As part of a crackdown on planning using testamentary trusts to obtain the benefit of multiple graduated tax rates, the Federal Government recently enacted a number of amendments to the Income Tax Act. These address circumstances where a testamentary trust (including an estate) incurs a debt or obligation to a beneficiary or any other person with whom a beneficiary of the trust does not deal at arm's length. In these circumstances, the trust could lose its status as a "testamentary trust", and with it, the graduated tax rates afforded to testamentary trusts.
The real worry for estate planners are debts arising from innocuous payments, such as funeral expenses paid by a beneficiary of an estate where the estate's assets are tied up in illiquid form (such as private company shares or land). Unless one of the exceptions apply, such a payment could very well cause an estate to lose its status as a "testamentary trust" and with it, the trust's graduated tax rates.
Fret bad debt
There are four types of obligations which are exceptions to this provision, and if one wants to avoid the loss of testamentary trust status, these requirements should be followed stringently.
The first exception is an obligation incurred in satisfaction of the beneficiary's interest in the trust, namely one incurred by the trust in satisfaction of the beneficiary's right under the trust to enforce payment of an amount of the trust's income or capital gains payable by the trust to the beneficiary, or to otherwise receive any part of the capital of the trust.
The second obligation is one owed to the beneficiary, if the debt or other obligation arose because of a service (which will not include any transfer or loan of property) rendered by the beneficiary to, for or on behalf of the trust. This could include, among other things, administration fees paid to a trustee who was also a beneficiary.
The next may potentially save the beneficiary paying the funeral expenses for a deceased individual. The test is that there must be an obligation owed to the beneficiary:
- which arose because of a payment made by the beneficiary for or on behalf of the trust;
- the debt is repaid by the trust within 12 months, or such longer period as the minister allows; and
- it is reasonable to conclude that the beneficiary would have been willing to make the payment if the beneficiary dealt at arm's length with the trust,
except that the third (arm's length) requirement is not necessary if the trust was an individual's estate and the payment was made within the first 12 months after the individual's death (with provision made for an extension of this period on application to the minister).
Thus, the payment of funeral expenses, if paid by the beneficiary within 12 months of the death of the individual and repaid in full by the trust within 12 months of payment, shall not cause the trust to cease to be a "testamentary trust" within the meaning of that term in subsection 108(1).
There is also a saving provision that grandfathers debts incurred before October 24, 2012 if which are repaid within 12 months after the day on which the Technical Tax Amendments Act, 2012 received royal assent, or such longer period as the minister allows.
My whole tax year ruined
One further consequence of a testamentary trust losing its status as such, aside from the loss of graduated tax rates, is a deemed taxation year end for the trust at the moment that the exclusion in the definition of "testamentary trust" applies, and a deemed new taxation year for that trust, beginning at that moment.
The real issue here is that once the testamentary trust has lost its status as such, capital losses incurred by the estate after the deemed year end created by the loss of testamentary trust status cannot be carried back to the deceased's final tax return under subsection 164(6), as capital losses may only be carried back which are incurred during the first taxation year of the estate. Thus, along with a high rate on income taxed in the trust, losses may potentially be rendered completely unusable.
So what?
Beneficiaries and trustees should thus tread lightly. Unless the obligation clearly fits within one of the exceptions, a testamentary trust should not incur obligations from its beneficiaries or persons related to these beneficiaries. If debt arises because of a payment made by a beneficiary on behalf of the trust, the debt should always be repaid, and promptly. And unless the payment is made after the first 12 months after the death of the individual whose estate is at issue, the terms of the payment made by the beneficiary should be such that he or she would have been willing to pay if he or she and the trust were dealing at arm's length.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
