable to trusts and estates

Budget 2013 announced the Canadian government’s intention to consult on possible measures to eliminate the tax benefits that arise from taxing at graduated rates, grandfathered inter vivos trusts (created by an individual during their lifetime before 18 June 1971), testamentary trusts (trusts created by will) and estates (after a reasonable period of estate administration).

Current treatment

Testamentary trusts and inter vivos trusts are both subject to income tax. However, they have different income tax rates. Testamentary trusts are taxed at the same graduated rates that apply to individuals (although a testamentary trust does not qualify for personal tax credits), while an inter vivos trust is taxed at a flat rate equal to the highest individual income tax rate (surtaxes may be added depending on the amount of income in any year). The exception to this rule is that inter vivos trusts created before 18 June 1971 are also taxed at graduated rates.

Inter vivos trusts

The high rate applicable to inter vivos trusts has been considered necessary to prevent taxpayers from transferring assets to numerous trusts and thus splitting income or capital gains among a multitude of taxpayers. For example, if an individual owned a CAD100,000 government of Canada bond and transferred it to a trust, the trust would pay tax on the interest at the graduated rate, while the taxpayer would pay tax only on their employment income. In such a case the individual would pay less income tax than if they had paid tax on employment income and on the bond interest. Using a separate trust for each investment could realise even greater tax savings.

Testamentary trust

Tax savings can often be achieved with testamentary trusts. This kind of trust might be created by an individual under a will, with the income to be paid to a spouse and taxed in the trust as a separate taxpayer. If the surviving spouse has an independent source of employment or investment income, the total tax paid by the testamentary trust and the surviving spouse would be less than the total paid if the surviving spouse had received the investment assets directly and added the investment income to their own income.

It is also possible for a testamentary trust to be established for each of several children, thus multiplying the use of the graduated rates. Such planning is often unwound after the testator’s death when adult children recognise the costs and inconvenience of keeping trust records and filing annual income tax returns for the trust, or wish to control their inherited assets directly.

Testamentary trusts are often significant for non-tax reasons. A typical example would be a trust established under a will for a disabled child, elderly parent or child who is incapable of handling their own property. Often income is to be paid out at the discretion of the trustees, and any income not paid out is to be accumulated in the trust. Taxing this accumulating income at the top personal rate would mean almost half of the income would be paid in tax, thus depriving the beneficiary of its future use. Children or other relatives who receive government support payments, such as Ontario disability support payments, would be particularly disadvantaged. Such individuals typically cannot receive more than a small income each year from a trust without jeopardising their entitlement to government support payments. To tax the income not paid out to the disabled beneficiary at almost 50 per cent could be a serious deprivation for an individual already living on a meagre income.

Budget 2013 proposal

The Budget papers suggest that the government is concerned with the use of multiple testamentary trusts and tax-motivated delays in completing the administration of estates. There are other ways to address these concerns than to penalise all beneficiaries of testamentary trusts. Budget 2013 announced that a consultation paper will be publicly released for comment, and it is hoped that interested parties will express their views on this proposed consultation.

Author block
Marni M K Whitaker

Marni M K Whitaker is a Partner at McMillan LLP.

The content displayed here is subject to our disclaimer. Read more