June 3, 2013
Consultation on Eliminating Graduated Rate Taxation of Trusts and Certain Estates
Note: A consultation is not a poll. Please do not send multiple or duplicate submissions.
Related Document
Invitation for Comments
Closing date: December 2, 2013
Who may respond: This consultation is open to anyone.
Submissions can be emailed to trusts-fiducies@fin.gc.ca.
Also, written submissions can be forwarded to:
Trust Graduated Rates
Tax Legislation Division
Tax Policy Branch
Department of Finance
L’Esplanade Laurier
17th Floor, East Tower
140 O’Connor Street
Ottawa, Canada K1A 0G5
Facsimile: 613-992-2036
Once received by the Department of Finance, all submissions will be subject to the Access to Information Act (ATI Act) and may be disclosed in accordance with its provisions. If a request pertaining to your submission is received under the ATI Act, you will be consulted under Section 27 of the ATI Act.
Introduction
A trust, in general terms, is a type of legal arrangement under which one person (the trustee) holds property for the benefit of another person (the beneficiary). An estate (including a civil law succession) arises on the death of an individual and involves a legal representative administering the final affairs and property of the individual.
The federal income tax system treats both trusts and estates as taxpayers. Trusts and estates are, therefore, required to pay tax on their taxable income.
Most trusts (including estates) are entitled to deduct in computing their income each year for tax purposes the portion of that income, otherwise determined, that is made payable in that year to their beneficiaries. This deduction eliminates tax at the trust level on that income. A trust’s beneficiaries are then required to include in computing their income for tax purposes the portion of the trust’s income that is made payable to them. The beneficiaries pay tax on any resulting taxable income at their marginal rate of taxation, which in the case of ordinary individuals is determined according to graduated tax rates.
Graduated rate taxation is provided under the federal tax rules that apply to individuals and certain trusts and estates. The rules contain four brackets for which different rates of tax apply depending on the level of taxable income. For 2013, the 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.
If, instead of making payable its income to its beneficiaries, a trust recognizes the income in the trust for income tax purposes, the trust (and not its beneficiaries) must generally pay tax on the resulting taxable income. The tax rate imposed on the trust in these circumstances depends upon whether the trust is a testamentary trust or a grandfathered inter vivos trust, as distinguished from an ordinary inter vivos trust.
A testamentary trust arises on and as a consequence of the death of an individual and the only contributions it receives must be as a consequence of an individual’s death. There are two categories of testamentary trust. The first consists of estates. The second consists of trusts created by will, including certain trusts created by court order in relation to a deceased individual’s estate.
Grandfathered inter vivos trusts are Canadian resident inter vivos trusts1 that were created before June 18, 1971 and that satisfy certain restrictions regarding their activities. This grandfathering exemption was provided as part of the 1972 tax reform. That reform introduced high flat-rate taxation for inter vivos trusts. Prior to that reform trusts generally had full access to the graduated rates applicable to ordinary individuals.
Testamentary trusts and grandfathered inter vivos trusts compute federal tax using the graduated tax rates available to individuals. Other trusts (ordinary inter vivos trusts) pay tax at the top federal marginal tax rate applicable to individuals, which is currently 29%.2
The flat top-rate taxation of ordinary inter vivos trusts, together with a number of anti-avoidance regimes applicable to trusts and their beneficiaries, constrain the use of these trusts for tax planning purposes. This promotes fairness and neutrality in the tax system, and protects the Government’s revenue base.
The taxation of testamentary trusts and grandfathered inter vivos trusts at graduated rates effectively allows the beneficiaries of those trusts to access more than one set of graduated rates. This tax treatment raises questions of both tax fairness and neutrality in comparison to the treatment of beneficiaries of ordinary inter vivos trusts and taxpayers receiving equivalent income directly.
Tax planning opportunities associated with the availability of trust-level graduated rates include the use of multiple testamentary trusts, tax-motivated delays in completing the administration of estates, and avoidance of the Old Age Security Recovery Tax. The tax benefits arising from tax planning of this nature raise questions of fairness, and negatively affect government tax revenues. In addition, the extent of tax planning in this area heightens these concerns.
Economic Action Plan 2013 announced the Government’s intention to consult on possible measures to eliminate the tax benefits that arise from taxing at graduated rates grandfathered inter vivos trusts, trusts created by will, and estates (after a reasonable period of estate administration).
This consultation paper is being released to provide stakeholders with an opportunity to comment on the proposed measures.
Proposed Measures
Graduated rates
The Government proposes measures to amend the income tax rules to apply flat top-rate taxation to grandfathered inter vivos trusts and trusts created by will. In addition, flat top-rate taxation is proposed to apply to estates (“flat top-rate estates”) after a reasonable period of administration. Specifically, a deceased individual’s estate would be considered a flat top-rate estate starting immediately after the 36-month period that follows the individual’s death.3 Estates of deceased individuals would therefore be eligible to retain, as testamentary trusts, access to graduated rates for up to the first 36 months of the estate’s administration. These measures would apply to existing and new arrangements for the 2016 and later taxation years.
Trusts for the disabled and for minor children
The income tax provisions contain special rules (i.e., the preferred beneficiary election rules and the rules for trusts for minor children) that suspend or lessen the effects of high flat-rate taxation on income accumulating in a trust for certain disabled persons or minor children. These special rules allow (subject to certain anti-avoidance rules) income to be recognized for tax purposes in the beneficiary’s hands (i.e., taxed at the beneficiary’s marginal rates) even though the income actually accumulates in the trust. The proposed measures on graduated rates would not change the preferred beneficiary election rules or the rules that apply to trusts for minor children.
Spousal trusts and common-law partner trusts
Upon the death of an individual, the individual’s capital property is generally subject to a deemed disposition, with the result that accrued gains on capital property are recognized in computing the individual’s income in their final tax return. Where the individual’s property is on death transferred to the individual’s spouse or common-law partner, the deemed disposition on death is suspended, and instead the property is transferred to the spouse or common-law partner on a tax-deferred (i.e., rollover) basis. The rollover is also available to eligible trusts, commonly referred to as spousal trusts and common-law partner trusts. The proposed measures on graduated rates would not change the rollover rules that apply on the death of a spouse or common-law partner.
Related income tax rules
Consistent with the proposed measures for the elimination of graduated rates for trusts and flat top-rate estates, the Government is also consulting on possible measures to amend a number of related tax rules that are available to testamentary trusts and grandfathered inter vivos trusts. The proposed measures, described in greater detail below, would generally limit the application of the related rules to estates other than flat top-rate estates. Affected trusts and estates would, as a result, be subject to the same treatment as ordinary inter vivos trusts.
Income tax instalments - The income tax rules contain an instalment system that imposes a requirement on affected taxpayers to pay a portion of their estimated tax liability for a taxation year in instalments over the course of the year. The rules for individuals require, when they apply, that instalment payments be made on a quarterly basis. Testamentary trusts are exempt from the tax instalment rules and therefore are required to pay any tax owing only within 90 days after the end of the taxation year. The proposed measures would extend the instalment rules to trusts created by will and flat top-rate estates.
Alternative minimum tax - Individuals, including trusts, are subject to the alternative minimum tax (“AMT”). In computing AMT, a $40,000 basic exemption is available to testamentary trusts and grandfathered inter vivos trusts. The proposed measures would deny the basic exemption to grandfathered inter vivos trusts, trusts created by will, and flat top-rate estates.
Taxation year and fiscal period - The taxation year of a trust is generally the calendar year, and, similarly, any fiscal period of a trust is required to end in the calendar year in which it began. Testamentary trusts are exempt from these rules, being allowed off-calendar year taxation years and fiscal periods. The proposed measures would require trusts created by will and flat-top rate estates to use a calendar year taxation year and require that their fiscal periods end in the calendar year in which the periods began.
Part XII.2 tax - Part XII.2 of the Act imposes a trust-level distribution tax on trusts that make payable certain Canadian source income to non-residents and, in certain circumstances involving dealings in beneficial interests in the trust, to certain Canadian tax-exempts. These beneficiaries are referred to in Part XII.2 as “designated beneficiaries”. Testamentary trusts are exempt from Part XII.2 and, in certain cases, from treatment as designated beneficiaries. The proposed measures would deny this preferential treatment under Part XII.2 to trusts created by will and flat top-rate estates.
Personal trust status – Personal trusts enjoy certain tax benefits, including the ability to distribute property to beneficiaries on a tax-deferred basis. A trust generally qualifies as a personal trust only if beneficial interests in the trust have not been acquired for consideration payable to the trust or to a contributor of property to the trust. Testamentary trusts automatically qualify as personal trusts, without regard to the circumstances in which beneficial interests in the trust are acquired. The proposed measures would subject trusts created by will and flat top-rate estates to the same conditions that apply to ordinary inter vivos trusts in determining eligibility as a personal trust.
Investment tax credits - Taxpayers, including trusts, are permitted to claim investment tax credits (ITCs) in respect of certain expenditures. Inter vivos trusts are generally required to recognize ITCs in the trust. Testamentary trusts, on the other hand, can make ITCs available to their beneficiaries for use by the beneficiaries in computing their own income tax liability. The proposed measures would require that the ITCs of trusts created by will and flat top-rate estates be recognized in the trust or estate.
Tax administration rules - A number of tax administration rules apply only to ordinary individuals, and not to trusts. An exception is provided, however, for testamentary trusts, which have access to these special rules. These rules extend the period:
(i) during which the Canada Revenue Agency (CRA) may refund an overpayment of tax,
(ii) for objecting to a tax assessment,
(iii) for filing an agreement to transfer forgiven amounts under the debt forgiveness rules, and
(iv) during which, at the trust’s request, the CRA may reassess or make determinations in respect of certain income tax liabilities.
The proposed measures would limit the category of trusts that would qualify for relief under the rules to testamentary trusts that are estates. Specifically, the rules would apply in respect of taxation years for which an estate that is a testamentary trust is not a flat top-rate estate.
Providing Your Input
Closing date: December 2, 2013
Who may respond: This consultation is open to anyone.
Submissions can be emailed to trusts-fiducies@fin.gc.ca.
Also, written submissions can be forwarded to:
Trust Graduated Rates
Tax Legislation Division
Tax Policy Branch
Department of Finance
L’Esplanade Laurier
17th Floor, East Tower
140 O’Connor Street
Ottawa, Canada K1A 0G5
Facsimile: 613-992-2036
Once received by the Department of Finance, all submissions will be subject to the Access to Information Act (ATI Act) and may be disclosed in accordance with its provisions. If a request pertaining to your submission is received under the ATI Act, you will be consulted under Section 27 of the ATI Act.
1 Inter vivos generally refers to a transfer between living persons. An inter vivos trust includes, for income tax purposes, any trust that is not a testamentary trust.
2 Provinces with a Tax Collection Agreement (TCA) (all except Quebec for personal tax) are required to mirror federal changes to the common tax base. The TCA definition of common tax base includes rules regarding the tax rate applied to trusts contained in section 122 of the federal Income Tax Act. As a result, the proposed measures would also result in similar changes to the provincial rates of taxation of trusts.
3 Upon expiry of that period, the estate would be subject to a deemed taxation year-end.