A testamentary trust or not a testamentary trust, that is the question

Introduction

According to Canada Revenue Agency (CRA), a trust receiving funds from a life insurance policy as a consequence of the death of an individual will be considered a testamentary trust notwithstanding that the terms of the trust may have been established prior to the individual’s death.

However, CRA has also stated that a trust created by the trustees of an inter vivos trust, such as an alter ego trust or joint spousal trust, following the death of the individual/settlor is not considered a testamentary trust.

The benefit of being considered a testamentary trust is that any income retained in the trust is taxed at the graduated income tax rates¹ whereas inter vivos trusts are taxed at the highest marginal tax rates which when combined with provincial tax rates may approach 50% depending on the province.

Testamentary Trusts

A testamentary trust is defined in subsection 108(1) of the Income Tax Act (the “Act”) as a trust or estate that arose on and as a consequence of the death of an individual but excludes: 

  • trusts created by a person other than the individual; and 
  • trusts created after November 12, 1981 if property has been contributed to the trust otherwise than by an individual on or after the individual’s death and as a consequence thereof.

Analysis

As set out in income tax rulings, RID # 9238555, 9605575 and 2001-0075375, CRA considers a trust funded from the proceeds of a life insurance policy as a consequence of the death of an individual and whose terms have been established by the individual prior to his or her death to be a testamentary trust.

CRA’s opinion is based on the fact that the trust was not settled (i.e. no amount was transferred to the trust) prior to the receipt of the insurance proceeds as a result of the individual’s death, that the individual was the owner of the life insurance policy and had designated the trust as the beneficiary of insurance policy and that the insurance designation was a testamentary instrument. It remains CRA’s view that a trust settled prior to the individual’s death remains an inter vivos trust following the death of the individual even though it may receive the bulk of its capital as a beneficiary under an insurance policy.

Also, as set out in CRA’s ruling, RID #2001-0075375, they take the position that a trust created by the trustees of an alter ego or joint spousal trust and settled with proceeds from the alter ego or joint spousal trust is an inter vivos trust and not a testamentary trust.

Such a trust fails to satisfy the definition of a testamentary trust (as set out above) as the trust would be considered to be created by the alter ego or joint spousal trust and not the individual as required.

In addition, a testamentary trust requires that property be contributed to the trust by the individual on or after his or her death. Contributions from an alter ego or joint spousal trust are not considered contributions by the individual. It is CRA’s understanding that a person cannot transfer his or her property on or after his or her death otherwise than by will or other testamentary instrument (such as an insurance designation).

It is important to remember that for the purposes of the Act, an annuity is considered a life insurance policy. Therefore, proceeds payable from segregated funds for example, as a consequence of the death of an individual will be eligible to be contributed to a testamentary trust provided the other rules set out above are satisfied.

Taxation of Trusts

Pursuant to subsection 104(2) of the Act, trusts are taxed as individuals, i.e. subject to the graduated tax rates¹. However, subsection 122(1) of the Act deems inter vivos trusts to be taxed at the highest marginal tax rate, which when combined with provincial taxes will approach 50% depending on the province.

Please note that this article is based on information available at the time of publication and is summarized here for general information purposes only. We recommend that clients seek the advice of a professional to discuss their specific situation.

Budget 2013 announced the intention to phase out graduated rate taxation for testamentary trusts starting in 2016. Testamentary trusts that benefit disabled individuals eligible for the disability tax credit will continue to be taxed at graduated rates.

Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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