Deduction and flow-through of income to beneficiaries
In computing a trust’s income, it can normally deduct any income (including taxable capital gains) for the year that is paid or payable to a beneficiary. This amount is then included in the beneficiary’s income.
As a general rule, the beneficiary’s income from the trust is considered generic income from property.
However, in some cases, the trust can designate an amount paid out so that it retains its character to the beneficiary as a different kind of income.
For example, if the trust pays out a taxable capital gain to the beneficiary and makes the appropriate designation, the amount retains its character for the beneficiary as being a taxable capital gain. The flow-through of character can be beneficial if the beneficiary has capital losses available, since such losses can only offset capital gains and not other kinds of income.
Similarly, a trust can designate taxable dividends that it received and pays out to a beneficiary, so that they remain taxable dividends in the beneficiary’s hands. An individual beneficiary can then use the gross-up and dividend tax credit mechanism that applies to dividends received from Canadian corporations. A beneficiary that is a Canadian corporation can deduct the dividends in computing its taxable income.
In each case, the trust must provide the beneficiary with a T3 slip for the year, indicating the amount and type of income distributed to the beneficiary.
Tax rate of trust
A “trust” is normally subject to a flat tax rate equal to the highest marginal rate, which is currently 29% for federal tax purposes. With provincial taxes, the combined rate will be about 40 – 50% depending on the province in which the trust is resident.
However, as discussed above, trust income paid or payable to a beneficiary is normally taxed to the beneficiary rather than the trust. Such income will of course be subject to the graduated rates applicable to the beneficiary.
Until the end of 2015, a “testamentary trust” is subject to the same graduated tax rates as other individuals rather than the high flat rate. Generally, a testamentary trust is one that arises upon death, including an estate and any trust set up by the deceased’s will.
However, starting 2016, a testamentary trust will be subject to the same flat tax as other trusts. There will be two exceptions, where the graduated rates will continue to apply. The first exception is a “graduated rate estate”, which essentially means a deceased’s estate for up to 36 months after death. The second exception is a “qualified disability trust”, 2
which is generally a testamentary trust with a disabled beneficiary who is entitled to the disability tax credit. As above, trust income paid or payable to a beneficiary will be subject to tax at the beneficiary’s graduated tax rates.
Election available where trust has loss carry-forwards
As noted, a trust’s income that is distributed (paid or payable) to a beneficiary is normally deducted in computing the trust’s income and included in the beneficiary’s income.
However, a trust can make a special election under which this income remains the income of the trust rather than that of the beneficiary (even though the income has been distributed to the beneficiary). This election is useful where the trust has loss carry-forwards available, which can be claimed against the income. The beneficiary then receives the income tax-free, since it is taxed at the trust level and not the beneficiary level.