Trusts have been widely used as a financial planning tool for both tax and non-tax purposes. Testamentary trusts have historically been attractive because they provide preferential tax treatments. However, those benefits could soon be eliminated or watered down due to proposals in the 2013 federal budget that would dramatically change the tax landscape for testamentary trusts. Indeed, the 2014 federal budget confirmed the implementation of many of the changes proposed.

Charterholders with clients planning to set up testamentary trusts or who are, or will be, beneficiaries of a testamentary trust should be aware of what these changes are and seek professional advice, if appropriate. It is safe to assume that many wills and trusts will need to be updated to avoid unpleasant surprises.

What’s changing

In the 2013 federal budget, the federal government announced that it would consider eliminating progressive tax rates for testamentary trusts after an initial 36 months of the trust’s establishment. The federal government stated that the unequal treatment of testamentary trusts and inter vivos trusts raised questions of tax fairness, neutrality, and the potential growth in tax-motivated use of testamentary trusts.

Various professional organizations, including the Society of Trusts and Estate Practitioners Canada, the National Wills, Estates and Trusts section of The Canadian Bar Association, the Joint Taxation Committee of The Canadian Bar Association, the Chartered Professional Accountants of Canada, and the Conference for Advanced Life Underwriting have offered alternative measures to the federal government to address its concerns.

Alternative measures proposed include

• Maintaining the current tax system but providing for specific, targeted anti-avoidance measures
• Integrating the taxation of trusts and beneficiaries
• Maintaining current tax treatment of testamentary trusts for trusts for minors and disabled beneficiaries
• Lengthening the initial 36-month period to allow more time to administer an estate before progressive tax rates cease and the highest marginal tax rate applies

Despite the alternative measures proposed by these various professional organizations, the 2014 federal budget still proposes that progressive tax rates for testamentary trusts will only apply for the first 36 months of a testamentary trust, with a major exception in cases where its beneficiaries receive the federal Disability Tax Credit. These rules were proposed based on the assumption that an estate requires only 36 months of administration, and beneficiaries receiving the federal Disability Tax Credit should be offered the progressive tax rates as special assistance.

The 2014 federal budget also proposes a number of other changes, including:

• Calendar year end: If the testamentary trust does not already have a calendar year end, it will be deemed to have a calendar year end on December 31, 2015.
• Instalment taxes: Testamentary trusts will have to pay their tax in quarterly instalments, something they were previously exempt from.
• Alternative Minimum tax: The basic $40,000 alter- native minimum tax exemption will no longer apply.

It is certain that these new tax measures will eliminate many of the long-standing benefits enjoyed by testamentary trusts. However, there are still valid reasons to set up a testamentary trust in many situations. The specific situation of a client must be prudently examined in order to make that decision. Alternatively, other tax-planning vehicles could be considered to achieve the same or similar results without the adverse tax consequences resulting from the new measures surrounding testamentary trusts.

Testamentary Trusts at a Glance

There are two types of trust: inter vivos and testamentary.

A testamentary trust is a trust created when an individual dies, while an inter vivos trust is defined as anything except a testamentary trust.

The single most important current difference between inter vivos and testame tary trusts is the applicable tax rate. While inter vivos trusts are generally taxed at the highest personal marginal rate, testamentary trusts in most cases can enjoy the personal progressive rates.

Other historical benefits of testamentary trusts include:

• Exclusion from paying instalment taxes, provided any income tax is paid within 90 days from the end of the taxation year
• Election to allow income to be payable (or paid out to) a beneficiary, but be designated and taxed as trust income
• Entitlement to the $40,000 alternative minimum tax exemption
• Ability to choose a year end other than December 31