Testamentary Trusts Under Scrutiny over Tax Benefits

National Post


One of the items in last week’s federal budget that perhaps got the least amount of attention yet could potentially affect the wills and estate planning of thousands of Canadians is the proposed consultation on the taxation of testamentary trusts.

A testamentary trust is an estate planning tool and describes a relationship that allows property to be managed by one person, typically called your estate trustee, for the benefit of another, called your beneficiary. So, instead of leaving an asset directly to a beneficiary under your will, you could create a testamentary trust and name a trustee who would manage the assets on behalf of the beneficiary under terms you specify. The term testamentary means that the trust arises as a consequence of your death.

Leaving assets in a testamentary trust can offer a number of benefits over direct gifts including control over the timing and amount of distributions to beneficiaries, flexibility in structuring payments to beneficiaries, reduced probate fees (where applicable) and maintaining privacy for your estate.

But trusts can also be used to lower tax bills for the surviving beneficiaries, who are often family members, through “post-mortem income splitting.”

For tax purposes, a trust is considered to be a separate individual for tax purposes such that any income earned on the funds invested inside the trust is taxed as if the income were earned by a person who is separate from the individual setting up the trust, the trustee or its beneficiaries. One significant difference between an “inter vivos” or family trust, which is established during your lifetime, and a testamentary trust is the tax rates that are applied to trust income.

An inter-vivos trust pays tax on all its income at the top personal marginal tax rate, which can be as high as 50%, depending on the trust’s province of residence. In a testamentary trust, however, the progressive graduated personal tax rates apply, resulting in lower tax rates on the first $135,000 of trust income. This can result in tax savings as high as $20,000 annually, which will vary by province, when income is taxed in a testamentary trust instead of perhaps in the hands of a high income beneficiary had they inherited the funds directly and subsequently invested them.

As the government pointed out in its federal budget document, “the taxation of testamentary trusts…at graduated rates allows the beneficiaries of those trusts to effectively 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.”

The budget also indicated that the government was concerned with the growth in what it called the “tax-motivated use of testamentary trusts and the associated impact on the tax base.” As a result, the government is planning to issue a consultation paper to the public on whether the tax benefits that arise from taxing income inside testamentary trusts at graduated rates should be eliminated.