TAXATION OF TRUSTS AND BENEFICIARIES
Trusts and estates are treated as individuals and taxpayers under the Income Tax Act. As such, they must report any income and pay tax on their taxable income, if any.
Although they are considered individuals, most trusts do not qualify for the graduated tax rates that apply to other individuals. Most trusts are subject to a flat tax equal to the highest marginal rate that applies to other individuals. The federal rate is 33% and the provincial rate depends on the province. The combined federal and provincial rate is typically around 50% or more.
The reason the high flat tax rate is used is to prevent income splitting through trusts. For example, if the graduated rates applied to trusts, you could set up multiple trusts and split your investment income, using the graduated tax rates, among the various trusts.
Two exceptions, where the regular graduated tax rates are available, apply to “graduated rate estates” and “qualified disability trusts”. In general terms, the first is a deceased’s estate for up to 36 months after death, with certain conditions. The second is a testamentary trust (set up under a deceased’s will) with a beneficiary who is disabled and eligible for the disability tax credit; again, certain other conditions must be met. All other trusts are subject to the high flat tax rate.
A trust computes its income in much the same way as other taxpayers. However, it can deduct the income in a taxation year that is paid or payable to its beneficiaries in the year. (A couple of exceptions to this “paid or payable” rule are noted below.) The beneficiaries then include that amount in their incomes, and the individual beneficiaries will be subject to the regular graduated tax rates.
Every trust other than a graduated rate estate (GRE) must use a taxation year that is the same as the calendar year. A GRE can use the calendar year, or it can choose to have an off-calendar taxation year for up to 36 months. If it chooses an off-calendar year end, it will have a deemed year-end after 36 months (when it stops being a GRE) and after that it will have a December 31 taxation year end. This flexibility can be beneficial, as illustrated in the following example.
X dies on July 1, 2018. The graduated rate estate chooses a calendar year taxation year. Therefore, the first taxation year ends on December 31, 2018, and as such is a short taxation year. The next two taxation years end on December 31, 2019 and 2020, and the fourth taxation year is a short taxation year that ends on June 30, 2021. This means the trust has four taxation years (over 36 months) in which it can earn income subject to graduated tax rates, rather than three taxation years. In other words, it gets 4 chances instead of 3 to use the low marginal rates that apply to the lower brackets of taxable income.
As an alternative, the estate could choose to have a taxation year ending on June 30, through 2021 (i.e., as long as it is a GRE). In this case, the first three taxation years will end on June 30, 2019 to 2021. If the trust income is paid to a beneficiary, it is included in the beneficiary’s calendar year in which the trust taxation year ends. For example, if the trust earns income in September 2018 and pays it out immediately to a beneficiary, the income is included in the beneficiary’s 2019 income, because the trust’s taxation year ends on June 30, 2019. This allows some deferral of tax.
There are various flow-though rules that maintain the character of the income in the beneficiaries’ hands. For example, if a trust receives dividends from a Canadian corporation and pays them out to a beneficiary, the trust can designate them to be dividends for the beneficiary. The beneficiary can then claim the dividend tax credit. Similar rules apply to capital gains, including those that qualify for the capital gains exemption for the beneficiary (e.g. gains from shares in qualified small business corporations).
Deduction for income vested in beneficiary under 21
If the beneficiary is under the age of 21, and their right to trust income in a year has become “vested indefeasibly”, the trust can deduct that income in the year even if it does not pay it to the beneficiary in the year. The beneficiary will then include the amount in their income. This rule allows the trust to retain more after-tax income, since the income will be taxed at the beneficiary’s graduated tax rates, rather than the trust’s high flat tax rate.
Since the beneficiary’s right must be vested indefeasibly (basically meaning that the beneficiary has entitlement to the amount), it means that they should receive it in a later taxation year. The subsequent receipt of the amount will be considered a capital receipt, not subject to further tax. Certain other conditions must be met.
Preferred beneficiary election
This is another situation where the trust can claim a deduction even though it does not pay its income in the year to a beneficiary. The beneficiary must be a “preferred beneficiary”, which generally means a disabled individual; again, certain other conditions must be met.
The trust can allocate an amount of its income to the preferred beneficiary, who includes it in their income. The trust deducts that amount from its income. The income is therefore taxed at the beneficiary’s graduated tax rates even though it remains in the trust. If the amount is paid out in a later year, it will not be subject to further tax.
Election to pay out income but remain included in trust’s income
Another rule allows a trust to pay its income to a beneficiary but not deduct that amount, so that it remains income for the trust but is not taxable to the beneficiary. The rule allows the trust to use loss-carryforwards to offset the income inclusion so that it does not pay tax on the amount.
A trust has $40,000 of unused non-capital loss carryforwards from previous years (they can be carried forward for up to 20 years). In the current year, the trust has $40,000 of investment income. It pays out the $40,000 to its beneficiary.
If the trust makes an election and does not deduct the $40,000 paid to the beneficiary, the $40,000 income remains income of the trust. However, it can use its $40,000 non-capital loss carry-forward to offset the inclusion, resulting in no tax for the trust. The beneficiary receives the $40,000 free of tax.
This rule applies only if the loss carry-forward brings the trust’s taxable income down to nil. This means that the loss carry-forward must completely offset the trust’s income. For example, if only $30,000 of the trust’s loss carry-forward in the above example was used, the trust could not make the election.
Deemed disposition dates for trust
In order to prevent trusts from deferring the taxation of accrued gains indefinitely, the Income Tax Act provides that most trusts are deemed to dispose of their properties and reacquire them at fair market value every 21 years. Any accrued gains and losses will be triggered upon the deemed disposition, which may result in tax being payable by the trust. There are exceptions. For example, the deemed disposition does not apply to mutual fund trusts.
For certain trusts, such as qualified spousal trusts and “alter ego” trusts, the first deemed disposition applies on the death of the beneficiary − the spouse for the former, and the person who created the trust (the "alter ego") for the latter. After that, the 21-year rule applies.