Publication
TITRE
Income Splitting with Testamentary Trusts
DATE
16 octobre 2007
Canadian taxpayers are subject to a progressive income tax system in which the rate of tax increases as the level of income increases. As a result, for many years, taxpayers have been diligently searching for ways to divert income to other family members who have little or no income and who will therefore pay tax at lower rates. Just as diligently, the tax authorities have regularly amended the Income Tax Act to foil these income-splitting techniques, usually by "attributing" the diverted income back to the high-rate taxpayer. With few exceptions, income-splitting for the average taxpayer is now very difficult.
However, taxpayers who receive good estate planning advice can still come out ahead. Generally, the attribution rules credit the diverted income back to the high-rate taxpayer if he is living and is a resident of Canada. Most Canadians are reluctant to give up their status as Canadian residents. However, we will all eventually die and thus cease to be affected by these attribution rules. This makes our last will and testament an effective tool for helping our adult children hold their inherited funds in a tax-efficient manner.
Consider a hypothetical Canadian taxpayer who has been predeceased by his wife and dies leaving three adult sons - each with a spouse and two children. He will, in all likelihood, divide his estate equally among his three sons. Assuming that he has an estate of $3 million, each son will inherit $1 million. In 2007, if each son has annual taxable income in excess of $120,000, his marginal rate of tax in Ontario will be approximately 46 per cent. Accordingly, if he manages to earn interest on his inheritance at a rate of five per cent, he will have additional income of $50,000 per annum, which after paying tax of $23,000 will be reduced to $27,000. If he could split that $50,000 among several low-rate taxpayers, the total tax bill would be significantly less.
Unfortunately, the aforementioned attribution rules severely restrict the son's ability to split his income with lower income family members. In this case, however, his father can do it for him! Instead of leaving the $1 million directly to each son, the father can leave it to a discretionary testamentary trust for each son and his family. The trust, established in his will, would direct that the income derived from the $1 million be divided among his son, his son's wife, and their children and grandchildren, in whatever manner the trustees of the trust decide is appropriate.
In this example, the trustees would likely divide the $50,000 into four equal shares - with one share being paid to his wife and each of his children and taxed in their hands. One share would also be distributed to the wife and the children, but would be taxed in the hands of the trust itself. (A testamentary trust is treated as its own taxpayer, paying tax at graduated rates.) Assuming none of the family members or the trust has any other income, the total tax paid on the $50,000 divided in this manner would be $5,625. This leaves a net amount after tax for the family of $44,375 - an increase of approximately 64 per cent. Payments to or for the children can in most cases find their way back into the hands of their father as reimbursement to him of amounts paid on their behalf for the cost of schools, camps, equipment, travel, etc.
One of the perceived disadvantages of this structure is that, although the son realizes tax advantages, he loses the benefit of having control over the funds. This need not be the case. The father's will should clearly state that in exercising their discretion, the trustees are to make his son's wishes their primary consideration. The trustees can be given the authority to distribute capital to the son or other members of the family at any time. In addition, the son can be one of the trustees or even the sole trustee of the trust for himself and his family.
Those who are familiar with the taxation of trusts will be concerned about the "21 year rule". A trust such as the one we have described is deemed for tax purposes to have disposed of all of its capital property every 21 years. The first deemed disposition will occur 21 years after the death of the father whose will established the trust. However, this deemed disposition and the resulting taxation of accrued gains can be avoided by distributing the assets of the trust prior to the expiry of the 21 years. In the example set out above, the assets could be divided among the members of the son's family or distributed to any one or more of them as the trustees see fit. If the son decides he still needs or wants the money, it can be paid to him. He will then be in the same position as if the $1 million had been left to him outright, except that he will have enjoyed 21 years of tax savings. The assets will form part of his estate when he dies and there will be tax paid on any accrued gains at that time in the normal course. Alternatively, if the son does not need the additional assets, the trustees can distribute them to his wife and/or children. By having them distributed to his children, he will be eliminating one generation of capital gains tax because the next deemed disposition will only arise on the death of the child. This process of skipping one round of capital gains tax also incidentally skips a round of estate administration tax - commonly known as probate fees.
Saving income tax through income splitting; saving capital gains tax by skipping a generation; and eliminating probate fees. Where is the downside? The only downside is the modest administrative cost of filing extra tax returns and some up-front legal fees for a more sophisticated will plan.
While baby boomers struggle to decide how to best distribute their assets among adult children, their advisors should consider recommending income splitting through testamentary trusts - an excellent strategy to provide long-term tax saving opportunities.
The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault LLP or any member of the firm on the points of law discussed.
For further information, please contact:
Peter E. Lockie (416) 216-4813
plockie@ogilvyrenault.com
