Changes May be Coming to the Taxation of Testamentary Trusts

Changes may be coming to the taxation of testamentary trusts.  Following comments made in the 2013 budget regarding access to graduated tax rates, the government released a consultation paper in June (http://www.fin.gc.ca/activty/consult/grt-itp-eng.asp) with more details on how it proposes to change the taxation of testamentary trusts.

A testamentary trust generally refers to any trust created as a result of a person’s death (for example, a trust created in a person’s will).  Under the current tax rules, testamentary trusts can take advantage of the graduated income tax rates available to individuals (the top tax bracket doesn’t apply until taxable income exceeds $135,054).  A non-testamentary trust, in contrast, pays the highest rate of tax from the first dollar.  As a result, many estate plans include the creation of at least one trust on the individual’s death, to take advantage of this tax planning opportunity.  In many cases, multiple trusts are created in an individual’s will, for their spouse and each of their children, increasing the potential tax savings.

The consultation paper proposes to eliminate the availability of graduated tax rates for testamentary trusts beginning 36 months from the date of death, so that after this time, the trusts will be taxed at the highest marginal tax rate for every dollar of income earned (which would result in the same tax treatment as is currently applied to trusts created during a person’s lifetime, also referred to as inter vivos trusts).

If the proposals are implemented, the tax benefits of using trusts as part of an estate plan will be significantly reduced, but many other significant benefits to using trusts in an estate plan remain, for example:

1. Trusts can help to shield the inheritance from the heir’s creditors.
2. Trusts are a flexible way to provide a life interest to one person (such as a current spouse) while ensuring that another person or other people obtain the ultimate benefit (such as children from an earlier marriage).
3. Trusts can ensure that an heir is given time to develop the skills and advisors needed to manage new wealth by staggering distributions of his/her inheritance.

As a result, trusts are still an effective estate planning tool in many cases, despite the looming changes.

As for the proposed changes, the government has requested that comments on the proposals be delivered by December 2, 2013, so it will likely be sometime next year before we know what changes, if any, will be made to the current tax regime.  Until that time, it is likely premature to remove trusts from your estate plan.

In any event, this is a good reminder that you should ensure that your wills and estate documents are up to date.  If your circumstances have changed since you last drafted your estate documents, or it has been over five (5) years since they were last examined, it is good practice to review the documents to ensure that no changes are required.