Testamentary trust, estate donations and kiddie tax measures
October 28, 2014
The recent Canadian federal budget, tabled in the House of Commons on February 11, 2014, contained proposals that will have an impact on people planning their estate as well as business structures that allow for income to be split with minor children. In August and October, draft legislative proposals to implement these tax measures were released.
The changes in the 2014 budget should not come as a surprise. Last year the federal government announced a consultation paper on measures to eliminate tax benefits enjoyed by testamentary trusts. Submissions by the public were due December 2013. The government announced its intentions to implement the changes in its 2014 budget thus eliminating long-established tax preferred status for testamentary trusts.
Income of a personal trust that is not paid or made payable to beneficiaries is taxed in the trust. Testamentary trusts (trusts created by wills or the estate of a deceased) have enjoyed lower tax rates as the trust’s income was taxed at graduated rates, the same as individuals. However, the income of inter vivos trusts (which are trusts created during a person’s lifetime) is subject to tax at the top personal marginal tax rate or “flat top-rate taxation”. This rate differential permitted families, in particular the spouse of the deceased, to continue to benefit from the deceased’s marginal tax rate by taxing a certain amount of the income of the estate in the trust (similar to the tax that would have been paid had the individual not passed away). Unlike individuals and inter vivos trusts, testamentary trusts have been exempted from the necessity of making quarterly tax instalment payments and therefore only pay tax within 90 days of the end of its taxation year. Also, the ability of a testamentary trust to select a year end other than the calendar year end could create an opportunity to delay tax.
Beginning in 2016, testamentary trusts will no longer benefit from graduated tax rates. Income of these trusts will be subject to the flat top-rate taxation. However, estates in their first 36 months of existence (defined in the proposals as a “graduated rate estate”) will be subject to tax at graduated rates. If the estate continues past this period, it will have a deemed year end 36 months after the date of death and will be subject to tax at the flat top-rate going forward.
Testamentary trusts with beneficiaries who are eligible for the disability tax credit will continue to be taxed at the graduated rates as a result of the introduction of a “qualified disability trust”. Under these rules, the beneficiary who is eligible for the disability tax credit and the testamentary trust will jointly elect in the T3 tax return to be a qualified disability trust for the year. The proposals also provide for a recovery of tax savings where taxable income of the qualified disability trust of a prior year is not distributed to an individual that was an “electing beneficiary” of the trust in a prior year.
On December 31, 2015, testamentary trusts (other than graduated rate estates) that have an off calendar year end will have a deemed year end. Testamentary trusts (other than graduated rate estates) will be required to remit instalments for 2016.
The proposed amendments contain welcome changes which simplify the deductibility of charitable donations at death. The seemingly simple act of making a charitable donation as part of estate planning was overly complex as the ability to claim the charitable donation tax credit relied on the Canada Revenue Agency’s (“CRA’s”) interpretations and administrative policies regarding the phrasing of the gift in the will. The phrasing of the gift in the will determined whether the gift would result in a charitable donation tax credit to the individual in the year of death (or preceding year) or a tax credit of the estate.
The proposals remove this complexity and the necessity to rely on the CRA’s interpretations. For deaths that occur after 2015, gifts made according to the individual’s will and gifts by the individual’s estate (either graduated rate estate or not) will be deemed to have been made only by the estate at the time that the property that is the subject of the gift is actually donated to the charitable organization. As a result of the proposed amendments, the executors of an individual’s graduated rate estate will have the ability to allocate donations made within the first 36 months of the individual’s death to either the individual’s last two taxation years, the taxation year of the estate in which the donation was made or an earlier taxation year of the estate. Estates which are not graduated rate estates will be able to claim donations in the year they are made or any of the five following years.
The proposed amendments also codify the CRA’s administrative position of permitting an individual to claim the charitable donations made by the individual’s spouse or common-law partner.
Extension of kiddie tax rules
Over the past number of years, the government has continued to review the rules on split income (known as the kiddie tax rules) and expand their application to additional types of income. The kiddie tax rules are designed to minimize any income splitting available with minor children. The 2014 budget proposed change to the kiddie tax rules could also impact certain business structures. The rules are extended to apply the flat top-rate of taxation to income that is paid, directly or indirectly, to a minor child from a trust or a partnership if the income is derived from a business or rental property and a person related to the minor child is actively engaged on a regular basis in the activities of the trust or partnership to earn income from any business or rental property. For example, a parent may provide professional services to third party clients of a partnership of which the individual’s minor child is a partner. The child’s partnership interest could be held directly or by way of a trust of which the child is a beneficiary. These rules apply beginning in the 2014 taxation year.
Actions to be taken
Trustees of testamentary trusts and executors of estates must ensure they are compliant with the new measures. Beneficiaries of testamentary trusts should consider how these measures will impact them. In particular, consideration should be given as to whether the trusts should continue to be part of their tax planning. Careful planning must be undertaken in connection with the dissolution of a trust to ensure there are no adverse tax consequences. Although the proposed rules will not eliminate the rollover of assets to a spousal testamentary trust, existing wills should be reviewed to assess the necessity of the creation of a spousal trust at death.
With the changes in the rules related to gifts from a will or estate, taxpayers should review their wills to ensure that the outcome of their planning will be consistent with the new rules.
Business structures that result in business income or rental income being allocated to minor children as partners or beneficiaries of trusts should be reviewed to determine the implications of the extension of the kiddie tax rules.
Should you wish to discuss how this information applies to your circumstances, please contact your Deloitte advisor or any of the practitioners noted on this release.
Gilles Fleury and Patricia McDougall, Ottawa
Canadian managing partner, Tax
National tax policy leader
National PCS Leader
Denis de la Chevrotiere
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