The Canadian government has made various amendments to the income tax legislation to prevent taxpayers from manipulating the rules to save taxes. These include the loss of a trust’s “testamentary” status if there is a debt between the trust and beneficiary which does not satisfy the arm’s length condition.
AG Tax professionals have prepared a brief summary on this recent change, including exceptions to the arm’s length condition.
A testamentary trust is a legal arrangement of a trust as a part of an individual’s will and comes into effect upon the death of the individual. Under a testamentary trust, a trustee (appointed by the individual) has the discretion to distribute capital and income between the beneficiaries nominated in the will and there can be as many testamentary trusts as there are beneficiaries. A testamentary trust is treated as a separate entity by law, which provides several benefits.
Benefits of testamentary trusts
• Graduated rates
One of the biggest advantages being taxation at graduated rates, which starts at 15% federally for income under $43,561 (in 2013) and rising to 29% once income is equal to or more than $135,000.
• Capital gain carry back
Capital losses incurred by an estate may be carried back to the deceased’s final tax return to offset other income, which helps to reduce the tax burden. However, if the trust loses its “testamentary” status, these capital losses go wasted leaving the trust’s income to be taxed at a potentially high rate.
Since a testamentary trust is a useful tool for minimizing taxes, it is advised that the trust avoids any monetary transactions with its beneficiaries, or relatives of beneficiaries, if it does not satisfy the above mentioned conditions.
Loss of testamentary status
However, “testamentary” status and its associated privileges may be lost if the trust carries out a monetary deal (loans or borrows) with a beneficiary, or anybody else dealt with by the beneficiary but not at arm’s length.
For example: If an estate comprises of illiquid assets (company shares/stocks and land), the necessary death payments, such as funeral expenses, are often paid by the beneficiary. If certain protocols are not followed, this transaction would lead to the loss of testamentary trust status.
Arm’s length transaction exceptions for testamentary trusts
The following transactions are exceptions to the arm’s length condition:
• If the trust borrows from the beneficiary in order to satisfy the beneficiary’s interest in the trust, such as payment of expenses by a beneficiary to carry out the income or capital distributions to beneficiaries.
• If the beneficiary pays for certain professional services (excluding transfer or loan of property), such as the trustee fee, on behalf of the trust.
• If the beneficiary is paying the deceased’s funeral expenses, fulfillment of the conditions below may help validate the debt:
o If the beneficiary paid the expenses for or on behalf of the trust;
o If the debt is repaid by the trust within 12 months, or any period that has been allowed by the minister; and
o If it is reasonable to conclude that the beneficiary would have made the payment even if it was an arm’s length transaction between the trust and beneficiary.
For more information on testamentary trusts, read the recent update by Bull Houser, one of Canada’s leading law firms dealing with estate planning.
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