Goodbye Graduated Tax Rates
Starting January 1, 2016, estates will only benefit from graduated tax rates for the first 36 months after death.1 After that point, the estate will have a deemed year-end of December 31st and will be subject to tax at the highest marginal rate on every dollar earned.2 Existing and all new testamentary trusts3 will also have a December 31st year-end (or will be deemed to have a year‐end on December 31, 2015). From then on, they will also be subject to tax at the highest marginal tax rate. No grandfathering is being provided. For the first $135,000 of income earned by the trust, the loss of graduated rates will mean additional tax of almost $20,000 per year. For wealthier families who created multiple testamentary trusts in their wills, the additional tax burden could be even more significant. Because of this amendment, we will likely see fewer testamentary trusts created under wills (probably replaced with one “family testamentary trust”). A testamentary trust will still serve many non‐tax purposes, such as protecting minor beneficiaries and/or spendthrift beneficiaries, while still allowing some income splitting through the sprinkling of the trust’s income to the beneficiary if he/she is in lower tax bracket. Just don’t expect to see multiple trusts filing multiple tax returns to achieve the $20,000 annual tax savings.
Many Tax Benefits Restricted to Graduated Rate Estates
Many of the tax preferential rules that apply to the final tax return of the deceased or to an estate are now being restricted.4 For instance, it is common to satisfy charitable bequests to registered charities with gifts of marketable securities held at the time of death rather than cash. By making the gift‐in‐kind the estate would benefit from no capital gains tax on the security at the time of death and a donation tax credit. Now only the ‘graduated rate estate’ (defined in the first footnote below) is eligible for the reduced capital gains tax rate.
The new rules could also seriously impact many post‐death reorganizations that are undertaken for private companies to avoid double taxation.5 One strategy that is often employed is a redemption of the deceased’s private company shares in the first year of the estate. The redemption creates a loss that offsets the gain arising on death6 and tax is only paid on the redemption dividend held by the estate. Again the new rules restrict this tax result to graduated rate estates.
In Ontario it is a common probate saving technique for the deceased to have two wills. The primary will covers assets requiring probate while the secondary will deals with assets not requiring probate such as private company shares and debts. Many practitioners take the position that there are two estates created on death. Now care will have to be taken to determine which estate should be designated as the “graduated rate estate” as this designation could have other tax implications.
Loosening of the Rules Applying to Charitable Donations
One positive benefit that will arise from the new rule changes is a loosening of the rules for charitable gifts specified in a will, or designated under a RSP, RIF, life insurance policy or TFSA7. Before 2016, the donation is considered to be made immediate prior to death.8 It can only be claimed on the terminal tax return of the deceased or carried back to the year before death to offset 100% of the net income on those returns. 9 For generous philanthropists, donations often fell off the table. The new changes starting in 2016 will now consider the charitable gift to be made when the actual gift is made by the estate trustees.10 The resulting credit can be claimed on the terminal tax return of the deceased or the return for the preceding year and/or on the estate tax return for the year of the gift, a prior year or any of the five subsequent years.11 This will add considerable flexibility and a greater ability to utilize tax credits for generous donors.
Changes to the Deemed Disposition Rules for Special Types of Trusts
Alter Ego trusts12 have a deemed sale of their property when the settlor dies. Joint Partner trusts13have a deemed sale of property when the second partner/spouse dies. Finally, Qualifying spousal trusts14 have a deemed disposition when the spouse beneficiary dies. Under existing rules, the capital gain arising on these deemed sales cannot be allocated to a beneficiary.15 Instead, the gain must be reported on the trust’s tax return for the taxation year containing the deemed disposition. The gain was therefore subject to top marginal tax rates in alter‐ego and joint partner trusts, and graduated rates in testamentary spousal trusts.
Beginning in 2016, three new rules will take effect. First, the death of the alter‐ego, or partner/spouse will trigger a deemed year-end for the trust.16 The trust will then have 90 days to file its tax return. Second, the income for the stub‐period up to the death along with the capital gain arising on the deemed sale will be attributed to the life tenant (i.e., the settlor of an alter‐ego trust, the second partner to die in a joint partner trust or the spouse in a spousal trust)17. Finally, there is joint and several tax liability between the trust and the life tenant18. However, the assets of the life tenant must be exhausted before the government can go after the trust for the tax.
These amendments have significant implications. Consider for instance a family with a second marriage. It is not uncommon that a spousal trust would be used to provide income and assets to the wife or husband from the second marriage, with the children from the first marriage being the ultimate beneficiaries of the spousal trust. Previously the spousal trust would have settled the tax related to the deemed disposition and the children would have inherited the after‐tax residue. Starting in 2016, the second spouse’s estate will be required to fund the tax arising from the deemed disposition, thereby depleting assets of that estate that would otherwise have been left to other heirs! How will the executor of the spousal trust be comfortable in distributing the assets until he has certainty that the tax bill has been paid? Because of this serious defect in the new legislation, many practitioners were surprised to see the new rules enacted at the end of last year.
Another consequence of this attribution of the capital gain is that it will prevent the wind‐up planning outlined above. The private company shares can be redeemed to create a capital loss but it will not be possible to allocate this loss to the life tenant to match against the deemed capital gain.
For anyone currently drafting their will, these changes can be taken into consideration and alternative planning incorporated. However, for all existing trusts there is no ability to mitigate the tax results failing a legislative amendment to these rules.
Restrictions on the Election to Tax Income in a Trust
Under current rules, it is possible to file an election to tax income or capital gains that were paid or made payable to a beneficiary in the hands of the trust.19 This allowed the income to be taxed at lower rates and allowed the trust to utilize losses or credits that would otherwise have been trapped in the trust. Starting in 2016, the election has been significantly curtailed. Now an amount can be elected to remain in the trust but the trust’s income must remain nil after the designation. Consequently, the trust will be able to utilize losses from previous years, but will not be able to use other credits such as donation or foreign tax credits and it will not be possible to elect income to be subject to graduated tax rates.
Qualified Disability Trusts (“QDTs”)
The last significant change involved the creation of a new type of trust for disabled beneficiaries. Known as QDTs, these trusts must be created under a will and must jointly elect with a beneficiary who qualifies for the disability tax credit.20 A QDT continues to benefit from graduated tax rates for the life of the disabled beneficiary. A shortcoming of these new rules is that there can only be one QDT per disabled person.
Takeaways for your Estate Planning
All estate practitioners and individuals need to review these new proposals before creating dual estates or including testamentary trusts in their estate plans.
As you review and update your will, consider providing for the administration to last for up to 36 months to benefit from the period of time that graduated rates apply.
Consider having only one family trust rather than multiple testamentary trusts to reduce administration costs in light of the loss of graduated rates.
Plan for the new deemed disposition rules by incorporating provisions in the will that require the trust to be responsible for the tax upon the death of the life tenant.
Review all charitable giving arrangements to ensure that the maximum amount of tax will be saved.
Other Reasons for Using Testamentary Trusts
While this article has focused on the recent tax changes affecting Canadian testamentary estates and trusts, there are several non‐tax reasons to still incorporate trusts into an estate plan. These will be discussed in a subsequent article.
Karen Slezak is a partner in at Crowe Soberman LLP. This article is not legal advice.
For further reading, see J. Van Rhijn, “Avoiding liability under new estate tax regime: January changes mean new financial reporting obligations for trustees,” Law Times, February 23, 2015, p. 14.
- A new definition has been added to Section 248(1) of the Income Tax Act (“ITA”) for a “graduated rate estate”. This is defined as an estate that arose on and as a consequence of the individual’s death if:
– That time is no more than 36 months after death;
– The estate is at that time a testamentary trust;
– The individual’s Social Insurance Number is provided in the Estate’s return;- The estate designates itself as a graduated rate estate in its first return of income for its fiscal taxation year that ends after 2015; and
– No other estate designates itself as a graduated rate estate of the individual in a return of income for a taxation year that ends after 2015. ↵
- ITA Section 249(4.1) (ii) deems the estate to have a deemed year-end once it is no longer a graduated rate estate and Subsection 122(1) assesses tax at the highest marginal tax rate. ↵
- Defined in ITA Section 108(1) ↵
- Only a graduated rate estate as defined above will be eligible for many of the preferential rules. ↵
- Double taxation could arise as the private company shares are subject to capital gains tax on death and the underlying corporate value could be subject to tax a second time when it is extracted in future by the succeeding shareholders. ↵
- ITA Subsection 164(6) provides that the loss arising on the redemption or purchase for cancellation of the shares can be carried back and applied against the capital gain arising on the terminal tax return. ↵
- RIF – Registered Income Fund, RSP – Registered Savings Plan, TFSA – Tax‐free Savings Account ↵
- ITA Subsection 118.1(5) ↵
- ITA Subsection 118.1(1) definition of “total gifts” for the year ↵
- Amendments to ITA 118.1(5) ↵
- These benefits are limited to the ‘graduated rate estate’. ↵
- Defined in ITA subparagraph 104(4)(a)(iv)(A) as a trust created by a taxpayer who was at least 65 years of age, and before the taxpayer’s death only the taxpayer is entitled to receive all of the income of the trust and no one other than the taxpayer has the right to use any of the capital of the trust. ↵
- Defined in ITA subparagraph 104(4)(a)(iv)(B) as a trust created by a taxpayer who was at least 65 years of age and before both spouses die, the taxpayer alone or in combination with his/her spouse is entitled to receive all of the trust income and no one other than the taxpayer in combination with his/her spouse has the right to use any of the capital of the trust. ↵
- Defined in ITA subsection 70(6) as a trust created as a consequence of death for the taxpayer’s spouse or common law partner who was resident in Canada immediately before the taxpayer’s death. The property of the trust must vest indefeasibly in the trust within 36 months of the testator’s death. Finally, before the spouse dies only the spouse is entitled to receive all of the income of the trust and no one other than the spouse can be entitled to use any of the capital. ↵
- ITA subparagraph 104(6)(b)(C) ↵
- ITA subparagraph 249(1)(c) ↵
- ITA Subparagraph 104(13.4)(b) ↵
- ITA Paragraph 160(1.4) ↵
- ITA Subsection 104(13.1) and (13.2) ↵
- Defined in ITA Subsection 122(3) ↵