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Testamentary Trust Rules 

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Tax Strategy

Testamentary Trust Rules

Estates incurring debt will eventually be subject to tighter rules.


According to federal income tax legislation, there are two basic types of trusts: a testamentary trust, also known as an estate, and an inter vivos trust. These trusts have three basic elements: a settlor, or creator; one or more trustees who administer the trust and have legal title to its property; and beneficiaries who can receive income, capital, or both from the trust. Both estates and inter vivos trusts have to file T3 returns within 90 days from the end of their fiscal years.

There are two main distinguishing features between an estate and an inter vivos trust. The first difference is that any source of income earned by the estate is taxed at graduated personal tax rates. Alternatively, in an inter vivos trust all sources of income are taxed at the highest marginal personal tax rate, which varies from 39 per cent to 48 per cent depending on which province the trust resides in.

The second difference is that the estate usually has a non-calendar year end coinciding with the death of the individual. An inter vivos trust always has a calendar year end.

An estate represents a major tool for income splitting because it is subject to tax at graduated personal rates. In the past, a common estate planning technique was to have an individual at the highest marginal tax rate loan money to an estate of which he or she is a beneficiary. The estate then invested the money, paid tax at the graduated tax rates (as opposed to the individual paying tax at the highest rate), and distributed the after-tax proceeds of the income as a tax-free return to the individual. Typically, the tax savings was magnified if the residence of the trust was in a low-tax rate province such as Alberta and the individual was in a high-tax rate province such as Quebec.

But the Department of Finance introduced proposed legislation as part of the December 20, 2002, technical amendments to curb what it deems to be excessive income splitting. The legislation is yet to be passed, but its thrust is twofold: to convert an estate subject to graduated rates to an inter vivos trust subject to the highest marginal rates; and to switch a non-calendaryear-end filing estate to a calendar year-end filing inter vivos trust.

A proposed amendment to subsection 108(1) of the Income Tax Act reads that an estate is a trust that arose as a consequence of an individual's death other than a trust that, at any time after December 20, 2002, and before the end of the taxation year, incurs a debt or any other obligation owed to any person with whom any beneficiary of the estate did not deal at arm's length. In other words, any non-arm's length debt incurred by an estate may re-characterize it into an inter vivos trust subject to tax at the highest rate. Tax practioners are advised to take note of this date, as once the legislation is passed, it is likely to be retroactive.

There are three exceptions of debt incurred by the estate that cover limited situations where the Department of Finance deems that no income splitting tax abuse arises. The first exception is debt incurred to satisfy income or capital distributions to beneficiaries.

The second exception applies when someone related to a beneficiary performs services for the estate and is reimbursed — a typical example is trustee fees. Professional fees paid to an accountant would generally not fall under this exception because the accountant is dealing at arm's length with the beneficiaries, and the testamentary trust rules only apply to debt incurred by the estate to a person not at arm's length with any beneficiary.

The third exception applies to expenses paid by the beneficiary on behalf of the estate, which must fully reimburse the beneficiary within 12 months from the date of death of the individual. A common example of this exception is the payment of funeral expenses by a relative of the deceased.

A new aspect of the proposed legislation includes a change in year end rules for estates that lost their testamentary trust status after July 18, 2005. If trust administrators are not aware that the estate has lost its testamentary trust status, they can easily miss two tax filing deadlines causing the estate to become an inter vivos trust.

The following example illustrates the application of these rules: An estate with an August 31 year end was created on the death of Mr. X. On October 31, the estate became indebted to one of its beneficiaries by way of an interest-free loan, and as a result, lost its testamentary trust status on that date.

As in prior years, the estate administrators file a trust return on November 29 (90 days after the estate's August 31 year end). The estate's second return is due on January 29(90 days after the October 31 deemed year end created by the non-qualifying debt), and the third return is due on March 31 (90 days after the estate's new December 31 year end).

Since the estate lost its testamentary trust status on October 31, it becomes an inter vivos trust with a December 31 year end. (All inter vivos trusts have a December 31 year end.) But if the estate's administrators do not realize that the estate's status has changed, they may miss both the October 31 and December 31 filing deadlines and the estate will face both late-filing penalties and interest charges.

Many accountants are not yet familiar with this proposed legislation, even though once passed, the new rules will likely create serious tax consequences for estates that incur indebtedness. The worst consequence may be that indebted estates will no longer be subject to graduated tax rates. Although it is uncertain when these proposed changes will become law, it is worth knowing that it is just a matter of time. Keeping abreast of these sorts of developments may make tax planning for estates easier in the long run. In my own experience, it is always worth having a long lead time to prepare for upcoming changes to the rules.

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