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RBC Wealth Management Services Testamentary trusts A reason to consider amending your Will

It is common to distribute your assets on death outright to your loved ones. A testamentary trust is an alternative to a direct or outright distribution of assets. It allows you to control the timing and distribution of assets to your beneficiaries. The assets held in the trust are invested and managed by the of the trust, who distributes the income and capital to the beneficiaries in accordance with your wishes stated in your Will. This article discusses reasons why you may want to consider amending your Will and reviewing your current ownership structure to provide for a transfer of some or all of your assets to a testamentary trust.

This article outlines several strategies, not all of which will apply to your particular circumstances. The information is not intended to provide legal or tax advice. To ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, Please contact us you should obtain professional advice from a qualified tax and/or legal for more information advisor before acting on any of the information in this article. about the topics discussed in this What is a testamentary trust? contributed to it by anyone other than the deceased individual as a article. A testamentary trust is a trust or estate that is generally created on consequence of that individual’s death. the day a person dies. The terms Directions for the creation of a of the trust are established in the testamentary trust and the terms of deceased person’s Will, by court order, the trust should be specified in your in relation to the deceased’s estate, Will. The Will should identify, among or by a separate trust document, in other things, the amount of money or the case of a testamentary insurance other property to be held in the trust, trust funded by a death benefit on the the beneficiaries of the trust property, individual’s death. the and their powers, the Generally, this type of trust is only duration of the trust, and when and created by a deceased individual and how distributions are to be made. comes into existence or is funded It is common practice (but not on the death of the individual. A mandatory) to have the executor testamentary trust can lose its of your estate also be the trustee status as a testamentary trust for of any testamentary trusts created. tax purposes if any property is Testamentary trusts may have 2 | RBC Wealth Management

a lifespan of a few years or may Taxation of testamentary trusts continue for many years after the Before January 1, 2016 initial administration of your estate has been completed. For more One of the benefits of having a information on appointing an testamentary trust has been the executor or trustee, or for any estate income tax advantages for the planning questions, please speak with surviving beneficiaries, which your RBC advisor, who can arrange an are not available to beneficiaries introduction to an RBC Estate & Trust that receive outright inheritances. Services advisor. Currently, taxable income earned in a testamentary trust is subject Since generally only assets passing to the same graduated tax rates through your estate can be as an individual taxpayer (this is subject to change after December Currently, taxable transferred to a testamentary trust 31, 2015). Since the income earned income earned in a (an exception exists for insurance proceeds that may be paid directly within a testamentary trust is testamentary trust is to the trust, rather than through the taxed on a separate tax return at subject to the same estate), taxes will likely have graduated tax rates, an income- graduated tax rates as to be paid. Furthermore, once your splitting opportunity arises for your an individual taxpayer testamentary trust is established, beneficiaries. (this is subject to annual trust tax returns may be change after December required. Probate taxes and the For example, let’s assume an adult 31, 2015). additional costs and complexities of child is in the top marginal tax preparing annual trust tax returns are bracket of approximately 46% (top two reasons that may deter you from marginal tax rate varies by province). establishing a testamentary trust. Upon the parent’s death, this child is expected to receive an inheritance Testamentary spousal trust of approximately $500,000. Further assume that this inheritance will If a spouse is a of your be invested to earn annual taxable testamentary trust, consider setting up income of 5% of the inheritance or a testamentary spousal trust, where $25,000 per year. The following table the assets may roll over to the trust at illustrates the income tax benefit prior their adjusted cost base (ACB). Speak to January 1, 2016 of investing an to your RBC advisor for a copy of the inheritance through a testamentary article “Testamentary Spousal Trusts” trust for the child’s benefit compared if you are interested in learning more to the child directly holding the about testamentary spousal trusts. inheritance and investing it.

Inheritance transferred to the Inheritance transferred to adult child outright a testamentary trust*

Taxable income $25,000 $25,000

Tax payable ($11,500) ($5,000)

Trust tax return fees $0 ($500)

Net income $13,500 $19,500

*It is assumed that trustee fees are nil and the trust is taxed at 20%. RBC Wealth Management | 3

As you can see in the table, the adult to the beneficiaries are taxable to child enjoys an overall savings of the beneficiaries on their personal $6,000 ($19,500 – $13,500) per year by tax return at their marginal tax rates. The graduated rates earning investment income through a If the beneficiaries have a higher testamentary trust. marginal tax rate than the trust, the for testamentary trustee can elect to have the amounts trusts will be However, there are some things you paid to the beneficiaries taxed in the replaced with flat need to keep in mind: the basic testamentary trust at graduated tax personal exemption is not available rates. This election serves to decrease top-rate taxation when completing a tax return for the tax owed by the beneficiary on the that’s currently used any trust including a testamentary income they receive from the trust. for most inter-vivos trust, and transferring assets to the After December 31, 2015, this election estate to establish the testamentary will no longer be available unless the trusts, subject to two trust could result in upfront probate trust has losses carried forward from exceptions. taxes. In our example, the estate could prior years. owe up to $7,500 (based on Ontario’s probate tax of 1.5%, the highest in After December 31, 2015 Canada: $500,000 x 1.5% = $7,500). The 2014 federal budget eliminated This probate tax would eliminate graduated tax rates that currently the tax savings of $6,000 and result apply to testamentary trusts, certain in an additional cost of $1,500 in estates and grandfathered inter- the first year; whereas transferring vivos trusts beginning in 2016. The the inheritance directly to the child graduated rates for testamentary without it passing through the estate trusts will be replaced with flat top- on the death of the parent (using rate taxation that’s currently used for non-registered accounts held in joint most inter-vivos trusts, subject to two tenancy with right of survivorship exceptions. An estate that designates [JTWROS] – not available in Quebec itself as a “graduated rate estate” will – or beneficiary designations, etc.) generally be subject to graduated rate would not be subject to probate. In taxation for the first 36 months of its addition, as discussed later on, after existence. As well, graduated rates December 31, 2015, testamentary will continue to apply in respect of trusts will be subject to flat top-rate testamentary trusts for the benefit of taxation, so there will be no tax disabled individuals who are eligible savings in taxation years after this date. for the federal Disability Tax Credit where the trust and the qualifying On a positive note, any assets beneficiary have jointly elected for the remaining in a testamentary trust trust to be a “qualified disability trust” after the death of the primary for a particular taxation year. beneficiaries can avoid a second probate tax. That is, assets remaining In addition, all testamentary trusts, in the testamentary trust that are ex­cept for graduated rate estates, will distributed according to the terms of be required to have a December 31 the trust to contingent beneficiaries year-end. (There are other related after the death of the primary measures that are beyond the scope beneficiaries do not form part of the of this article.) These measures will estate of the primary beneficiaries. apply to both existing and new trust arrangements for 2016 and later tax In addition, if the income earned years. and capital gains realized within the testamentary trust are paid out or As a result of the new measures made payable to the beneficiaries, in the budget, the tax benefits of then it is not taxed within the trust. testamentary trusts mentioned in Instead any income and realized the previous section of this article capital gains paid or made payable will generally only be available for a 4 | RBC Wealth Management

limited time. You should be aware, T3 return of income for the year to however, that while the measures be a qualified disability trust for the may increase the amount of tax year. In addition, for the trust to be a the trust will pay on investment qualified disability trust for the year: income, the negative tax effects may be reduced by taking certain steps. ●● the election must include the For example, where the terms of the electing beneficiary’s Social trust allow income to be distributed Insurance Number; to the beneficiaries, the trustee can ●● the electing beneficiary must be an elect to pay out the trust income to individual, named as a beneficiary the beneficiaries. In this case, the (e.g. John Doe) in the instrument income will be taxed at their marginal that created the trust. For example, tax rates. This may result in some tax if the deceased set up the trust for savings if their marginal tax rate is As well, graduated "my issue" then the beneficiary lower than the trust’s tax rate. Also, rates will continue to cannot elect to have the trust the trustee may choose to invest in apply in respect of treated as a qualified disability tax-efficient investments. testamentary trusts trust. for the benefit of Graduated rate estate disabled individuals ●● the electing beneficiary must be A graduated rate estate of an who are eligible for eligible for the disability tax credit; individual is an estate that arises the federal Disability on and as a consequence of the ●● the electing beneficiary must not Tax Credit where individual’s death and satisfies the make an election in respect of any the trust and the following conditions: other trust; qualifying beneficiary have jointly elected ●● the estate is a testamentary trust for ●● the trust must be factually resident for the trust to be a tax purposes; in Canada (i.e., not a non-resident “qualified disability trust that is deemed to be resident ●● no more than 36 months have in Canada); trust” for a particular passed since the deceased’s date of taxation year. death; ●● the trust must be resident in Canada for the year (and not just ●● the estate designates itself, in its the end of the year); and T3 return of income for its first taxation year (or if the estate arose ●● the requirement to pay a recovery before 2016, for its first taxation tax cannot apply to the trust for year after 2015), as the individual’s the year (a detailed discussion graduated rate estate; on the recovery tax is beyond the scope of this article but is briefly ●● no other estate is designated as mentioned later). a graduated rate estate of the individual (there can only be one An electing beneficiary is an individual graduated rate estate); and beneficiary under the trust who qualifies for the federal disability tax ●● the estate includes the deceased credit, and who has jointly elected individual’s Social Insurance with the trust for the trust to be a Number in its return of income for qualified disability trust for the year. each taxation year of the estate that ends after 2015. This means that a testamentary trust can be a qualified disability trust in Qualified disability trust one year but not in another year. It A qualified disability trust is a is an annual election that gives the testamentary trust that jointly testamentary trust its status as a elects, together with one or more qualified disability trust. beneficiaries under the trust, in its RBC Wealth Management | 5

Recovery tax, that was mentioned Non-financial benefits of a previously, is generally a claw back testamentary trust of tax savings enjoyed by a qualified Despite the changes to the tax disability trust for income taxed at treatment of testamentary trusts, graduated rates in a previous year testamentary trusts still provide but where that capital was or will be significant subsequently distributed to a non- opportunities and should be electing beneficiary. considered for reasons other than A qualified disability trust will have to taxation. Testamentary trusts can be pay a recovery of tax if: used to create solutions to complex family situations – a disabled

●● none of the beneficiaries at the child, a spendthrift beneficiary, end of the year are an electing grandchildren in need, a second beneficiary for a preceding year; marriage, etc. Despite the changes to the tax treatment of ●● the trust ceased to be resident in Protecting beneficiaries with testamentary trusts, Canada; OR special needs If you have a disabled child, you testamentary trusts still ●● a capital distribution is made to may want to ensure that they are provide significant estate non-electing beneficiary. planning opportunities well taken care of, both physically and financially, after you are gone. and should be 21-year deemed disposition rule A testamentary trust may allow considered for reasons It is important to be aware of the you to set aside funds and name a other than taxation. deemed disposition rules for trusts, trusted individual to take care of including testamentary trusts. In your disabled child’s financial needs. general, a trust is deemed to dispose In addition, if your child would of certain capital property at fair otherwise qualify for provincial market value 21 years after the day disability support, leaving the funds the trust was created, and every directly to that child may jeopardize 21 years thereafter, and to have the child’s eligibility for this support. reacquired the capital property at In some provinces, you may be fair market value. An exception to able to leave significant funds in this rule applies to a testamentary a testamentary Henson trust and spousal trust where the first deemed still allow your disabled beneficiary disposition of the trust property is to qualify for provincial disability deferred until the death of the spouse. support. If you would like more If the trust property has appreciated information on Henson trusts, ask in value, any accrued capital gains your RBC advisor for a copy of our will be deemed to be realized on the article “Henson Trusts.” 21st anniversary of the trust and will be taxable to the trust. The realized Trust for minor children or spendthrift gains cannot be deducted from the beneficiaries trust and taxed in the beneficiaries’ Funds left outright to a minor child hands, but must be taxed in the trust. cannot be paid directly to the Given the significant tax liabilities minor child as they do not have that may arise on the 21st anniversary the legal capacity to manage those of the trust, it is important to consult funds. Depending on the governing with a professional legal and tax provincial legislation, the funds may advisor on planning strategies that have to be paid to a provincial body, may be implemented to minimize the such as the Office of the Children’s effect of this deemed disposition. Lawyer or the Public Guardian and Trustee or a court-appointed guardian of property, to hold and manage the funds until the child 6 | RBC Wealth Management

reaches the age of majority. The use Planning for blended/modern of the funds may be restricted. As families well, this may result in excessive time, If you are in a second marriage costs and complexity in managing or common-law relationship and the child’s estate. These potential you have children from a previous difficulties may be avoided by marriage or you have children establishing a testamentary trust in from different relationships, a your Will for the benefit of your minor testamentary trust may be a suitable children and designating a trustee/s vehicle to provide for all your desired to manage the trust funds. You may beneficiaries who are part of your specify in your Will what the trust family. For example, you can create a funds are to be used for and when testamentary trust that provides for they can be used. Alternatively you your spouse during their lifetime and, A testamentary trust may leave those decisions to the on the spouse’s death, distributes may allow you to set discretion of your chosen trustee/s. the trust assets to your children aside funds and name from your previous marriage or Even if you do not have minor relationship and not to your spouse’s a trusted individual children, you may have a particular children or heirs. Alternatively, you to take care of your child or person you wish to benefit may want to establish more than disabled child’s who may not be good at handling one testamentary trust for different financial needs. their financial affairs, or who may family members that are managed by have addiction issues. A testamentary different trustees. trust may allow you to ensure that the beneficiary does not exhaust the trust To preserve continuity of ownership assets too quickly. (e.g. cottage property, family Providing for education and business) other expenses of children and If your family owns a cottage and grandchildren you would like to ensure, as much as possible, that it is kept in the family You may want to establish a trust for future generations, you may for a very specific purpose, such as consider establishing a testamentary to fund the educational expenses trust to hold the property instead of of your children or grandchildren. leaving it outright to your children. Establishing a trust allows your The concept of holding a cottage or trustee/s to control how the inherited other vacation property in a trust is funds are used. discussed in our article “Canadian Control over timing of distribution Vacation Property Succession Planning.” If you are interested, ask of assets your RBC advisor for a copy. If you have a significant estate and your children or other beneficiaries Other assets, such as shares of a are relatively young, you may feel that family business, which you wish to it would not be a good idea to leave a preserve ownership of, may also be significant amount of money to your held in a testamentary trust. beneficiaries until they have reached a certain level of maturity. You may Wealth protection and management feel that they are too young to handle The family that you leave behind may a sizable estate before the age of 30 or be accustomed to having you take care 35, for example. Establishing a trust of the financial affairs. Establishing may allow you to control the timing a testamentary trust with a capable of distributions of assets to your trustee/s may be a way to preserve and beneficiaries. protect your wealth for your intended beneficiaries. The trustee/s can manage your investments and your RBC Wealth Management | 7

other assets to provide for your family. create a new Will if you do not have a If you do not have an appropriate valid Will already in place. individual to act as trustee and manage your assets, you may consider Second, your assets that you currently appointing a corporate trustee. own may need to be restructured so that upon your death they will “flow Creditor protection through your estate.” Therefore, assets If the testamentary trust is properly that are currently held in JTWROS may structured, it may be possible to need to be changed to sole ownership. protect the assets in the trust from the Note that if assets are held in JTWROS creditors of the beneficiaries including with non-spouses who have beneficial marital creditors. ownership, capital gains may be triggered when ownership is changed to you only. Therefore, a thorough If the testamentary Providing for successive generations cost-benefit analysis needs to be You may want to provide for more trust is properly undertaken. structured, it may than one generation or may wish to be possible to skip a generation and provide for your Designated beneficiaries of RRSP/RRIF protect the assets grandchildren and not your children. A assets may have to be removed so testamentary trust can protect assets in the trust from that these assets pass through your across generations. the creditors of estate. Note that an exception exists with insurance policies. That is, it is the beneficiaries Fulfilling charitable intentions including marital possible to transfer a death benefit Your assets may be so significant that payable from an insurance policy creditors. there is more than enough to provide to a testamentary trust without the for your family during their lifetime. assets forming part of your estate and You may wish to provide the assets without probate taxes being paid. that remain after your family members’ deaths to your favourite charity. This Probate concerns may be accomplished by establishing Probate tax may be incurred prior a testamentary trust for the benefit to creating a testamentary trust. of your family members with any The probate tax is incurred since remaining assets after their death the testamentary trust assets will going to the charity of your or your form part of the deceased’s estate. trustee’s/s’ choice. It is through a specific provision of the deceased’s Will that the Next steps in establishing a deceased’s assets are transferred to testamentary trust the testamentary trust. Hence, this First, your Will needs to be amended is just another factor that must be to provide for the establishment of a assessed prior to deciding whether a testamentary trust. This amendment testamentary trust makes economic will involve a meeting with a lawyer sense. All provinces except for familiar with estate planning. As a Alberta and Quebec levy potentially result, there will be professional fees significant probate taxes. incurred to amend your Will or to 8 | RBC Wealth Management

Legal, accounting and trust administration fees It is important to The creation of a testamentary consider all of the trust will result in annual fees. It is costs and complexities imperative that a cost-benefit analysis be done to ensure that this structure involved in setting up is a viable option for you and your and administering a beneficiaries. testamentary trust. It is important to consider all of the costs and complexities involved in setting up and administering a testamentary trust. You may still prefer an outright distribution of your estate due to its simplicity and potential to minimize probate fees. If there are reasons why a testamentary trust makes sense for you and your family, you should consult with a qualified legal and tax advisor to determine how to achieve your estate planning objectives.

Please contact us for more information about the topics discussed in this article.

This document has been prepared for use by the RBC Wealth Management member companies, RBC Dominion Securities Inc. (RBC DS)*, RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC), RBC Global Asset Management Inc. (RBC GAM), Royal Trust Corporation of Canada and The Royal Trust Company (collectively, the “Companies”) and their affiliates, RBC Direct Investing Inc. (RBC DI) *, RBC Wealth Management Financial Services Inc. (RBC WMFS) and Royal Mutual Funds Inc. (RMFI). *Member-Canadian Investor Protection Fund. Each of the Companies, their affiliates and the Royal Bank of Canada are separate corporate entities which are affiliated. “RBC advisor” refers to Private Bankers who are employees of Royal Bank of Canada and mutual fund representatives of RMFI, Investment Counsellors who are employees of RBC PH&N IC, Senior Trust Advisors and Trust Officers who are employees of The Royal Trust Company or Royal Trust Corporation of Canada, or Investment Advisors who are employees of RBC DS. In Quebec, financial planning services are provided by RMFI or RBC WMFS and each is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RMFI, Royal Trust Corporation of Canada, The Royal Trust Company, or RBC DS. Estate & Trust Services are provided by Royal Trust Corporation of Canada and The Royal Trust Company. If specific products or services are not offered by one of the Companies or RMFI, clients may request a referral to another RBC partner. Insurance products are offered through RBC Wealth Management Financial Services Inc., a subsidiary of RBC Dominion Securities Inc. When providing life insurance products in all provinces except Quebec, Investment Advisors are acting as Insurance Representatives of RBC Wealth Management Financial Services Inc. In Quebec, Investment Advisors are acting as Financial Security Advisors of RBC Wealth Management Financial Services Inc. RBC Wealth Management Financial Services Inc. is licensed as a financial services firm in the province of Quebec. The strategies, advice and technical content in this publication are provided for the general guidance and benefit of our clients, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. This publication is not intended as nor does it constitute tax or legal advice. Readers should consult a qualified legal, tax or other professional advisor when planning to implement a strategy. This will ensure that their individual circumstances have been considered properly and that action is taken on the latest available information. Interest rates, market conditions, tax rules, and other investment factors are subject to change. This information is not investment advice and should only be used in conjunction with a discussion with your RBC advisor. None of the Companies, RMFI, RBC WMFS, RBC DI, Royal Bank of Canada or any of its affiliates or any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. ® Registered trademarks of Royal Bank of Canada. Used under license. © 2016 Royal Bank of Canada. All rights reserved. NAV0034 (07/16)