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Income Tax Changes Affecting Trusts and Estates Effective January 1, 2016

Author(s): Janet Sim

Dec 2, 2015

Several important income tax changes affecting trusts and estates will come into force on January 1, 2016. Most significantly, the amendments will limit the use of testamentary trusts as a means of income splitting in estate planning by the elimination of taxation at graduated rates. As a result, income that is not paid or payable to the beneficiaries of a trust will be taxed in the testamentary trust at the top marginal personal income tax rates. In addition, amendments will significantly alter the taxation of spousal, joint partner and alter ego trusts. The liability for the tax on any accrued gains arising in the trust upon the death of the spouse, surviving joint partner or settlor will now be the responsibility of such person’s estate rather than a liability of the trust and the ultimate capital beneficiaries of the trust. Although many expected revisions to these amendments before becoming law on January 1, 2016, this now appears unlikely. As the year-end approaches it is recommended that people review their estate planning to determine whether changes should be made as a result of the income tax amendments. 

Taxation of Testamentary Trusts

At present, estates and testamentary trusts (set up as a result of an individual’s death) are taxed at marginal tax rates. This permits income splitting between the estate or trust and its beneficiaries resulting in tax savings of more than $20,000 for each trust for those resident in Ontario or Québec.

As a result of certain income tax amendments in the 2014 Federal Budget which come into effect on January 1, 2016, with limited exceptions, estates and testamentary trusts (including those in existence at January 1, 2016) will be taxed at the top marginal personal tax rates. One exception to this new tax regime is the “graduated rate estate” (GRE), a new concept introduced by the amendments which will apply to estates in the first 36 months. A GRE will be subject to tax at graduated rates. If the estate continues to exist past 36 months following the date of death, the estate will have a deemed year-end and will thereafter be taxed at the top marginal personal tax rates. The only other exception to the new tax rules are those trusts established for beneficiaries who qualify for the disability tax credit. These qualified disability trusts will continue to be taxed at marginal tax rates.

While income splitting is only one of many reasons to include testamentary trusts in estate planning, people may wish to consider whether such trusts should continue to be part of their estate plan.

Shifting of Tax Liability

The amendments will also change the way in which spousal trusts, and other life interest trusts are taxed. Upon death, an individual is generally deemed to have disposed of his or her capital property at its fair market value, triggering any accrued capital gains or losses at that time. The deemed disposition is deferred when the property of the deceased is transferred to the deceased’s spouse or to a trust for the sole benefit of that spouse. In such cases, the deemed disposition is deferred until the spouse’s death. Currently, the spousal trust is liable for any tax on any capital gains triggered upon the spouse’s death. Under the amendments effective January 1, 2016, the spousal trust and the spouse’s estate will be jointly and severally liable for the tax payable as a result of the deemed disposition upon the spouse’s death. This shift in the burden of taxation can mean an unexpected cost for the beneficiaries of the spouse’s estate.  In addition, the trustees of the spousal trust may not have the required authority to pay the taxes arising upon the spouse’s death. Often the beneficiaries of the spousal trust are different from the beneficiaries of the spouse’s estate, particularly in second marriage situations, which could lead to disputes over who should bear the tax burden.

There are further amendments proposed which may rectify this shifted tax burden but until such amendments become law, those whose planning involves spousal trusts may wish to review their planning.