Moore
October 2015 Newsletter

General rules

A trust is a taxpayer under the Income Tax Act (“ITA”), and is deemed by the ITA to be an “individual”, so that it must file a tax return, subject to many exceptions to the tax rules that apply to individuals. There is a special return for a trust, the T3 return, along with relevant schedules. An estate (after a person’s death) is considered a trust for purposes of the ITA.

In many ways, a trust computes its income and taxable income in the same manner as other individuals. For example, it will determine its income from business or property, or taxable capital gains, using most of the same rules that apply to individuals. A trust’s tax payable is computed by applying the relevant tax rate to its taxable income.

Deduction and flow-through of income to beneficiaries

In computing a trust’s income, it can normally deduct any income (including taxable capital gains) for the year that is paid or payable to a beneficiary. This amount is then included in the beneficiary’s income.

As a general rule, the beneficiary’s income from the trust is considered generic income from property.

However, in some cases, the trust can designate an amount paid out so that it retains its character to the beneficiary as a different kind of income.

For example, if the trust pays out a taxable capital gain to the beneficiary and makes the appropriate designation, the amount retains its character for the beneficiary as being a taxable capital gain. The flow-through of character can be beneficial if the beneficiary has capital losses available, since such losses can only offset capital gains and not other kinds of income.

Similarly, a trust can designate taxable dividends that it received and pays out to a beneficiary, so that they remain taxable dividends in the beneficiary’s hands. An individual beneficiary can then use the gross-up and dividend tax credit mechanism that applies to dividends received from Canadian corporations. A beneficiary that is a Canadian corporation can deduct the dividends in computing its taxable income.

In each case, the trust must provide the beneficiary with a T3 slip for the year, indicating the amount and type of income distributed to the beneficiary.

Tax rate of trust

A “trust” is normally subject to a flat tax rate equal to the highest marginal rate, which is currently 29% for federal tax purposes. With provincial taxes, the combined rate will be about 40 – 50% depending on the province in which the trust is resident.

However, as discussed above, trust income paid or payable to a beneficiary is normally taxed to the beneficiary rather than the trust. Such income will of course be subject to the graduated rates applicable to the beneficiary.

Until the end of 2015, a “testamentary trust” is subject to the same graduated tax rates as other individuals rather than the high flat rate. Generally, a testamentary trust is one that arises upon death, including an estate and any trust set up by the deceased’s will.

However, starting 2016, a testamentary trust will be subject to the same flat tax as other trusts. There will be two exceptions, where the graduated rates will continue to apply. The first exception is a “graduated rate estate”, which essentially means a deceased’s estate for up to 36 months after death. The second exception is a “qualified disability trust”, 2

which is generally a testamentary trust with a disabled beneficiary who is entitled to the disability tax credit. As above, trust income paid or payable to a beneficiary will be subject to tax at the beneficiary’s graduated tax rates.

Election available where trust has loss carry-forwards

As noted, a trust’s income that is distributed (paid or payable) to a beneficiary is normally deducted in computing the trust’s income and included in the beneficiary’s income.

However, a trust can make a special election under which this income remains the income of the trust rather than that of the beneficiary (even though the income has been distributed to the beneficiary). This election is useful where the trust has loss carry-forwards available, which can be claimed against the income. The beneficiary then receives the income tax-free, since it is taxed at the trust level and not the beneficiary level.

Example

A trust has an unused business loss carryforward of $50,000 from 2013. In 2015, it has $40,000 of income, which it distributes to its beneficiary.

For 2015, the trust can make the special election with respect to the $40,000 distributed to the bene-ficiary. The $40,000 remains income of the trust, but it can be offset by $40,000 of the trust’s loss carry-forward (out of the $50,000 available).

As a result, the trust will have no taxable income and pay no tax. Similarly, the $40,000 amount distributed to the beneficiary will be tax-free to the beneficiary.

Note: Beginning in 2016, this special election is available only if the trust’s taxable income is nil. Basically, this means the trust must use all available “Division C” deductions under the Act to bring its taxable income down to nil – loss carry-forwards being the main such deduction. This new rule would not affect the example above, since the trust’s taxable income, after applying the loss-carry-forward, was nil.

Situations where beneficiary is taxed on income retained in trust

There are two situations under which the trust gets a deduction for its income that is not distributed to a beneficiary and thus retained in the trust. In these cases, the income is taxed to the beneficiary rather than the trust.

First situation: Where a trust has a “preferred beneficiary”. Basically, this means a disabled beneficiary who is the settlor of the trust, the spouse or common-law partner of the settlor, or a child, grandchild or great grandchild of the settlor.

The trust and the preferred beneficiary can jointly elect in a taxation year for any of the beneficiary’s share of the trust income for the year to be included in the beneficiary’s income rather than the trust. This election can be useful where the beneficiary’s average tax rate is lower than that of the trust, which will often be the case.

Second situation: This situation deals with a trust where a beneficiary is less than 21 years of age. In this case, if the beneficiary’s right to trust income in a year is “vested” in the beneficiary but is not distributed to the beneficiary in the year, it is included in the beneficiary’s income rather than the trust’s income. The right must vest unconditionally, or with the sole condition being that the beneficiary must survive to an age not exceeding 40.

Tax instalments

A trust is generally required to make quarterly instalments of tax, if its net tax for the taxation year and one of the two preceding years exceeds $3,000 ($1,800 federal tax for trusts resident in Quebec).

For 2015, a testamentary trust is not required to make instalments. However, beginning with the 2016 taxation year, testamentary trusts other than graduated rate estates (see above) will be required to make instalments.

Regardless of the kind of trust, current CRA administrative policy is not to impose either interest or penalty on a trust for unpaid or under-paid instalments, so many trustees ignore the requirement to pay instalments.

Taxation year

As of 2016, trusts must generally have a taxation year that coincides with the calendar year. However, a graduated rate estate can use an off-calendar year.

Last modified on October 14, 2015 12:00 am
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