A testamentary trust is an arrangement set up in a Will directing the executor (“estate trustee” in Ontario) of the Will to hold certain estate assets for the benefit of certain individuals or to transfer certain assets to a separate trustee who will do so. The executor or separate trustee is then directed to pay out the estate assets and income on the assets over a period of time.
Provided the trust is properly structured, such an arrangement can provide a number of benefits, including the following:
Potential creditor protection
Potential protection against a Family Law Act claim (in the event of a marriage breakdown)
Potential annual income splitting tax benefits (resulting from accessing the graduated marginal tax rates available to individuals)
The avoidance of Ontario Estate Administration Taxes (“probate taxes”) on the trust assets on the death of the lifetime beneficiary of the trust
The annual income splitting tax benefits of such trusts have been available in Canada for more than 25 years. Because the Canadian government became concerned with the growth in the tax-motivated use of testamentary trusts, it announced its intention in the 2013 Federal Budget to review and consult on possible measures aimed at eliminating these special tax benefits. Following a consultation period, the 2014 Federal Budget reaffirmed the government’s intention to proceed with these measures.
On December 17, 2014, the new rules received royal assent. Under these new rules, effective January 1, 2016, testamentary trusts are now subject to tax at the top federal tax rate of 29%, with the exception of certain “Graduated Rate Estates” and “Qualified Disability Trusts”. (The Department of Finance released further draft legislative proposals on the “Tax Rules for Certain Trusts and Their Beneficiaries” on January 15, 2016.)
The combined top marginal federal/provincial rates currently range from 39% to 54%, depending on the trust’s province of residence. The potential tax savings available to a trust qualifying for graduated rate taxation, as opposed to being taxed at the top marginal tax rate, has been estimated to exceed $15,000 per year.
The two exceptions to the new rules consist of the following:
“Graduated Rate Estates” - Graduated rates will continue to apply for the first 36 months of an estate that qualifies as a “testamentary trust” under the Income Tax Act; i.e. it is a trust that arises on and as a consequence of an individual’s death. The 2014 Tax Measures Supplementary Information states that “this recognizes that estates require a period of administration and that estates are generally administered within their first 36 months. If the estate remains in existence more than 36 months after the death, it will become subject to flat top-rate taxation at the end of that 36-month period.” To qualify as a “graduated rate estate” (GRE) the estate must designate itself as the deceased individual’s GRE in its trust tax return in its first taxation year that ends after 2015. (The estate will be deemed to have a year-end when it ceases to be a graduated rate estate [at the end of the 36 months] and it is then required to select a December 31 taxation year-end.)
“Qualified Disability Trusts” - A second exception to the new rules applies to trusts having as their beneficiaries individuals who are eligible for the federal Disability Tax Credit. Such trusts (which may include “Henson Trusts”) will continue to receive the benefit of graduated rate taxation as long as the beneficiary continues to qualify. The existing graduated rate taxation of testamentary trusts for the benefit of disabled individuals has been an important tool in preserving access by these individuals to income-tested benefits, in particular provincial assistance benefits, such as Ontario Disability Support Program payments.
Despite these current and forthcoming changes, it is worth noting that income-splitting opportunities (e.g. among each adult child’s own family members), will continue to exist with respect to properly drafted and properly administered testamentary family trusts created in Wills. Also, the potential creditor protection and potential protection against a Family Law Act claim will also be unaffected by the existing and proposed legislative changes.
(Important note: The above commentary is of a general nature only. It is not legal or tax advice and does not provide an exhaustive list of changes to the taxation of testamentary trusts. It is recommended that the reader obtain legal advice and/or tax advice specific to any particular situation.)
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