A testamentary trust is a trust arising on and as a consequence of the death of an individual. Canada Revenue Agency (“CRA”) confirmed in a technical interpretation (2011-0422471E5) that an estate is treated by CRA as a testamentary trust for purposes of the ITA and will cease to exist only when all the assets are distributed to the beneficiaries. Currently, an estate and other testamentary trusts, such as a spousal trust, are taxed at graduated rates similar to an individual. Other trusts (ordinary inter vivos trusts) pay tax at the top federal marginal tax rate applicable to individuals.
For 2013, the graduated rates are 15% on the first $43,561 of taxable income, 22% on the next $43,562 of taxable income (on the portion of taxable income over $43,561 up to $87,123), 26% on the next $47,931 of taxable income (on the portion of taxable income over $87,123 up to $135,054), and 29% on taxable income over $135,054.
Some estate planners have used this favourable tax treatment given to testamentary trusts to “income split” between the estate or trust and its beneficiaries. For example, by creating a testamentary trust structure which has a distribution scheme that allows for discretionary payments of income to its beneficiaries and also permits accumulation, subject to certain anti-avoidance rules (see subsection 104(2) of the ITA), such a trust can both distribute its income to its beneficiaries and/or retain income in the trust, thus minimizing the amount of tax paid overall by taking advantage of the trust’s and the beneficiaries’ respective graduated rates. In addition, subsection 104(13.1) allows a trust to choose to have distributed income taxed in the trust rather than in the hands of the beneficiary.
In the Federal Government of Canada’s 2013 Budget, the Government announced its intention to apply the top marginal rate of taxation to testamentary trusts, including spousal trusts, and estates, though in the case of estates the graduated rates would continue to apply for 36 months after the death of individual. The proposed changes were published for public consultation until December 2, 2013. These changes are proposed to come into effect in 2016. Draft legislation has not yet been released.
In response to these changes, we recommend Wills that create testamentary trusts provide estate trustees with discretion to be able to distribute as much income as they consider advisable in order to access the marginal rates of the beneficiaries of the trust.
