Budget 2013: Trust Rules Proposed to Change, Too

The March 21, 2013 budget is an extensive and far-reaching document, which underscores the depth of the tax reforms Canada is in today. Trust and estate planning will be affected by the proposals as well, as explained.

Consultation on Elimination of Graduated Rates of Taxation. Certain trusts created by will, known as testamentary trusts and grandfathered inter-vivos trusts created before June 18, 1971 compute federal taxes on graduated tax rates. Other trusts pay tax at the top marginal tax rates (29%). The government is concerned that the use of trusts with graduated tax rates erodes the tax base, including the avoidance of the Old Age Security Recovery Tax (known as a Clawback). 

It is their view that subjecting ordinary inter-vivos trusts to the high flat tax rates, as well as plugging the outcomes of planning from multiple testamentary trusts structured to delay the completion of the administration of estates, will help to prevent tax erosion. A consultation on the matter will be initiated to close these loopholes.

Thin Capitalization Rules. Budget 2013 features the extension of Canada's thin-capitalization rules to trusts resident in Canada and to non-resident corporations and trusts that operate in Canada or elect to be taxed on a net basis under section 216 of the Income Tax Act.

Thin capitalization rules determine how much of the interest paid on corporate debt is tax deductible. The thin capitalization rules previously only applied to corporations, but Budget 2012 extended them to partnerships that had at least one Canadian resident member.

Instead of shareholders, beneficiaries of the trust will be used to determine whether a lender is a specified non-resident, and the equity of the trust, for the purpose of the debt-to-equity calculation, will consist of contributions to the trust from specified non-residents, less capital distributions. All beneficiaries of discretionary trusts will be considered specified beneficiaries.

Loans used in non-arm’s length transactions between a Canadian branch operation of a non-resident trust or corporation and a specified non-resident for thin capitalization purposes will constitute an outstanding debt following Budget 2013. A 3-to-5 debt-to-asset ratio will be used in these calculations rather than the standard 1.5-1 ratio.

These rules will also apply to non-resident corporations or trusts earning rental income in Canada that elect under Section 216 of the Income Tax Act to be taxed on their net income under Part I, as opposed to being subject to Part XIII tax on gross rental income.  

Loss-Streaming Rules for Trusts. The extension of the loss-streaming rules, currently applicable to corporations, is proposed by Budget 2013 to apply to trusts following an acquisition of control in circumstances where the trust is subject to a “loss restriction event”.

A “loss restriction event” is essentially when a person or partnership becomes a majority-interest beneficiary of a trust, meaning a beneficiary who has a beneficial interest in the trust’s income or capital with a fair market value over 50% of the fair market value of all the beneficial interests (income or capital). The Government has invited taxpayers to contribute their ideas over the next six months as to whether particular types of transactions should be included or excluded from the ambit of a "loss restriction event".

Over the next five years, the Government estimates that this new measure will generate approximately $335 million additional tax revenue, although this is pure speculation without knowing what will constitute a “loss restriction event”.

Greer Jacks is updating jurisprudence in EverGreen Explanatory Notes, an online research library of assistance to tax and financial professionals in working with their clients.