Testamentary trusts are currently taxed at graduated rates, but as of January 1, 2016 they will be subject to tax at the highest marginal rate on income generated in the trust. The change will apply to existing and new testamentary trusts, as well as grandfathered inter vivos trusts that are currently taxed at graduated rates. There are two exceptions to the new rules. The first allows for graduated rate taxation for graduated rate estates (i.e., GREs). (For more, read Make sure clients understand graduated rate estates.) The other exception applies to Qualified Disability Trusts (QDTs), which will be the focus of this article.
In order for a trust to be considered a QDT, there must be at least one beneficiary who is an electing beneficiary. An electing beneficiary is someone who receives the federal disability tax credit (DTC) and elects to treat the trust as a QDT. A QDT must also meet the following criteria:
- At the end of the trust year, it must be a testamentary trust that arose on and as a consequence of death (so it cannot be created while someone is alive).
- It must be resident in Canada for the trust year.
- In its tax return, it must elect jointly with one or more beneficiaries to be a QDT for the year. That election must include the social insurance number of each beneficiary. At this time, there is no specific form for this election, but we understand that one is being developed.
QDT versus Henson Trust
Since only people receiving the DTC are able to be electing beneficiaries on a QDT, only certain disabled people can benefit from graduated rates. If a Henson trust were set up for a disabled person who is not DTC-eligible, he would not be able to elect for the trust to be a QDT and would be taxed at the highest marginal rate.
Also, the QDT definition is a narrower definition than the preferred beneficiary election available under subsection 108(1), which includes people who depend on someone else because of their mental or physical infirmities. A Henson trust would still benefit these individuals since, as a fully discretionary trust, it will shelter their assets from the asset test for provincial benefits in most provinces. When a trust does not qualify as a QDT and is subject to top-rate taxation, tax-efficient investing becomes critically important.
Just one QDT
Only one QDT is permitted per beneficiary, meaning the beneficiary can only benefit from one trust subject to graduated rates. This could cause issues for family members who want to set up more than one trust for a disabled family member.
When an individual is named as beneficiary of multiple trusts, it’s important to have a discussion during the planning process as to which trust should be designated as the DT. For instance, say a parent of a child with a disability (and who qualifies for the DTC) is planning to leave that child with an insurance death benefit, paid directly into a trust upon the parents’ death. In addition, say the parent also provides for a testamentary trust in her will of which the disabled child is named as beneficiary.
The result is that the child with a disability is the beneficiary of two trusts; an insurance trust as well as a testamentary trust created by will. What planning can be done to benefit from the the QDT election?
One solution could be to have the insurance proceeds paid to the estate instead of the trust. The result would be that all assets (including the estate assets as well as the insurance proceeds) will form part of the estate and one trust can be created, which can qualify for the QDT election.. While this may allow for all assets to form part of the QDT and benefit from graduated tax rates, it could expose the insurance proceeds to probate fees since the proceeds would flow through the estate.
The other option is to choose one of the two trusts as the QDT. Which trust should be designated as the QDT will require additional planning. However, if the insurance proceeds are sizable, it may make sense to designate the insurance trust as the QDT as this will allow the client to benefit from potentially significant probate savings as well as graduated rate taxation on income generated by the trust investments.
Beware of recovery tax
A QDT recovery tax will apply if any of the following occur:
- none of the beneficiaries at year-end is an electing beneficiary for the previous year;
- the trust ceases to be resident in Canada; or
- a capital distribution is made to a non-electing beneficiary.
The recovery tax is essentially used to claw back tax savings for income that was taxed at the graduated rate but should have been taxed at the highest marginal rate. For example, a QDT allows for someone who is not an electing beneficiary to be a beneficiary of the trust. However, if the non-electing beneficiary receives capital from a QDT, a recovery tax will apply since that beneficiary should have been taxed at top tax rate. In an effort to reduce the likelihood that the recovery tax will apply, it’s probably a good idea to have the person with the disability as the only beneficiary. This will ensure that, as long as the beneficiary remains DTC-eligible and continues to elect for the trust to be a QDT, the recovery tax will not apply.
One of the pitfalls of the QDT election is that there is no relief for a late filed election. This means that if your client does not elect to have the trust treated as a QDT on time, the trust will be taxed at the highest marginal rate for the year.
The election must be made on an annual basis by the electing beneficiary. If the beneficiary does not have capacity to handle his or her own affairs, then the beneficiary’s legal guardian would be required to file the election. If no legal guardian exists, a legal guardian would need to be appointed by the court.
Finally, the beneficiary must also be a named beneficiary (e.g., “Jane Khan”) of the asset that was used to set up the trust. This means a beneficiary cannot elect to have the trust treated as a QDT if the deceased set up the trust for “my children” or “my issue,” which is fairly common in trusts. This requirement adds another layer of planning when a will is drafted.
It is great that an exception has been made to allow a QDT to receive graduated rates. But, it is extremely important that your clients understand what is required to benefit from continued graduated rate taxation.