by Mitchell Rattner
Amendments to the Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.)) (“ITA”), which came into effect on January 1, 2016, stipulate that the income and realized capital gains of testamentary trusts will now be taxed at the highest marginal rate (29%), but for two key exceptions.
Exception #1: Graduated Rate Estate
Graduated Rate Estate (“GRE”) is defined in section 248(1) of the ITA, and per the new tax regime, is an exception to the new mandate that trusts are taxed at 29%. In order to benefit from the graduated rate, the estate must be designated as a GRE in the estate’s first tax return (T3), beginning after taxation year 2015. The income tax return must include the individual’s social insurance number for the given taxation year and all prior taxation years that ended after 2015. The estate must be a testamentary trust that arose on and as a consequence of the individual’s death, and it must be the only estate designated as a GRE for a taxation year beginning after 2015. Finally, the eligibility of the estate to be designated as a GRE and taxed accordingly, expires 36 months after the death of the individual.
Exception #2: Qualified Disability Trust
Qualified Disability Trust (“QDT”) is defined in section 122(3) of the ITA, and is another exception to the 29% rate at which other trusts are now taxed. As with GREs, the QDT must be a testamentary trust such that it arose on and as consequence of the individual’s death, and further, the trust must be resident in Canada for the given taxation year. The trust requires that there must be a joint election in the T3 with one or more of the ‘electing beneficiaries,’ and the electing beneficiary’s/ies’ social insurance number/s must be recorded in the election. The electing beneficiary must be named personally as a beneficiary of the trust by the trust instrument. The electing beneficiary is only allowed to elect one trust in each given taxation year to be the Qualified Disability Trust. Most importantly, in order to qualify as an electing beneficiary, the individual must be eligible for the Disability Tax Credit (“DTC”).
The DTC is a non-refundable tax credit that is available for persons with disabilities or for those that support them. The qualifications for the Disability Tax Credit are as follows, per section 118.3(1)(a) and (b) of the ITA:
· The individual must have an impairment of mental of physical function/s that is prolonged (12 months or more);
· The individuals’ impairment of mental or physical function/s must be severe such that it restricts him or her at least 90% of the time; and
· The severe and prolonged impairment of mental or physical function/s must be certified by a physician using Form T2201, Disability Tax Credit Certificate.
A QDT need not be comprised entirely of electing beneficiaries; it only needs a minimum of one electing beneficiary to be qualified accordingly.
However, 122(2) of the ITA provides for a recovery tax where QDT status is lost for a particular year. This would occur when there is a capital distribution made to a non-electing beneficiary after a given year`s income had already been taxed at the graduated rate. The recovery tax claws back any tax savings, by, roughly, taxing the trust the amount that would have been payable in the previous year had it been subject to the highest marginal rate, excluding the amount of any capital that was subsequently distributed to any electing beneficiaries.
The recovery tax will also apply when the trust ceases, in a given year, to have among its beneficiaries any individuals who previously were electing beneficiaries, or when the trust ceases, in a given year, to be a resident of Canada. The former condition includes the death of the last living electing beneficiary.
The QDT, as an estate planning tool, has several limitations, not the least of which is that only one testamentary trust can be designated as a QDT. In the case where an individual is a named beneficiary of multiple trusts – for example, one testamentary trust established by a grandparent, and one established by a parent – the individual will have to elect as between the two trusts which should be designated as the QDT and subject to graduated rate taxation. Further, as a given trust is subject to recovery tax in the year it ceases to be designated as a QDT, it would be in the interest of the electing beneficiary not to change his or her election too frequently, unless the poor performance of a particular QDT necessitates the change to another. In order to maximize the benefit for a potential electing beneficiary, family and/or other grantors of trusts intended for eligible beneficiaries should consider cooperating in channeling assets into the possession of a single testator, to the extent possible, and where family relationships so allow. Further, the CRA stipulates that a valid testamentary trust cannot include property contributed to it other than by a deceased individual as a consequence of the individual’s death [s. 108(1) of the ITA], so caution should be afforded to ensure that the testamentary trust intended to be designated as the QDT is not tainted.
The implementation of these estate planning strategies is complicated, and it is recommended that you consult with a lawyer to assist with your estate planning needs.