A testamentary trust is a trust that is established on death. Most often, it is established in a will. A testamentary trust can also be established as part of a life insurance beneficiary designation.
Currently, testamentary trusts pay income tax at graduated rates (as do living individuals). The government proposes to make the trusts pay tax at a flat rate on each dollar of income. The rate would be equal to the highest applicable marginal tax rate (curently 43.7% in British Columbia on interest income).
The discussion paper presumes that wealthy individuals, as they die, are creating multiple testamentary trusts in order to reduce income tax for their heirs. However, the Canada Revenue Agency (the “CRA”) already has tools to deal with individuals who create multiple testamentary trusts. If a deceased creates a series of testamentary trusts and the trusts are conditioned so that the income will ultimately accrue to the same group or class of beneficiaries, the trusts are considered to be a single trust and have to share a single set of graduated rates.
The proposed rules will most likely prevent low-and-middle-income Canadians from using testamentary trusts to benefit their heirs.
For example, spouses often try to split income during their lifetimes. On the death of the first spouse, however, income-splitting comes to an end. If the deceased spouse simply gifts assets to the surviving spouse, all income from those combined assets will increase the taxable income of the surviving spouse and push the surviving spouse into a higher tax bracket. A testamentary trust allows the surviving spouse to continue to manage tax obligations in the same way as when both spouses were living. This reduces the financial burden caused by the death of the first spouse.
Testamentary trusts are also used for the benefit of vulnerable persons who are unable to wisely manage money. This could be due to a variety of reasons, including a gambling addiction, a substance abuse problem or a simple lack of ability -- issues that will not allow the individual to qualify for the disability tax credit (special rules apply to trusts for individuals who qualify for the disability tax credit). In order to protect such individuals (from themselves and from those who would prey on them), a parent will often leave funds in a testamentary trust created on death so that income accumulates in the trust and is distributed only as and when needed. If a trustee had to distribute all income to the beneficiary in order to avoid having that income taxed at the top rate, the trustee would be in a terrible dilemma. Does the trustee distribute all the income so that it is taxed at the beneficiary’s lower rate (but with the risk that the extra income might do more harm than good) or does the trustee pay the top rate of tax on the income (which reduces the ability of the trust to build up the trust capital for future emergencies)? A beneficiary who cannot handle money will usually want the funds out of the trust and may well bring a court action against the trustee for retaining the income and causing the income to be subject to an unreasonably high tax rate.
The proposed changes threaten to further erode the ability of a spouse or parent to make provision for a surviving spouse or child in the way that the spouse or parent considers most appropriate. Anybody who wishes to object to the proposals should email objections to trusts-fiducies@fin.gc.ca by no later than December 2, 2013. The discussion paper itself can be viewed at http://www.fin.gc.ca/activty/consult/grt-itp-eng.asp.
Blair P. Dwyer
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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.