In this spring's federal budget, there was a statement that caused the hearts of many estate and tax planning specialists to momentarily stop. It stated that it was the government's intention to "consult on the potential introduction of measures that would eliminate the tax benefits associated with the graduated lax rates enjoyed by certain testamentary trusts."
These days, it seems that everyone is receiving and giving estate planning advice – from banks to estate planning professionals to family members. One piece of advice that is constantly talked about is the use of testamentary trusts in Wills to reduce income taxes payable by beneficiaries. But what is everyone talking about and why did this statement that was buried deep in the 2013 federal budget cause such a stir?
What is a Trust?
A trust is a legal entity that is created by words in a will or in a deed of trust. You need four "certainties:" a person who creates the trust (the settlor or, in the case of a Will, a testator); the person that the settlor or testator wishes to benefit (the beneficiary); the asset that the settlor or testator wishes to set aside for the beneficiary; and a period of time that the trust is to exist So long as you have these four certainties, you can have a trust. There are two types of trusts: one created by a settlor in his or her lifetime and that starts during the settlor's lifetime which is called an "inter vivos trust;" and one that is created by a settlor or testator in his or her Will and that only starts when the testator dies, and this type of trust is called a "testamentary trust".
What is the purpose of a testamentary trust?
At its basic level, the purpose of a testamentary trust is to set out conditions or criteria in a Will that must be met before a beneficiary will receive any part of the deceased's income or assets. The most common testamentary trust is one established to hold a beneficiary's share of an estate until that beneficiary should attain a certain age, such as 18, 23, 35 etc. Many testamentary trusts allow this same beneficiary to receive payments from the trust before a certain age is attained for the education or other benefit of the beneficiary, but normally at the discretion of the executor.
What is the income tax treatment?
The Income Tax Act (the "Act") levies income tax on income, dividends, and capital gains (we will call all of this collectively “income” for the purposes of this discussion) earned in an inter vivos trust at the highest marginal rate in the province in which the trust is located. In Ontario, the highest marginal rate is approximately 46 per cent. The income earned in a testamentary trust, however, is taxed at the same graduated rates as individuals (but excluding the various personal deductions). Clearly, the tax treatment of income earned by a testamentary trust is much more beneficial to the trust and the beneficiary than the tax treatment of the same income earned by an inter vivos trust.
Common tax planning for estates and estate beneficiaries
Currently, many estate planners recommend testamentary trusts solely as a means to reduce the overall tax that would otherwise be payable by a beneficiary if the income earned in the trust was added to the income otherwise earned by the beneficiary. The classic estate plan is a parent's Will that contains a testamentary trust established by the parent for his/her spouse during the spouse's lifetime and, upon the death of the spouse, a testamentary trust established for each of the parent's children that would be activated upon the death of the second parent. This same estate plan would have the spouse and then each child as both the beneficiary of his or her own testamentary trust and also the sole trustee of the same testamentary trust This would give the spouse/child complete control over how much of the trust income and trust capital would be paid out to that person each year. But the income generated in each testamentary trust would be taxed at graduated rates separate from and without regard to any other income earned by the beneficiary from any other source.
From the point of view of the Federal Department of Finance and the Canada Revenue Agency, this use of a testamentary trust simply to reduce income tax otherwise payable is not a good thing. If income earned from a testamentary trust was taxed at the highest marginal rate as an inter vivos trust, or simply added to the global income of the beneficiary and taxed at the beneficiary's personal marginal rates, this would produce, from the perspective of the taxing authorities, a "fairer" result.
What's the outcome of these consultations?
This is anyone's guess and depends on how driven the federal government is on changing this perceived loophole, as well as the arguments presented by the financial institutions and various investment and estate planning organizations. At the end of the consultation period, there may be no change in the tax treatment of testamentary trust income, there may be an abolition of the current tax treatment of testamentary trust income or there may be some form of compromise whereby testamentary trusts that have trustees who are different from beneficiaries would retain the same graduated rates of tax, but testamentary, trusts that have trustees who are also beneficiaries would be taxed at the highest marginal rates.
When might a change occur?
This is a very sensitive topic and affects Canadians in a wide range of economic circumstances. Testamentary trusts are not established solely for income tax purposes but can also have many other reasons to exist. Testamentary trusts also affect the marketing and products of all financial institutions and estate planning entities. I believe that this mention of a "consultation" in the federal budget is a trial balloon to start a dialogue between the various stakeholders. The timeline is not yet public. I foresee that if there is any change in the current tax treatment of income earned by testamentary trusts, this change will apply in a manner that will grandfather existing testamentary trusts that have already been established in Wills by those who have not yet died and those who have died. Otherwise, any such change could have a detrimental effect on estate planning that might have taken place some years before.
Are there still uses for testamentary trusts?
There are many uses for testamentary trusts. For many of the Wills that I draft, the reduced tax rate is often the last thing that is discussed or that is of concern to the testator. Testamentary trusts are used for many purposes, including:
- To provide an age or ages where an underage beneficiary will inherit and at the same time, allow the income and capital from the beneficiary's trust to be used to benefit that beneficiary;
- To allow a careful release of funds to or for a "spendthrift" beneficiary, to enable that beneficiary to have the funds for a longer period of time;
- To allow creditor proofing for vulnerable beneficiaries;
- To allow funds to be paid to or for spouses of second marriages and, at the same time, to set aside some part of an estate for the children of a first marriage;
- To create a Henson Trust to allow a disabled beneficiary to continue to collect full ODSP payments while, at the same time, to allow the income and capital of the trust to be used (within the ODSP regulatory framework) for the benefit of the disabled beneficiary;
- To allow generation skipping whereby funds are set aside for the grandchildren of the testator rather than be paid or transferred to the children.
Regardless of the income tax treatment of testamentary trusts, I foresee an ongoing use for these trusts in the future.
John Peart is a partner with the Ottawa law firm of Nelligan O'Brien Payne LLP (www.nelllgan.ca) and part of its Wills and Estates Group. John is a certified specialist in estates and trusts law by the Law Society of Upper Canada and is also a member of the International Society of Trust and Estate Practitioners.
[This article originally appeared in the September 2013 issue of Fifty-Five Plus Magazine.]