Testamentary Trusts

The following article on testamentary trusts appeared in the latest edition of the Hamilton Law Association Law Journal.

Most estates are “testamentary trusts” for tax purposes, and as such they enjoy certain advantages under the Income Tax Act,[1] including the right to pay tax at graduated rates. A testamentary trust is a “trust or estate that arose on and as a consequence of the death of an individual.” The trust can lose its status as such and become an ordinary inter vivos trust, which pays tax at the highest rate. A loss of status occurs if a person other than the deceased makes a contribution to the trust or, in accordance with draft legislation currently before Parliament, the trust incurs certain debt obligations.

What should you watch out for to ensure that a trust will not lose its testamentary status?

· In general, the trust should not accept contributions of property of any kind from any person.

· If the trust must buy property from or sell it to a beneficiary, and the other party to the transaction is a beneficiary or a person not dealing at arm’s length with a beneficiary, the trust must take particular care to ensure that the transaction occurs at fair market value.

· If the trust is also a spousal trust, and the spouse beneficiary wishes to disclaim his or her rights under the trust, the trust must ensure the disclaimer occurs at the right time and in the proper manner.

· If someone pays an expense on behalf of a trust or estate, the trust or estate must reimburse the person in full, and the reimbursement should occur promptly.

· The trust should avoid accepting loans from its beneficiaries or any person or partnership not dealing at arm’s length with its beneficiaries. If the trust must incur such a loan, the trust should ensure that certain relieving exceptions will be met.

What is a Testamentary Trust

In the Canadian income tax universe, there are two kinds of trusts, those that are testamentary trusts and those that are not. Those that are not are called “inter vivos” trusts in the Act. Testamentary trusts enjoy numerous tax advantages. A testamentary trust is subject to tax at graduated rates, while an inter vivos trust pays tax on every dollar of taxable income at the highest marginal rate. A testamentary trust can choose an off-calendar year-end; an inter vivos trust cannot. In addition, a testamentary trust, unlike an inter vivos trust, is not required to pay instalments.

Under the Act, a testamentary trust is a “trust or estate that arose on and as a consequence of the death of an individual.”[2] Sometimes, whether a trust qualifies as a testamentary trust can be a complicated question. For example, if RRSP proceeds are used to form the property of a trust, is it a testamentary trust? The Canada Revenue Agency (the “CRA”) has said yes, under certain circumstances.[3] Leaving aside these more complex scenarios, however, a testamentary trust generally comes into existence when an individual’s Will creates it by contributing property to it and specifying its terms and conditions.

A testamentary trust can lose its status as such, however, and become an inter vivos trust subject to tax at the highest rate on all income. Those of us responsible for administering estates or other testamentary trusts must be sure we understand the tax do’s and don’ts in this regard so that we can avoid such an expensive outcome.

Losing Status as a Testamentary Trust

A trust will cease to qualify as a testamentary trust if, before the end of a taxation year, property is “contributed to the trust otherwise than by an individual on or after the individual’s death and as a consequence thereof.”[4] This is an anti-avoidance rule. The ability to create a taxpayer (a trust) that pays tax at graduated rates can be quite advantageous from a tax perspective. A person subject to tax at the highest marginal rate might be tempted to split income and avoid tax by contributing property to a testamentary trust where income earned on the property will be subject to tax at lower rates. The Act anticipates this temptation by deeming a trust that receives property in such circumstances to be an inter vivos trust.

The consequences of this anti-avoidance rule are unusually harsh. It applies even if no income splitting actually occurs: it would apply apparently even if a prohibited person contributed a car to a testamentary trust. Moreover, once the trust’s testamentary status is lost, it is lost forever. The problem cannot be cured by subsequently distributing the property to a beneficiary of the trust.

What is a “Contribution”?

A contribution likely includes any transfer of property to a trust. “Contribution” likely also includes a transaction that amounts to the conferral of some kind of tangible benefit.

Buying and Selling Property

To carry out its objects, a testamentary trust must be able to buy and sell property. Does “contribution” include property transferred to a trust in the course of such transactions at fair market value? Common sense, while it is often an unreliable guide in tax matters, nevertheless suggests that “contribution” cannot include such transfers or else very few trusts could qualify as testamentary. On the other hand, the CRA would almost certainly review very carefully a transaction between a trust and a beneficiary or a person not dealing at arm’s length with the beneficiary where, for example, the purchase price paid by a trust for a property was well below fair market value. A testamentary trust, then, must be careful about entering into such transactions for fear that a mistake about the fair market value of a property that is the subject of the transaction could result in the trust losing its testamentary status.[5]

Spousal Trusts

If a testamentary trust is also a spousal trust, then by its terms the spouse beneficiary must be entitled to receive all of the income of the trust that arises before the spouse’s death. What happens if the spouse disclaims his or her right to the income of the trust? In several technical interpretations, the CRA has taken the position that a disclaimer of income is a contribution of property by the spouse. On the other hand, the CRA has also stated that a disclaimer of a right to income before the income becomes payable to the spouse will not result in a loss of status.[6]

These positions are difficult to distinguish substantively inasmuch as the effects of a disclaimer in either case appear identical: the trust retains the after-tax income as accumulated capital, which earns income that will be subject to tax at lower rates. The CRA is constrained, perhaps, by subsection 248(8), which, among other things, provides that a

transfer, distribution or acquisition of property as a consequence of a disclaimer, release or surrender by a person who was a beneficiary under [a] will [of a taxpayer] […] shall be considered to be a transfer, distribution or acquisition of the property as a consequence of the death of the taxpayer

Whether subsection 248(8) really assists a spousal trust where the spouse has disclaimed a right to income is somewhat unclear inasmuch as the subsection does not refer to a “contribution”. “Transfer”, however, would seem to include a “contribution”.

Paying Expenses for a Trust

What if a person pays an expense of a trust, and the person purports to disclaim any entitlement to reimbursement? In that case, the person will likely be considered to have contributed property to the trust by assuming one of its liabilities. [7] The trust will cease to be a testamentary trust.

Of course, it does not follow that every expense paid by a person on behalf of a trust will result in it losing testamentary status. If a person pays an expense on behalf of the trust, and the trust was legally obliged to pay the expense, the person is entitled to reimbursement. Arguably, then, the trust has not received any property from the person.

In fact, it is not uncommon for an executor or beneficiary to pay some of the expenses of an estate. Funeral expenses must sometimes be paid before an executor can obtain access to the funds of the estate. Provided it is clear that the person paying expenses is entitled to reimbursement from the estate and he or she in fact receives such reimbursement within a reasonable time, the estate should not cease to become a testamentary trust merely because of the payment. This common sense rule, however, has been modified by proposed amendments to the Act that are discussed below.

Loans

An individual who wished to avoid tax might consider loaning property to a testamentary trust rather than contributing it outright. The individual with a good income could loan an amount to a testamentary trust under a demand, non-interest bearing promissory note. The trust would use the property to earn income subject to tax at rates lower than the rate that would have applied if the high-income earner had kept the property and earned investment income with it. Arguably, the individual has not contributed property to the trust, but the tax benefits that accrue are the same as if he or she had made such a contribution.

New Rules

The Department of Finance seems to have believed that the latter possibility represented a large loophole, or that executors and beneficiaries were paying funeral expenses all the time without seeking reimbursement, thereby depriving the fisc of millions in tax revenue. But even if millions were not at risk, why let pass an opportunity to make life more complicated for Canadian taxpayers? Finance, therefore, added another yet anti-avoidance rule to the : under new paragraph (d) of the testamentary trust definition, a trust ceases to be testamentary if, at any time after December 20, 2002, and before the end of the trust’s taxation year

(1) it incurs an obligation of any kind to a “specified party”, or

(2) the specified party guarantees any obligation of the trust.

A “specified party” is a beneficiary of the trust or any person or partnership not dealing at arm’s length with any such beneficiary.

Paragraph (d) does not apply to an obligation if one of three exceptions applies.

First Exception

Paragraph (d) does not apply to a debt or other obligation incurred by the trust in satisfaction of the specified party’s right as a beneficiary under the trust to enforce payment of an amount of the trust’s income or capital gains payable by the trust to the specified party. Presumably, then, a testamentary spousal trust can issue a promissory note to a spouse in satisfaction of her right to income without falling afoul of paragraph (d).

Second Exception

The new anti-avoidance rule also does not apply to obligations that “arose because of a service […] rendered by the specified party to, for or on behalf of the trust.” The legislation states that “for greater certainty”, “service” does not include any transfer or loan of property. Finance’s technical notes to the draft legislation state that this exception, among other things, is meant to cover “debts or obligations arising in respect of services rendered in a person’s capacity as an executor or administrator of an estate.”

Third Exception

What about an obligation owing for expenses of the trust that the specified party paid? The third exception will apply only if the obligation meets all of the following conditions:

(1) The obligation must have arisen because of a payment made by the specified party for the trust.

(2) In exchange for the payment, the trust transferred property to the specified party, the fair market value of which property was at least equal to the amount of the obligation arising because of the payment. Finance’s technical notes point out that a transfer of property that does not settle or cancel the obligation will not meet the requirements of this rule. For example, a distribution of capital to a spouse beneficiary in partial satisfaction of his capital interest in the trust will not meet the requirements of this rule because the distribution would not settle the obligation (it is made in satisfaction of the capital interest).

(3) The transfer of property under rule (2) occurred within 12 months after the payment was made.

(4) It is reasonable to conclude that the specified party would have been willing to make the payment if the specified party had dealt at arm’s length with the trust. This rule seems to require, among other things, that the specified party charge the trust an arm’s-length rate of interest.

(5) Rule (4) does not apply if the trust is an individual’s estate and the payment was made within 12 months of the death of the individual.

A trust can apply to the CRA to extend the 12-month limitation periods mentioned in rules (3) and (5), but the application must be made within the 12-month period. The CRA can extend the period as it “considers reasonable in the circumstances”.

The 12-month periods are also subject to coming into force rules. Finance first proposed paragraph (d) in December, 2002, but it is still not law and its rules have been amended in several substantive ways since 2002. Paragraph (d) now forms part of Bill C-33, which received First Reading on November 22, 2006. The Bill’s coming-into-force provisions make it clear that the 12-month periods referred to above will be measured from the later of the dates specified above and the date the legislation receives Royal Assent.

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John Loukidelis is one of Simpson Wigle LLP’s tax partners. He maintains a blog on tax issues of interest to owner-managers and their advisors at blog.simpsonwigle.com. If you have a question on a tax topic that you would like to see addressed in the HLA Journal, please write to John at [email protected].