Important Tax Changes for Trusts Created in a Will

On August 29, 2014, the Department of Finance released draft legislation that would implement measures proposed in the 2014 Federal Budget.  These measures contain some important changes that will significantly curtail the tax advantages currently available to testamentary trusts.

A "testamentary trust" is a trust created at death, typically in a person's will.  An estate is also considered a testamentary trust for income tax purposes.  Currently, testamentary trusts are taxed at graduated marginal rates just like individuals (from 20.05% rising up to 49.53% in Ontario).  By contrast, a trust created during a person's lifetime (called an "inter vivos" trust) is taxed on all its income at the highest marginal rate of 49.53%.  By managing the amount of income that is taxed in the trust rather than personally, beneficiaries are effectively able to income-split by accessing more than one set of graduated tax rates.

Starting in 2016, graduated rates for testamentary trusts will be eliminated, and all income taxed within a testamentary trust will be subject to flat top-rate taxation, just like an inter vivos trust.  In addition, a number of other tax advantages will be eliminated for such trusts, including the exemption from the requirement for a December 31 tax year-end, the exemption from income tax instalment rules and others.  Graduated rates will still apply for the first 36 months of an estate in order to allow a reasonable period of administration.  Graduated rates will also continue to apply where beneficiaries of the testamentary trust are eligible for the Disability Tax Credit.

For taxation years ending prior to January 1, 2016, income earned by a testamentary trust will continue to be taxed at graduated tax rates.  Therefore, it is still possible to undertake some tax-planning strategies before the Budget proposals take effect or to unwind any testamentary trust planning undertaken under the existing framework.  Even once the proposed changes come into effect, there are still many reasons to include testamentary trusts as part of a person's estate planning, including the preservation of capital for a younger generation or protecting a beneficiary's inheritance from creditors or marital property claims.