Taxation of Testamentary Trusts – A Canadian Tax Lawyer Analysis
Introduction: What is a Testamentary Trust?
A testamentary trust is a type of trust that arises on or as a result of an individual’s death (Income Tax Act, Subsection 108(1)). A testamentary trust allows an individual to decide, while they are alive, through their last will and testament, who will benefit from their wealth and under what circumstances, upon their death. Accordingly, a deceased individual’s last will and testament will establish the terms of any testamentary trust (Hess v The Queen).
A testamentary trust contains four elements: (1) the contributor of the trust property into the trust (also known as the testator or testatrix); (2) the subject matter being the trust property; (3) the trustee or trustees who are responsible for managing and distributing the trust property, pursuant to the trust terms or court order; and, (4) the trust beneficiary or beneficiaries who benefit from the trust property.
The Benefits of a Testamentary Trust
A testamentary trust is an estate planning tool that can be used for various reasons including, but not limited to:
- minimize estate disputes;
- provide for the education of children and grandchildren;
- protect assets for minor dependents;
- protect assets and provide for dependents who are incapacitated;
- minimize access of funds to beneficiaries with financial issues;
- achieve tax planning and wealth management objectives;
- control trust property and its disposition to the trust beneficiaries;
- testamentary trusts offer protection from creditors; and,
- reduce the estate tax liabilities and probate fees (also known as death tax) payable.
How Does a Testamentary Trust Work?
The testator or testatrix will draft the terms of the trust during his or her lifetime in the last will and testament. The testamentary trust comes into effect immediately upon the decease of the testator or testatrix. After the testator or testatrix’s death, the Will goes through probate to confirm its authenticity. The provisions for establishing the testamentary trust and its restrictions are located in the deceased person’s last will and testament. Once the testamentary trust is in effect, the estate executor or executors are responsible for transferring the trust property into the testamentary trust. Thereafter, the appointed trustee is responsible for managing and distributing the trust property, in accordance to the trust provisions until either the trust expires, or the trust beneficiaries are in control of the trust property. If the testator or testatrix did not select a trustee or where the trustee declines his or her appointment, the court will appoint a trustee.
Tax Treatment of Testamentary Trusts
For income tax purposes, a trust is deemed to be an individual pursuant to subsection 104(2) of the Income Tax Act. This means that an annual T3 Trust Income Tax and Information Returns must be filed with the Canada Revenue Agency (CRA) for each taxation year of the trust.
Under paragraph 150(1)(c) of the Income Tax Act, a T3 Trust Income Tax and Information Returns is due within 90 days from the end of the trust year. A testamentary trust must have a taxation year that must coincide with the calendar year.
For 2016 and subsequent years, the 2014 federal budget enacted the following changes with respect to the tax treatment of testamentary trusts:
- testamentary trusts established post 2015 are ineligible for a graduated tax rate;
- commencing 2015, all testamentary trusts are required to have a calendar year for taxation purposes and are permitted to have their first calendar year end in the year in which the trust commenced;
- testamentary trusts are required to make quarterly tax instalment payments, and
- the graduated tax rates applicable to testamentary trusts were replaced with a top-flat rate tax applicable to testamentary trusts commencing post 2015.
The top-flat rate tax rule is subject to two exceptions: graduated rate estates and qualified disability trusts. First, a graduated rate estate, which is essentially an estate that arose on or as a result of an individual’s death, if such time is not more than 36 months after the death of the individual and the estate is at that time a testamentary trust pursuant to the Income Tax Act. Second, qualified disability trusts, which are testamentary trusts established for the benefit of beneficiaries who qualify for the disability tax credit, are subject to gradated tax rates.
Testamentary Trust Property – Contribution and Disposition
Only assets passing through a deceased person’s estate can be transferred into a testamentary trust. Insurance proceeds are the only exception to this rule. This means that insurance proceeds can be paid directly into a testamentary trust, without passing through the deceased person’s estate.
A transfer of property into a testamentary trust constitutes a disposition of property pursuant to subsection 248(1) of the Income Tax Act. This means that where property is transferred to a testamentary trust on or as a result of an individual’s death, such property will transfer to the trust at its tax cost to the deceased individual, unless the person elected otherwise.
The 21-year deemed disposition rule pertaining to trusts (including testamentary trusts) is found in subsection 104(4) of Canada’s Income Tax Act. Where a testamentary trust holds capital property, subsection 104(4) deems the trust to have disposed of all of its capital property equal to the fair market value of the property and to have immediately reacquired that property at fair market value (being the cost equal to the deemed disposition) every 21 years. The purpose of this deemed disposition rule is to force the trust to recognize and pay tax on its accrued capital gains every 21 years and to prevent the trust from holding capital property indefinitely without incurring any tax liability. The effect of the 21-year deemed disposition rule is that the tax triggered, pursuant to subsection 104(4) of the Income Tax Act, can be significant.
However, subsection 107(2) of the Income Tax Act provides a commonly used estate and tax planning strategy for avoiding the 21-year deemed disposition rule under subsection 104(4). That is, a testamentary trust can avoid the tax triggered by subsection 104(4) if capital property in the trust is rolled over to its beneficiaries under subsection 107(2) of the Income Tax Act, as was the case in Fishleigh-Eaton v. Eaton Kent. A subsection 107(2) rollover permits a deferral of the tax (that would have been triggered under subsection 104(4)) until such beneficiary disposes of the property in future or a deemed disposition is recognized under the Income Tax Act (for example upon the beneficiary’s death). Needless to say, where it is impractical to distribute capital property to the beneficiaries under the trust prior to the 21st anniversary of the trust, the deemed disposition under subsection 104(4) will occur and any taxable capital gains triggered as a result of such disposition will become taxable to the trust.
Maintaining Testamentary Trusts Status
A testamentary trust can lose its status as a testamentary trust where (1) property is contributed into the trust by anyone, other than the deceased individual, as a result of that individual’s death; (2) the trust property is not distributed in accordance with the terms of the trust; or, (3) the trust acquires a debt or it is obligated to pay an amount to its beneficiary or a specified party (which includes any other person or partnership) with whom any beneficiary of the trust does not deal with at arm’s length. However, this excludes:
- debts and obligations acquired by a testamentary trust to meet its beneficiary’s right to enforce payment from the trust to that beneficiary;
- amounts owed to the beneficiary for services provided by such beneficiary for the trust; and,
- amounts owed to a beneficiary consequential of a payment made by the beneficiary, on behalf of the trust, and such payment was transferred another person within 12 months and the beneficiary would have made such payment had they dealt with the trust at arm’s length.
If a testamentary trust loses its status, the trust property will be held on a resulting trust for the testator or testatrix’s residuary estate and will be distributed either in accordance with the residuary provisions in the Will or the applicable provincial and territorial laws if the individual died intestate. In Ontario, the Succession Law Reform Act governs the distribution of an intestate individual’s estate.
Pro Tax Tips – Testamentary Trusts
The taxation of testamentary trusts is a complex area of law that requires detailed analysis and advice from an experienced Canadian tax lawyer. If you are a trustee of a testamentary trust you should consider further steps that could be taken to minimize the trust’s tax liability. If you have a trust included in your last will and testament and that Will was drafted prior to the 2016 changes relating to the taxation of testamentary trusts you should consider obtaining advice from an experienced Canadian tax lawyer on how the above-mentioned rules may impact you, the trust and your estate planning objectives.
Further, if you are setting up a testamentary trust and have questions pertaining to your estate and trust planning objectives or the tax treatment of testamentary trusts, please contact our tax law office to speak with one of our experienced Certified Specialist in Taxation Canadian tax lawyers.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."