Qualifying Disability Trusts – Canadian Income Tax – Toronto Tax Lawyer Guide

Overview – Qualifying Disability Trusts

As of January 1, 2016, testamentary trusts began having their income taxed at the highest marginal tax rate unless a specific exception applies which allows for graduated income tax rates to apply. If a trust earns substantial income, this can result in significant additional tax payable. The most common exception is that of the Graduated Rate Estate. A single testamentary trust arising from the death of an individual can elect in its income tax returns to be a Graduated Rate Estate. However, a strict time limit of 36 months from the date of the deceased’s death applies to the availability of Graduated Rate Estate status.

The Graduated Rate Estate helps when the deceased’s assets will be passed to beneficiaries within a few years. However, there are some situations where the deceased will create a trust in their will that will last for a long time. One of these scenarios is when the deceased wants to leave a trust for the long-term support of a disabled individual. Qualifying Disability Trust status exists to address this problem by allowing some testamentary trusts intended to benefit disabled individuals to be taxed at graduated income tax rates on an indefinite basis.

Requirements Qualifying Disability Trust Status – Qualifying Disability Trusts

A qualifying disability trust needs to be a testamentary trust, in other words, a trust that was created in a will as a consequence of an individual’s death (or in some cases by a court order in regard of an individual’s estate). Trusts established by individuals during their lifetimes or corporations cannot qualify for Qualifying Disability Trust status.

Qualifying Disability Trust status is determined on a tax year by tax year basis. The primary requirements that a testamentary trust must meet to have Qualifying Disability Trust status for a particular tax year are:

• The trust must be resident in Canada for tax purposes during the particular tax year,
• The trust must make a joint election with at least one “qualifying beneficiary” to be a Qualifying Disability Trust,
• Each electing beneficiary must be named as a beneficiary in the instrument under which the trust was created,
• Each electing beneficiary must qualify for the disability tax credit during his or her tax year in which the trust’s particular tax year ends,
• Each electing beneficiary that is the beneficiary of multiple trusts can only make the qualifying disability trust election in regard to one of those trusts.

The joint election must be filed with the trust’s income tax return for the relevant taxation year. The joint election must include the names and social insurance numbers of the electing beneficiaries.

The requirement that every electing beneficiary must be named in the instrument under which the trust is created is significant because some wills create a testamentary trust using wording like “my issue” or “my children” to define the beneficiaries of the trust. An individual who is a beneficiary of a testamentary trust by virtue of this type of wording alone cannot make the Qualifying Disability Trust election.

Consequences of Qualifying Disability Trust Status – Qualifying Disability Trust

The main consequence of a trust having Qualifying Disability Trust status during a tax year is that the trust will be subjected to graduated income tax rates as opposed to being taxed at the top marginal rate. This means there will be a tax savings on an annual basis. Unlike the graduated rate estate, there is no built-in time limit for how long Qualifying Disability Trust status lasts.

A trust that has Qualifying Disability Trust status in the past and benefited from graduated tax rates can be subject to a recovery tax if certain conditions are met. The purpose of this recovery tax is to claw back the benefit of Qualifying Disability Trust status when income that was taxed at graduated rates is subsequently paid out to a non-electing or otherwise ineligible beneficiary. This can happen if none of the beneficiaries of the trust are eligible for the disability tax credit, if the trust ceases to be a Canadian tax resident, or if capital is a paid out to a specific non-electing or non-disability tax credit eligible beneficiary.

Pro Tax Tips – Qualifying Disability Trusts

Setting up a will such that it will create a Qualifying Disability Trust requires careful advanced planning and consultation with an experienced Canadian tax lawyer and in particular specifying beneficiaries by name. As beneficiaries who could be eligible beneficiaries of a Qualifying Disability Trust are also typically eligible for government benefit programs like the Ontario Disability Support Program (ODSP), it can make sense to structure a trust intended to be a Qualifying Disability Trust so that it is also a Henson trust to maximize benefit eligibility.

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About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch