The recent Canadian budget tabled on February 11, 2014 contained a number of measures intended to close perceived tax loopholes.  One measure, previously addressed in the 2013 budget, was a proposal to change the taxation of testamentary trusts.

Background

A testamentary trust is a trust that arises on the death of an individual and benefits from graduated rates of taxation.  These trusts are taxed at the same progressive rates as individuals, with lower marginal tax rates applying to lower levels of income.  This is in contrast to inter-vivos trusts, which are trusts established by an individual while alive and which are subject to the highest rate of tax on all taxable income.

2014 Budget Proposal

Following a consultation period in 2013, the 2014 Budget proposes legislation to change the taxation of testamentary trusts in the following way:

• Application of the top tax rate to all testamentary trusts for 2016 and all subsequent years;
• For an estate that is a testamentary trust, the high rate of tax will only apply after the first 36 months following the death of the testator;
• However, testamentary trusts created to benefit disabled individuals who are eligible for the federal Disability Tax Credit, will not be affected, as these trusts will continue to be subject to graduated rates of tax.

Existing testamentary trusts that do not have a calendar year-end will have a deemed taxation year-end on December 31, 2015, after which they will be subject to the top rate of tax starting in 2016.

Non-tax advantages of testamentary trusts

While this will eliminate the tax advantages, beyond the initial 36 month period following death, of having testamentary trusts, there are some non-tax advantages arising from such trusts:

• As mentioned above, trusts benefiting disabled individuals will still be subject to graduated tax rates. This allows disabled individuals to receive income-tested social assistance benefits without being adversely affected. “Henson trusts” as these trusts are often called, give full discretion to the trustee as to the timing and amount of distribution to the beneficiary.  Many provinces exclude the assets and income from such trusts when determining the entitlement to provincial support for disabled persons.
• For minors who are receiving assets pursuant to a will, a trust will allow the deceased to name a trustee(s) who can control the flow of income and capital as needed for the benefit of the minor beneficiaries, until reaching a certain age. Income may be allocated to minors to make use of their lower taxed status.
• A testamentary trust continues to be important in the case of reconstituted families. If an individual remarries, and has children from a first marriage, a spousal trust set up in the will could provide income for the surviving spouse and allow the tax-free rollover of assets to the trust.  However, upon the death of the surviving spouse, provision could be made in the will to have the remaining assets distributed to the children from the first marriage.

The legislation proposed in the February 2014 budget will provide some food for thought in terms of estate planning that was predicated on the use of these trusts to save tax through income splitting.