With the passage of Bill C-43 in December 2014, most testamentary trusts will be subject to top marginal tax rates. The two exceptions are the first 36 months of a graduated rate estate and a qualified disability trust for a beneficiary who meets the criteria for the disability tax credit (see AER, January 2015).
For most testamentary trusts, the new tax rates kick in on December 31, 2015. While trustees cannot change the law, they may be able to take planning steps to mitigate the damage, at least in the case of investments carrying unrealized capital gains.
Advisors managing such investments should reach out to trustees to inform them about appreciated holdings.
Changes: Timeline and cost
Until now, the main tax distinction among personal trusts has been the way they came into existence. Inter vivos trusts, those created while a person is living, remain subject to top marginal brackets and use a calendar year-end. Testamentary trusts are created under a person’s will, and had been entitled to graduated tax bracket treatment. They also could choose a non-calendar year-end.
Both these tax advantages (and others) for testamentary trusts have now been eliminated. As a quick phase-in, existing testamentary trusts will have a deemed year-end this December 31 to bring them in line with calendar year-ends thereafter.
These changes will affect income earned annually in future, understanding that a trust is subject to the combined federal-provincial personal tax rates in the province where it is resident. On the federal component alone, the tax will almost double on the first dollar of income for testamentary trusts for 2016 and beyond, given that the lowest federal bracket is 15% and the highest 29%. For capital gains, the federal increase will be 7% (since only half of capital gains are taxable). Here are the net differences based on combined rates in each province.
Taking action on capital gains
It may be possible for capital gains to be managed in the face of this development. If a trust holds investments with as yet unrealized capital gains, the trustee may trigger some or all those gains through dispositions.
To be clear on the application of the new rules, there will be a deemed year-end on December 31, but not a deemed disposition of capital assets. This means a trustee must take steps to cause actual dispositions while graduated brackets remain applicable.
For securities, extra care should be exercised to allow for the three business days from trade date to settlement date to ensure gains are realized before the trust’s year-end. As well, trades by the trust and related parties in the month before and after must be carefully scrutinized, lest the superficial capital loss rules be inadvertently triggered, potentially undoing the plan. For trusts with a non-calendar year-end, there will be two year-ends in 2015. So, it is doubly critical to act with haste for such trusts, as with each passing day, planning opportunities are expiring.
There is no grandfathering or carry-forward that will make those low rates available in 2016 or later. Simply put, the last opportunity for these trusts to access graduated brackets is in 2015.
Revisiting planning options
Preferential tax treatment has been a useful feature of testamentary trusts for almost half a century. In some situations, it may have been a by-product of other planning priorities such as managing disability needs, controlling asset distribution or providing for minors. Elsewhere, the tax aspects may have been central to the plan. Either way, trustees will begin looking at whether current trusts can or should continue, which may mean more asset movements to come.
Combined federal-provincial tax rates on capital gains
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