The favourable tax rules enjoyed by estates and testamentary trusts until now are almost dead. Major changes that were introduced in the 2014 federal budget are about to come into effect on January 1, 2016. Don’t be caught off guard.
Estate vs. Testamentary Trust
Until now, most of us have viewed a testamentary trust in basically the same way we would an estate. They both essentially were included in the definition of a “Testamentary Trust”, meaning a trust arising as a consequence of the death of an individual. As such, they were treated in similar fashion under the law, both benefiting from graduated tax rates and both able to have an off-calendar fiscal period for tax purposes.
But now, we must make a distinction between an estate and a testamentary trust.
A testamentary trust is generally a trust that is created by the will of the deceased person. Assets from the deceased’s estate are transferred to the trust for the benefit of named beneficiaries. These assets are then administered by designated trustees. Such a trust could go on for an indefinite period of time, depending on the terms of the trust.
On the other hand an estate is essentially the bundle of assets owned by an individual at the time of death, which is to be distributed by the liquidator to the beneficiaries pursuant to the will within a relatively short period of time. The CRA likes to refer to the “executor’s year”, implying that it should take a year or so to clear the estate and distribute the assets. In many cases it may take longer.
Elimination of Benefits to Testamentary Trusts
Now that we have our terms of reference, the first thing to note is that beginning in 2016, most testamentary trusts will no longer benefit from graduated tax rates, and they will have to switch to calendar taxation years. The only exception will be for “Qualified Disability Trusts”, which essentially is a testamentary trust with a beneficiary that qualifies for the disability tax credit.
There are no grandfathering rules. All existing testamentary trusts will have to cut off their taxation years on December 31, 2015. This could result in many trusts having two tax years in 2015. You should note that the due date for the first of these calendar taxation years will be March 30, 2016.
Furthermore, beginning in 2016, these trusts will:
- be subject to the highest marginal tax rates
- will have to make quarterly tax instalments
- will lose the $40,000 alternative minimum tax exemption
- will lose the ability to object to an assessment within one year (i.e. the 90 day deadline will apply)
- will lose the ability to transfer investment tax credits to its beneficiaries
- will lose the right to apply for a refund after the normal reassessment period
- may become subject to part XII.2 tax on certain types of income where non-resident beneficiaries exist
Graduated Rate Estates
On the other hand, estates may continue to benefit from graduated rates and off-calendar fiscal years, under certain conditions. Estates that meet the requirements will be known as “Graduated Rate Estates” (“GRE”).
A GRE will qualify only under the following conditions:
- no more than 36 months have passed since the death of the individual
- the estate otherwise meets the definition of a “Testamentary Trust” under the law
- the estate designates itself as a GRE in its tax return for the first taxation year ending after 2015
- the deceased individual’s social insurance number is provided in the tax return
- no other estate is designated as the GRE with respect to that individual.
Once 36 months has expired, the estate will no longer be a GRE and will become subject to the less favourable rules described above.
Charitable Donations by a GRE
Currently, a charitable gift made by an estate that was designated by the will of an individual is deemed to have been made by the deceased, and is not deductible within the estate.
Beginning in 2016, a GRE will benefit from new and more flexible rules regarding the claiming of charitable donations. If the estate is a GRE, then such donations may be claimed by:
- the deceased in the year of death or the preceding year
- the estate in the year in which the donation is made, or
- the estate in an earlier taxation year or subsequent 5 years.
Other more complex changes regarding testamentary trusts are coming into effect as well, but a detailed description of these is beyond the scope of this short summary. Briefly, the election to pay tax within a trust, notwithstanding that income is paid to beneficiaries, will be virtually eliminated, unless certain conditions apply.
Finally, for testamentary life interest trusts, such as spousal trusts, upon the death of the beneficiary, a year-end will occur, and any gains or income triggered upon death will be deemed to have been paid to the beneficiary’s estate, making it liable for the taxes on death. This may create a mismatch between the liability for taxes and the ownership of the assets in cases where trust capital is to be paid out to persons who are not beneficiaries of the deceased beneficiary’s estate. A common circumstance where this issue could become a problem is in a case such as a second marriage where children from the first marriage are to receive the capital of a spousal trust upon the death of the beneficiary spouse.