(2) A separate taxpayer in the form of a trust is created and that taxpayer is taxed at progressive rates like the way individuals are taxed. The income of the trust may be taxed in the trust or be distributed to the beneficiaries so that they pay tax on it. As the income is spread among more than one taxpayer, it would be taxed at a lower rate.

(3) In cases where the trustees have the discretion to distribute or not to distribute income of the trust and in what amount to its beneficiaries, such discretion can be exercised in a way that beneficiaries at a higher tax bracket receive less distribution from the trust whereas those at a lower tax bracket get more, resulting in an overall effect of lower amount of tax payable.

(4) Where the testamentary trust is a discretionary trust, creditors of the beneficiaries would not be able to demand payment from the trustees because the value of a beneficiary’s interest in the trust cannot be determined as it depends on the discretion of the trustees. However, some family law cases indicate that such protection is not foolproof when a spouse seeks division of net family property of the beneficiary.

In view of these advantages, one can appreciate the paramount importance of preserving the status of a trust as a testamentary trust. If such status was lost or “tainted”, the trust would become an inter vivos trust, which is taxed at the top marginal rate (over 46% in Ontario for the current year), which is obviously undesirable. Under the Income Tax Act (Canada) (the “Act”), any trust that is not a testamentary trust is an inter vivos trust (with certain narrow exceptions).

A testamentary trust would be “tainted” if individuals other than the deceased person who created the trust contributed property to the trust. However, there is an exception for testamentary trusts created before November 13, 1981 provided that the contribution was made on or before June 28, 1982.

On February 27, 2004, amendments to the Act were proposed to create a new way by which a testamentary trust will be “tainted” and rendered an inter vivos trust. The proposed legislation provides that a testamentary trust will lose its status in a taxation year if after December 20, 2002 and before the end of the taxation year, the trust incurs a debt or any other obligation to pay an amount to, or guaranteed by, a beneficiary or any other person or partnership with whom any beneficiary of the trust does not deal at arm’s length (the “specified party”). In very general terms, individuals who are married, in a common-law partnership or related by blood (i.e., siblings, parents and children etc.) and the corporations and partnerships controlled by them are all not dealing at arm’s length.

The proposed legislation is an anti-avoidance rule in response to concerns that beneficiaries of a testamentary trust paying tax at the top marginal rate lending funds to the trust for the purpose of income-splitting. The proposed legislation provides for a few narrow exceptions like debts or obligations arose because of services rendered by the specified party or payments made by the specified party for or on behalf of the trust.

Although the proposed legislation has yet to be proclaimed into law, only minor amendments are expected and it is unlikely for the effective date of December 20, 2002 to be changed. It means that once the proposed legislation is proclaimed into law, it will be applied retroactively. Accordingly, taxpayers should take steps now to address any issues in connection with the proposed legislation rather than to wait until it becomes law.

Our firm is experienced in preparing wills that create testamentary trusts. We also provide on-going advice to trustees on the administration of trust and ways to prevent a testamentary trust from losing its status.