A qualified disability trust (“QDT”) is a testamentary trust that can be set up for disabled beneficiaries who are eligible for the disability tax credit. A testamentary trust basically means a trust that is set up under your Will, and takes effect after you die.
You might consider setting up a QDT if you have a disabled relative, because of the tax advantage described below.
Most trusts are subject to a flat tax on all taxable income at the highest marginal tax rate (typically 50% or more depending on the province). However, a QDT is subject to the graduated tax rates that apply to individuals, so that they typically pay much less tax on their income relative to most other trusts.
There are various conditions required to meet the QDT status. Essentially, a QDT for a taxation year is a testamentary trust that meets all of the following tests:
- The trust arose on and as a consequence of the death of an individual;
- The trust is resident in Canada for the taxation year (this is normally determined by its “central management and control” − where the trust is controlled from);
- The trustee of the trust makes a joint election in the trust tax return for the taxation year with one or more beneficiaries (“electing beneficiaries”) that are eligible for the disability tax credit;
- The electing beneficiary is named as a beneficiary in the will or other testamentary instrument that created the trust; and
- The electing beneficiary does not make such an election with any other trust for that trust’s taxation year, meaning that each electing beneficiary can benefit from only one QDT per taxation year.
If a QDT no longer qualifies as a QDT in a taxation year, it may be subject to a “recovery tax”, summarized below. A QDT can cease to qualify in a taxation year if:
- None of the beneficiaries at the end of the year was an electing beneficiary in previous taxation years. In other words, at least one beneficiary must have been an electing beneficiary in a previous year; or
- The trust ceased to be resident in Canada; or
- An amount is paid or distributed to a beneficiary in the year who is not an electing beneficiary, unless the amount was deducted in computing the trust’s income or was on account of an amount that was deducted by the trust in a previous year.
Basically, the last condition above prevents a QDT from retaining income in the trust, taxed at graduated rates, and then later distributing it tax-free as a capital distribution to a non‑electing beneficiary. If the trust does this, it will cease to be a QDT in the taxation year of that distribution.
The recovery tax, if applicable, is essentially imposed on the trust’s taxable income for each previous year in which it was a QDT that was distributed in a later year to a non‑electing beneficiary as a capital distribution (so that the non-electing beneficiary receives capital of the trust that was previously taxed at graduated rates and not the highest flat tax rate). In general terms, the recovery tax is then levied at the highest marginal rate in excess of the tax payable for that previous year.
The provision is quite complex. In its Explanatory notes to the provision, the Department of Finance explains that… “no tax is recovered …on the amount of a trust’s after-tax retained taxable income for a taxation year if that amount is distributed to one or more individuals during their lifetimes, those individuals were electing beneficiaries of the trust for the taxation year and no capital distributions are made to other beneficiaries before that amount, and similar amounts for other taxation years, are distributed to those individuals”. Otherwise, the recovery tax could apply.
One further note: Graduated rate estates
We have discussed this issue before, but we note it here because a “graduated rate estate” (GRE) is the only kind of trust besides a QDT that is subject to graduated tax rates rather than the high flat tax rate that applies to other trusts. (Your estate is considered a trust for income tax purposes.)
In general terms, your estate, from the date of your death and for up to 36 months, can qualify as a GRE. More specifically, the following conditions must be met.
Your estate will be a GRE at a particular time in a taxation year if:
- No more than 36 months have passed since your death;
- Your Social Insurance Number is provided in the estate’s tax return for the taxation year and for each of its earlier taxation years;
- The executor or trustee of the estate designates the estate as your GRE in its tax return for its first taxation year; and
- No other estate is designated as your GRE in a tax return for a taxation year. This means you can only have one GRE. (In most cases, a person has only one estate anyway.)