Recent amendments to the Income Tax Act have made fundamental changes to the tax rules for estates and wills. Lawyers and trustees should familiarize themselves with these new aspects.

As a general rule, all income from trusts is taxed at the top individual tax rate of about 54 per cent. There are a few exceptions to the top tax rate rules. Currently, the new legislation shifts the tax burden of a spousal trust to the estate of the surviving spouse. Fortunately, however, it appears that these provisions will be cancelled, as discussed further below.

Top tax rate for trusts

Formerly, testamentary trusts were taxed at graduated rates: the first $40,000 of income was taxed at about 20 per cent, the next $30,000 at about 32 per cent, and increasing to about 50 per cent when income exceeded $220,000. Effective January 1, 2016, all trusts will be taxed at the top rate of about 54 per cent. There are two exceptions: 1) the deceased’s estate for the first 36 months (this is called the Graduated Rate Estate, or GRE); and 2) one trust per year for an individual who qualifies for the disability tax credit (this is called the Qualified Disability Trust, or QDT).

Exceptions to top rate QDT rules

The QDT rules are complex. Though the new rules retain a graduated rate for the QDT, the accumulated tax savings produced by the low rate tax over a period of years are subject to a new tax that effectively “claws back” these savings when the disabled individual dies or ceases to qualify for the disability tax credit. In order to realize the savings, the income must be distributed to the disabled beneficiary before the year of death. This will require attentive management by trustees in cases where provincial benefits are received.

GRE rules

A qualifying estate must designate itself as a GRE. If the estate ceases to qualify as a GRE, it loses GRE status. Consequently, charitable donation credits and deductions for losses of the estate may be lost, and the top tax rate will apply. This can have serious consequences for the estate and in some cases can result in double tax, in particular where shares of a private corporation are held by the estate. A GRE can lose its status before 36 months if the estate receives contributions from persons other than the deceased, including certain loans or loan guarantees made by non-arm’s length persons.

Dual wills

Dual wills for owners of private corporations are now common. The Canada Revenue Agency has indicated that it intends to treat what are often referred to as primary and secondary estates in these dual wills as one graduated rate estate. As a precaution, it is advisable to address this issue specifically in the will to indicate the intention to direct the estate trustee to designate both estates as being one graduated rate estate. It is also prudent to name the same person(s) as estate trustee(s) of both estates.

Likely cancelation of taxation shifting provision

The Department of Finance introduced draft legislation in January that effectively cancels new provisions shifting the tax burden on the death of a surviving spouse from a spousal trust to the surviving spouse’s estate. The prior legislation, which was effective January 1, 2016, leaves the beneficiaries of the spousal trust with a windfall, as the tax ordinarily payable on the spousal trust assets became payable by the surviving spouse’s estate, to the detriment of the beneficiaries of the surviving spouse’s estate. Fortunately, it appears this provision will be eliminated, as it caused major problems, particularly in second-marriage families.

Review of existing wills

There are no “grandfathering” provisions to cushion existing trusts from these changes. Consequently, now is a good time to review client wills and the provisions creating these trusts. Each trust should be examined carefully. In some cases, the trustees are required to continue the trusts. In other cases, the trustees might consider distributions to one or more beneficiaries after having obtained a legal opinion.

Trusts remain useful in many cases. Significant tax savings may remain where trustees have the discretionary power to allocate taxable income to beneficiaries with lower tax rates. A trust might also protect an inheritance from creditor claims and perhaps matrimonial claims. In other cases, a simplification of the will to eliminate the complexity of the trusts will be preferred.