Budget 2013: proposed consultation on changes to the income tax rate applicable to trusts and estates 


March 2013

Tax Bulletin

Budget 2013 announced the 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 his or her lifetime before June 18, 1971), testamentary trusts (trusts created by will), and estates (after a reasonable period of estate administration).

Both testamentary trusts and inter vivos trusts are treated as if they are entities subject to income tax. However, a major distinction for income tax purposes between testamentary trusts and inter vivos trusts is the applicable income tax rate. Testamentary trusts are taxed at the same graduated rates which 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 (to which surtaxes may be added depending on the amount of income earned in any year). The exception to this rule is inter vivos trusts created before June 18, 1971, which are also taxed at graduated rates.

The high rate applicable to inter vivos trusts has generally been considered necessary in order to prevent taxpayers from transferring assets to a multitude of trusts and thus splitting up income or capital gains among a multitude of taxpayers. For example, an individual owning a $100,000.00 Government of Canada bond would pay less income tax overall if the taxpayer transferred the bond to a trust and the trust paid tax on the interest earned at the graduated rate while the taxpayer paid tax only on his employment income than the taxpayer would pay if he paid tax on his employment income and on the bond interest. Using a separate trust for each investment could realize even greater tax savings.

While one does not usually think of tax motivated dying, tax savings can be achieved with a testamentary trust. For example, it is not uncommon planning for an individual to create a testamentary trust under her will with the income to be paid to her spouse and taxed in the trust as a separate taxpayer. If the surviving spouse has his own source of employment or investment income, the total tax paid by the testamentary trust and the surviving spouse would be less than the total tax would be if the surviving spouse had received the investment assets directly and added the investment income to his own income.

It is also not uncommon 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 recognize 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 of significance for reasons totally unrelated to tax efficiency. A typical example would be a trust established under a will for a disabled child or for an elderly parent or child who is incapable of handling his or her own property. In many cases, income is to be paid out in the discretion of the trustees and any income not paid out to the beneficiary is to be accumulated within the trust. Taxing this accumulating income at the top personal rate would mean that almost half of the income would be paid in tax each year, 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 amount of income each year from a trust without jeopardizing their entitlement to government support payments. To tax the income not paid out to the disabled beneficiary at a rate of almost 50% could be a serious deprivation for an individual who is already living on a very meagre income.

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 penalize 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.

by Michael Friedman, Peter Botz and Marni Whitaker

a cautionary note

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2013