How Trusts are Taxed in Canada
Taxation of Trusts
The taxation of trusts and their beneficiaries are dealt with under Sections 104 to 108, inclusive, of the ITA. The fundamental principle with respect to taxation of trusts and estates is given in Subsection 104(2) of the ITA, which considers a trust or estate to be an “individual” for tax purposes. A trust (which includes estates) created by a will, also known as a testamentary trust, and the estate of a taxpayer who has died intestate are both treated, for tax purposes, as trusts. Consequently, inter vivos and testamentary trusts and estates are made distinct taxable entities. However, the estate of a deceased is separate and distinct from the deceased for tax purposes. The income of the deceased is taxable until the day of death and any income after that time is taxed separately as the estate’s income. An important and useful exception to this principle is given under ITA, s. 164(6), permitting the estate to transfer capital losses and terminal losses incurred during its first taxation year against the deceased’s income in the year of death. Considering that a trust or estate can own property or even carry on a business, it is subject to income tax on the taxable income derived from the property or earned from the business, including any taxable capital gain and recapture incurred on the sale of its capital or depreciable property.
A trust or estate can also be regarded as a channel for tax purposes because the incomes of the trust flow out to its beneficiaries for them to spend as they like. Naturally, such amounts are regarded as income to the beneficiaries and, in order to ensure that the trust is not taxed on the same income twice, the ITA provides the trust with a deduction for all amounts going out to beneficiaries. There are two situations in which a trust or estate may flow income through to its beneficiaries and claim a deduction:
1) Where the trust or estate actually distributes the income to its beneficiaries; and
2) Where the income is “payable”, although not actually paid, to the beneficiaries.
Though there are no provisions in the ITA for determining the residence of a trust or estate, subsection 104(1) of the ITA states that a reference to a trust or estate in the ITA is to be read as a reference to the trustee, executor, or other legal representative “having ownership or control of the trust property”. As the clause indicates, the relevance of the residence of the trustees becomes a question of fact to be determined according to the circumstances in each case. In general, a trust is considered to be located where the trustee, executor, administrator, or other legal representative who manages the trust or controls the trust’s assets resides.
For an inter vivos trust, the taxation year has to always coincide with the calendar year (ITA, ss. 104(2) and 249(1)). The taxation year, for a testamentary trust or estate could (but need not) be the calendar year. Under ITA, s. 104(23) it can be the period for which the accounts of the trust are ordinarily made up, or, in the absence of an established practice, any period adopted by the trustees for that purpose, provided the period does not exceed twelve months. The day after the death of the taxpayer is the beginning of the first taxation period of a testamentary trust, which ends at any time within the next twelve months selected by the trustees. For maximum deferral of tax, usually the fiscal year of a testamentary trust or estate is based on the twelve month period following the day of the taxpayer’s death. However, for convenience of accounting or timing of income, a personal representative would perhaps like to select some other fiscal period. A change in the taxation year of a testamentary trust can only be made with the permission of the Minister of National Revenue.