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Pitfalls of Testamentary Trusts

October 25, 2013

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.

Testamentary Trust

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.

AG Tax LLP Can Help

If you have any tax-related queries, need assistance with tax planning or filing your tax returns please contact us. Our team comprises of highly experienced tax professionals with extensive knowledge of U.S. and Canadian tax laws as well as cross-border compliance

Furthermore, as a full service accounting firm, AG Tax assures complete assistance with even your most complex tax needs.

We can assist with:

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  • Estate Planning, Inheritance tax advice

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Disclaimer: The information in this publication is accurate as of the time of its publication. AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document. The information provided is for general information purposes only and should not be acted upon without seeking professional advice. If you would like to engage our services, please contact our staff and obtain authorization to send our firm confidential information. A client relationship is not created by the transmission of information. A client relationship is only formed with our firm when a scope and engagement letter signed by the firm and the potential client detailing the terms of engagement is present.

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With offices across Canada, we are positioned to manage and process the full scope of your Canadian, US and US Canada cross-border tax filing needs.
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With offices across Canada, we are positioned to manage and process the full scope of your Canadian, US and US Canada cross-border tax filing needs.
12752 28th Ave, Surrey, BC, V4A 2P4
104–4220 98 St NW Edmonton AB, T6E 6A1

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