Qualified Disability Trusts
On December 16, 2014, Bill C-43, Economic Action Plan 2014 Act, No 2 received royal assent. The Bill implements several tax measures included in the 2014 federal budget. The changes will come into effect January 1, 2016 and will have a significant impact on estate planning, specifically the taxation of testamentary trusts.
What is a testamentary trust?
A testamentary trust is a trust, for the benefit of another, established by a person as a result of his or her death. Testamentary trusts have been a popular estate planning tool for many reasons; favourable tax treatment being among the most important.
What are the changes?
Testamentary trusts will no longer have access to graduated rates of taxation; testamentary trusts will be subject to tax at the highest federal tax rate, which is currently 29%. It is likely that the Provincial governments will amend their tax legislation to align with the federal tax rates resulting in an effective combined tax rate of nearly 50% in most Provinces.
The Bill provides for two exceptions:
- the Graduate Rate Estate: nearly all testamentary trusts will be eligible for graduated marginal tax rates for the first 36 months of the trust’s existence; and
- the Qualified Disability Trust.
The Qualified Disability Trust
The Qualified Disability Trust (“QDT”) can only be established for disabled beneficiaries and will continue to be eligible for graduated rates of taxation. For a trust to be considered a QDT for income tax purposes, the trust must:
- be a testamentary trust as defined under the Income Tax Act (the “Act”);
- be a resident in Canada for the entire year, not just at year end;
- elect jointly with one or more beneficiaries who is a beneficiary under the Will;
- have at least one electing beneficiary that is eligible for the Disability Tax Credit (“DTC”); and
- not have any beneficiaries that have made a joint QDT election with another trust. There is a limit of one QDT per DTC-eligible individual.
It is important to note that a regular testamentary trust can later become a QDT if the capital beneficiary of the trust later becomes disabled and become eligible for the DTC.
There are numerous issues with the new taxation regime for testamentary trusts and especially for the new QDT:
- Elections: It will be crucial for the Trustees of the QDT to ensure the proper timing of making the QDT election; there is no clear relief from a late election.
- DTC-eligibility: the test for qualifying for the DTC certificate is onerous and many individuals with significant disabilities will not qualify (please see my prior article titled: The Disability Tax Credit – Do you qualify?).
- Death of electing beneficiary: if the sole electing beneficiary dies, the eligibility for graduated rates will immediately cease (unless it is still within the first 36 months since the death of the settlor and there is no other trust under the same will that has made the graduated rate estate election).
- Recovery tax: The QDT is subject to graduate rates of taxation for any year it elects to be a QDT but it will be required to pay a recover tax for the previous year if:
- none of the beneficiaries were a DTC-eligible and electing beneficiary;
- the QDT ceased to be a resident of Canada; or
- QDT capital is distributed to a beneficiary that is not DTC-eligible or has not made the QDT election.
Recovery tax payable
The amount of tax that would have been payable in the previous taxation year if the trust had been subject to the highest marginal rate of tax and taxable income for that year excluded amounts that were subsequently distributed as capital to electing beneficiary.
The intent is to claw back tax savings for income taxed at graduated rates for which was subsequently distributed as capital to a non-electing beneficiary.
Recovery Tax = A – B
A: hypothetical tax for preceding year if tax rate of 29% and taxable income reduced by amounts paid to electing beneficiary and tax payable that reasonably relates to distribution to electing beneficiary.
B: amount of tax payable for the preceding year.
The new rules with respect to the taxation of testamentary trusts is a significant change for all taxpayers and their advisors. With the loss of graduate rates for all testamentary trusts for all but the 36-month Graduate Rate Estate exemption, determining whether one is eligible for the Disability Tax Credit has become even more crucial. Everyone should review their estate plans prior to 2016 to ensure that it is still appropriate. At Siskinds we understand the complexities of planning for those with significant disabilities. If you have any questions please contact Daniel Strickland at email@example.com or 877.672.2121.