Wednesday, November 01, 2006

Federal Tax Changes to Income Trusts, Age Credits and Pensions

Yesterday's announcement by the Federal Minister of Finance, Mr. Jim Flaherty, that the Government will be making significant changes to the way income trusts are taxed has caused quite a stir on the financial markets and in the House of Commons. I enjoy the political show, but I am most interested in how the changes might affect some of the estate planning I do with my clients.

I expect that I will have some clients ask me whether any of these changes will affect their family trusts, or trusts provisions in their wills. I can't be sure of the answer yet. But, after reading the press release, I expect that the changes will not change the way personal trusts are taxed.

The way the Canadian income tax system works, when a corporation earns income, the income is taxed at a corporate rate. When the corporation pays out some of its profits to the shareholders, the shareholders are taxed again. For large corporations, the rates of taxation are such that the combined amount of corporate tax and the tax the shareholders pay, may be more than if all of the income were earned directly by the shareholders, instead of through a corporation.

By using a trust rather than a corporation, businesses were able to give some of their investors a better after-tax return. The trust distributed profits to investors, and the investors paid all of the tax on their income, but the trust didn't have to pay any tax on the income the trust distributed. The tax liability was flowed through to the investors. Instead of the two layers of tax with a corporation, income earned by an income trust was taxed once.

The Federal Government is proposing to tax the income trusts and other flow through entities such as some partnerships in a similar manner to large corporations. To the extent that the income trusts distribute their profits to investors, the income trusts will have to pay tax at corporate tax rates, and the income distributed to investors will be taxed as dividends.

Fortunately, it appears from the Department of Finances press release that the new tax treatment will only apply to trusts that meet several conditions including being "listed on a stock exchange or other public market." If so, this should not affect personal trusts, such as family trusts, and trusts created in wills.

The Minster also announced a couple of tax changes to benefit seniors--perhaps to make the rest of the announcement more palatable. The good news includes, to quote the press release, "An increase in the Age Credit Amount by $1000 from $4,066 to $5,066 effective January 1, 2006. This will benefit low and middle-income seniors."

Additionally, the Government plans to allow income splitting of some pension and retirement income between spouses or common law partners. This will benefit couples who have significant disparities in their pension or retirement income, by allocating some of the income to the person who is in the lower tax bracket. According to the press release,
For individuals aged 65 years and over, eligible pension income includes lifetime annuity payments under a registered pension plan, a registered retirement savings plan or a deferred profit-sharing plan and payments out of or under a registered retirement income fund. For individuals under 65 years of age, eligible pension income includes lifetime annuity payments under a registered pension plan and certain other payments received as a result of the death of the individual’s spouse or common-law partner.

For income tax purposes, the amount allocated will be deducted in computing the income of the transferor (the person who actually received the pension income) and included in computing the income of the transferee (the person to whom some or all of the pension income is allocated). Since it will in many cases increase the transferee’s tax payable, both persons must agree to the allocation in their tax returns for the year in question.

Why not allow spouses and common law partners to split all kinds of income?I have never thought it made sense to tax the household in which one spouse earns $80,000 and the other spouse $20,000 more than the household in which each spouse earns $50,000.

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