28 Nov

When the changes to the tax rates for testamentary trusts were announced in the 2014 Budget, there was disappointment but also some enthusiasm. Many practitioners thought we were about to move into a new and empowered era for estate planning which focussed more on inter vivos trusts and less on Wills and testamentary trusts. Sadly, the affair may be short lived. Draft legislation was released on August 29, 2014 in relation to the 2014 Federal Budget’s changes to the tax treatment of testamentary trusts. As expected, the graduated rates are gone, with minor exceptions. What is more shocking (than a glimpse of stocking) are the following two provisions included in the draft legislation.
1. GRE – It stands for “Graduated Rate Estate”, not “Graduate Record Exam”, and it is everywhere in the proposed changes. One of the problems with this GRE is that it implies a person can have more than one estate. This is a relatively novel concept for estate lawyers and likely flows from the practice in some jurisdictions, such as Ontario, where it is possible to have more than one Will.

Having more than one Will can give rise to more than one testamentary trust but should not change the number of estates a person has at any time. Notionally, estate lawyers talk about Primary and Secondary estates or the Canadian estate and the US estate, but that is from an estate administration perspective not for tax purposes.

This new conundrum leaves estate and tax lawyers wondering if CRA will allow one terminal tax return to be filed regardless of the number of Wills. It’s not often you hear tax lawyers wanting to consolidate and file one return but, in the terminal year and at least the first year of the estate, it can have significant implications for post mortem planning especially if there are shares in a privately held corporation.

The GRE is a vitally important concept going forward and, as reported in a recent STEP presentation, it is linked to various things like: access to a new flexible charitable donation credit where the donation is made in the Will or estate; nil capital gains inclusion for the donation of shares on death; and the provisions of s.164(6) and 112(3.2).

How multiple Wills are treated by CRA may in fact depend on the drafting. If each Will is drafted such that it implies a totally separate testamentary trust that is to function independently of the other, including the liability for taxes and payment thereof, I can see where some confusion may arise. However, if the two Wills are integrated and the estate trustee of one Will is the only executor with the responsibility for the filing of tax returns, this may help.
On the down side, to the extent that assets from the non-GRE estate are needed to pay the taxes, it could create a receivable in the GRE which would increase the amount of estate administration tax. However, this is a relatively minor problem compared to losing other benefits by forcing a choice between the Primary and Secondary “estates” in terms of which one is the GRE. Care will still be needed in the coordination of the two Wills to ensure that any perceived contribution from one “estate” to the other does not taint the recipient estate such that it is no longer a testamentary trust as the is a paramount requirement to qualify as a GRE. This transfer is a bigger problem for item 2 below.

It is worth noting that testamentary trusts can arise in documents other than Wills. However, not all testamentary trusts are an estate.

2. Life interest trusts – I am referring here to alter ego trusts, joint spousal or joint partner trusts as well as spousal or common-law partner trusts. Under existing rules, on the death of the life interest or surviving life interest, there is a deemed disposition which would trigger tax in the trust. There is still a deemed disposition on the date of death with the new rules, BUT all income of the trust for that final year is deemed payable in the year to the deceased life interest, or surviving life interest, beneficiary.

The problem with this scenario is immediately obvious. The assets with which to pay the taxes are in the trust and the beneficiaries of the trust may be completely different than those of the deceased beneficiary’s estate. The small upside is that the deceased beneficiary’s estate will hopefully be a GRE but this may have little impact in larger estates and could create confusion.

An Explanatory Note released in October 2014 tried to soften the blow by stating that “it is intended that the Minister apply subsection 160(2), in respect of an amount owing under subsection 160(1.4), as though the trust were liable in the first instance for that amount.”

Interesting to say the least. If it is the intention that the trust pays the tax, why not just leave things alone? The consensus so far is that the new provisions are intended to defeat provincial tax planning where the trust would be resident in a lower tax province than the deceased life interest beneficiary.

While Finance has issued this statement, there has been no follow up from CRA in terms of how it will enforce 160(2) and (1.4). Even if they confirm the treatment, it is problematic to rely on enforcement provisions. If the estate does not pay the tax, interest and penalties will presumably accrue. However, if they do pay the tax initially and are reimbursed by the trust, this transfer could taint the estate as a GRE.

It appears that the Explanatory Note was an attempt to walk a fine line that creates its own problems. This reminds me of a Henry David Thoreau quote about what to do if you know someone is intentionally going to try to assist you – “If I knew for a certainty that a man was coming to my house with the conscious design of doing me good, I should run for my life.”

Assuming that most clients intend for the taxes owing in respect of the deemed disposition to be payable from the trust, this suggests that one solution is to change the drafting of the trust to just say the taxes are payable from the trust. However, this might start to look like a transfer or loan to the GRE. Unfortunately, this could taint the GRE.

What are the options? Taking a narrow reading of the definition of “testamentary trust” in s.108 it seems that the estate could be a beneficiary of the trust because this would be a contribution to the estate by an individual on or after the individual’s death and as a consequence thereof. Therefore, there could be a specific provision in the trust, or a power of appointment in the trust exercisable by the life interest beneficiary, to specify that taxes owing in respect of the deemed disposition are to be payable from the trust. Leaving the payment of taxes to the discretion of the estate trustee would likely taint the trusts since the payment would not comply with the requirements of s.108.

Some commentators are concerned about the gap period until practitioners can update their precedents. Where existing trusts have a power of appointment provision, I think that is an option worth exploring. Unwinding a trust and resettling might be possible in some situations but that is a more expensive option. If neither of these is possible, the proposed changes can present real problems for existing plans and take some of the gloss off the prospects for the future of life interest trusts in estate planning.