December 23, 2015
The New Year will bring several important income tax changes to estates and testamentary trusts. Effective January 1, 2016 estates and testamentary trusts will be subject to new rules which alter the rates of taxation, year end, and way in which spousal trusts and other life interest trusts are taxed.
Currently, estates and testamentary trusts are taxed at graduated tax rates. This permits income splitting between the estate or trust and its beneficiaries, which can result in tax savings. Income earned by a testamentary trust that is not paid out to a beneficiary will soon be taxed at the top marginal personal tax rate – 49.53 per cent. The exceptions to this rule are few: trusts established for the benefit of someone eligible for the disability tax credit, or estates which qualify as graduated rate estates (“GRE”). GREs are a new concept which will apply to an estate for the first 36 months of the estate if certain criteria are met. If the estate continues to exist past 36 months following the date of death it will be then be taxed at the top marginal rates.
Until now, testamentary trusts have been able to choose a non-calendar year end, up to one year after the date of death. Under the new rules, testamentary trusts and estates that exist for longer than 36 months will have a December 31st year end. Existing testamentary trusts that have already had a year end in 2015, will be deemed to have another year end at December 31, 2015, and must file a tax return within 90 days.
Another significant change is to the way spousal and other life interest trusts such as alter ego and joint partner trusts are taxed, with the trust and estate being jointly and severally liable for any tax on capital gains payable as a result of the deemed disposition upon the life tenant’s death. This could mean an unexpected cost for the beneficiaries of the life tenant’s estate, and where the beneficiaries of the life tenant’s trust are different from the beneficiaries of the life estate, this could lead to unfairness and disputes; for example, in a second marriage situation where a spousal trust is used to provide income and assets to the spouse from a second marriage, with the children from the first marriage being the ultimate beneficiaries of the spousal trust. Previously the spousal trust would have been responsible for the tax related to the deemed disposition on the second spouse’s death and the first spouse’s children would have inherited after the taxes were paid. With the new rules, the estate of the second spouse will be required to pay the tax arising from the deemed disposition at the death of the second spouse.
The Department of Finance recently issued a letter acknowledging concerns of practitioners to such a scenario and seeking input on a possible solution. One solution being considered is to amend the Income Tax Act so that it would not apply to a trust in respect of the death of a particular beneficiary unless the beneficiary’s GRE and the trust jointly elect to have it apply. The Department of Finance’s openness to explore the subject of amendments comes as good news to practitioners and individuals concerned about the amendments as they stand. Nevertheless, those whose estate planning involves spousal trusts may wish to speak with their practitioner about what the changes in 2016 could mean for their estate plan.