Tax Treatment of Trusts: Finance Canada Responds to Concerns of Practitioners

Recently a group of professional organizations, including the Society of Trust and Estate Practitioners (STEP), expressed their concerns about amendments to the Income Tax Act (the Act), which received Royal Assent on December 16, 2014. The provisions, related to subsection 104(13.4), the tax treatment of trusts, come into effect on January 1, 2016. The Department of Finance responded to those concerns in an open letter on November 16, 2015, a summary of which follows.

Prior to subsection 104(13.4) becoming effective, certain income of spousal trusts that is deemed to be recognized on the lifetime beneficiary’s death is not able to be paid to beneficiaries on a tax-deductible basis and, therefore, the amounts are generally recognized in the trust for the relevant tax year.

The new subsection 104(13.4) modifies this tax treatment by deeming the trust’s taxation year in which the lifetime beneficiary’s death occurs to end at the end of the day on which that death occurs and deems the trust’s income for the year to have become payable to the lifetime beneficiary in that year.

Where subsection 104(13.4) applies to a trust and a beneficiary, they are held to be jointly and severally liable pursuant to subsection 160(1.4) for the tax. (However, the explanatory notes for that subsection provide that the Canada Revenue Agency will treat the trust as liable in the first instance for the tax.)

STEP and the other groups were primarily concerned with two issues with the new legislation. The first concern was the possibility that the tax liability under subsection 104(13.4) could be borne by the beneficiary’s estate, even though the trust’s property will be enjoyed by the trust’s beneficiaries.

The second concern surrounded charitable giving and the possible “stranding” of donation tax credits, which remain attributable to the trust, separate from the tax liability of the beneficiary. This could occur when an affected trust makes a gift of property after the death of the beneficiary. The effect of deeming all of the trust’s income for the taxation year in which the beneficiary dies to have become payable to the beneficiary, is that the trust itself will not have tax otherwise payable against which it can deduct the donation tax credit for the gift made.

The discussions with STEP and the other groups culminated in a suggestion by those groups that the tax treatment of these types of trusts should continue to apply to the income deemed to be recognized on the death of the beneficiary in the trust.

To enable this, the Department of Finance suggested that subsection 104(13.4) could remain largely as enacted, except paragraph 104(13.4)(b) would be amended so that it did not apply to a trust in respect of the death of a particular beneficiary unless:
a) the trust is immediately before the particular beneficiary’s death a testamentary trust that is a post-1971 spousal or common-law partner trust;
b) the trust was created by the will of a taxpayer who dies before 2017;
c) the particular beneficiary is resident in Canada immediately before the particular beneficiary’s death; and
d) the trust and the particular beneficiary’s graduated rate estate jointly elect in prescribed form to have that paragraph apply.

Also, in order to address the stranding issue mentioned above, there would be an option permitting a trust to allocate the eligible amount of a donation made by the trust after the beneficiary’s death, but during the calendar year in which the death occurs, to the taxation year in which the death occurs.

The Department of Finance claims that such a provision would be expected not to impose any additional compliance burden on the trust because paragraph 104(13.4)(c) has the effect of deferring the trust’s filing due date for that taxation year to the day that is 90 days after that calendar year.

The Department of Finance concludes the letter by stating that the main thrust of the new amendments to the Act are to ensure that trusts do not obtain unintended tax benefits, but that they will include in their consideration whether the above option should be recommended and whether additional amendments may be necessary to give effect to the overreaching objectives of fairness, neutrality and the prevention of tax base erosion.

Greer Jacks practices law in Victoria and contributes to the update of EverGreen Explanatory Notes and is an instructor of the Use of Trusts in Tax and Estate Planning Course.

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