Canada: NRT Tax Traps And The Non-Specialist Advisor - Part 4

This article is the last instalment of the four-part series.

In this, the fourth and final instalment of the Series, we'll examine what happens when trusts become subject to and then cease to be subject to the Section 94 Trust Rules. Using this knowledge and the technical knowledge described in the second and third instalments of the Series we'll then analyze how the Section 94 NRT Rules apply to common cross-border testamentary planning undertaken by Canadians who have US beneficiaries (i.e., the fourth example described in the first instalment of the Series). I have also added a discussion of how the choice of executors, trustees and how even assisting ailing and/or aging family members can inadvertently engage the Section 94 NRT Rules. As a bonus, the Series will close out with a review of some tax traps involving Pure NRTs.

Impact on a trust of becoming and ceasing to be subject to the Section 94 NRT Rules²

Canada is one of the few tax jurisdictions in the world that subjects its residents to tax on emigration: the so-called departure tax, where immediately prior to emigration the departing resident is deemed to have made an FMV disposition of all of the emigrant's property other than property such as Canadian real property and most property used in a business carried on through a permanent establishment in Canada. Similar concepts apply at the time a taxpayer immigrates to Canada; property other than the types of property excluded from the emigration rule is deemed to be brought into Canada at a tax cost equal to its FMV. These rules are found in section 128.1.

A major issue that can arise where a trust becomes or ceases to become subject to the Section 94 NRT Rules is that the rules in subsection 94(4) will cause the trust to become subject to a modified version of the rules in section 128.1 relating to immigration and emigration.

Among other things, the subsection 94(4) rules generally cause a trust to have a deemed year-end prior to its change in status and they will also generally provide for a step-up in the adjusted cost base ("ACB") of most assets owned by a trust that becomes a Section 94 NRT. In addition, a trust that ceases to be a Section 94 NRT will be deemed to dispose of all of its property, immediately prior to the change in status, on a fully taxable basis. As was the case under section 128.1, property such as Canadian real property and most property used in a business carried on from a permanent 1 Unless otherwise noted, defined terms in this article have the meaning designated in the establishment in Canada are excluded from these deemed disposition rules.³

Unfortunately, if a trust is not properly monitored it could change its status among one or more of being a factually resident Canadian trust, a Pure NRT, and a Section 94 NRT, and if these changes in status occur the application of the subsection 94(4) rules could give rise to among other things the untimely creation of year-ends and the deemed taxable realization of gains for Canadian income tax purposes.

Example 4 – Canadian estate planning for US beneficiaries⁴

Canadian resident clients who have significant estates and who also have US heirs, are often encouraged by their US tax counsel to put in place special planning in respect of the portion of their estate that is intended to be left to their US beneficiaries. In particular, I commonly see US counsel advising those clients to have their estates fund one or more special US trusts (each a "US Trust"). This type of US Trust is generally formed to accomplish objectives that include: potentially continuing the trust indefinitely;⁵ providing protection of the gift from creditors of the US beneficiary, including spousal creditors of the US beneficiary; and avoiding the gift becoming part of the US beneficiary's US taxable estate, which would otherwise cause the inheritance to become subject to US estate tax.

Unfortunately, the Section 94 NRT Rules would seem to catch otherwise Pure NRTs formed for this purpose. This result occurs because instead of a deceased parent, who will have ceased to exist on his or her death, contributing⁶ the property to a US Trust, it is the estate of the deceased parent that will be considered to have made the contribution.⁷ The result is that even with the most careful of planning, the Canadian estate will be a resident contributor to the US Trust and this will cause the US Trust to become a Section 94 NRT.⁸

While the US Trust is a Section 94 NRT it will be subject to Canadian taxation and based on prior CRA commentary it appears doubtful that treaty relief will be provided under Canada's tax treaties.⁹ The result could well be double taxation unless the competent authorities intervene.

The US Trust will then continue to be a Section 94 NRT at least until the deceased parent's estate is wound-up, at which time if there are no Canadian resident beneficiaries the Section 94 NRT Rules should cease to apply to the US Trust. As described in the preceding section, immediately prior to losing its status as a Section 94 NRT the US Trust will, pursuant to subsection 94(4), be deemed to have a taxation year-end making it taxable on income earned up until that date and, subject to the exceptions mentioned previously, it will be deemed to dispose of all of its property on a taxable basis for Canadian tax purposes. US advice may be required to ensure that the US Trust, which at that point in time will have become a Pure NRT, has the best US tax attributes possible following emigration from Canada.

Although in cases where there are significant delays in winding up an estate the subsection 94(4) deemed disposition could give rise to material tax consequences, if the US Trust's sojourn in Canada as a Section 94 NRT is a short one, then hopefully the impact of having been a Section 94 NRT will be mainly limited to administrative nuisance and will not give rise to significant tax consequences.

Finally, it is again worth mentioning that even after the US Trust becomes a Pure NRT again, if it is not properly monitored or, if in the future a Canadian becomes a beneficiary of the US Trust, then the US Trust could find itself once again trapped in the Section 94 NRT rules.

Bonus Example – Choice of Executors, Trustees and Assisting Aging and/or Ailing Family Members

While working on a file, I recently discovered another very scary section 94 NRT real-life situation that could impact the general practitioner. I have no doubt that I'll continue to discover other situations.

If non-residents are appointed as executors of an estate and/or are found to have central management and control of an estate they could cause the estate itself to become a Section 94 NRT. If the subsection 70(5) deemed disposition on death taxes would have arisen in any case, then the subsection 94(4) tax consequences of such a status change would hopefully be more aggravating then problematic. However, if the subsection 70(5) taxes had been expected to e deferred because a surviving spouse or spousal trust was to have received the deceased's property, then this status change could be a very serious issue.

Hopefully, because non-resident executors may be required to post an administrative bond before being able to act,¹⁰ this issue should not arise too often in an estate context. However, this issue may be much more likely to affect inter-vivos trusts and, in particular, alter-ego and other lifetime trusts, where administrative bond requirements may not be required.¹¹

In such situations, I understand that it is not unusual for a child to be appointed as a successor trustee for his or her parents. Even if a child is not appointed as a trustee of a trust, it is possible to imagine situations in which the child, in caring for his or her aging and/or ailing parents, might become so involved in their affairs that the child could end up exercising the true central management and control of the trust. In both of these types of situations, if the child is a non-resident and unless the child receives proper and timely advice, a change in the trust's status to being a Section 94 NRT might arise while the parent is still alive, which could give rise to potentially untimely and problematic subsection 94(4) tax consequences.¹²

Pure NRT – A Couple of Tax Traps and a Planning Point

The last topics that will be covered in the Series are thankfully not Section 94 NRT related issues but instead relate to Canadian issues that may impact Pure NRTs.

Tax Trap 1

As is the case for all non-residents of Canada, Pure NRTs can be taxable in Canada, though the exposure to Canadian income tax is generally limited to Canadian source income rather than their worldwide income. One issue that often comes as a surprise to advisors of Pure NRT's is that the 21-year deemed disposition rules in subsection 104(4) can apply to them if they own "taxable Canadian property".¹³ This tax trap is easily missed and can often catch Pure NRTs off guard.

Tax Trap 2

Another trap that can catch Canadian beneficiaries of Pure NRTs that are personal trusts by surprise can arise where a Pure NRT makes a capital distribution to a Canadian resident beneficiary and the distributed property's FMV exceeds the ACB of the property. The essence of this trap is that even though the distributing trust is a Pure NRT, the rules in subsection 107(2) would generally cause the distribution from the Pure NRT to have been made to the Canadian resident beneficiary on a rollover basis at the ACB of the Pure NRT. As a result, without planning, the Canadian resident beneficiary will be subject to tax on gains realized in the future based on the ACB inherited from the Pure NRT, which depending on the distributed asset, could be significantly less than the FMV of the property at the time of its distribution.

A Planning Point

This issue was discussed in CRA document 2015-0582701E5.¹⁴ One way to manage this potential tax trap is to try and ensure that only high ACB properties are distributed by a Pure NRT to its Canadian resident beneficiaries. Even if the Pure NRT does not have high ACB properties, it may still be possible to tax efficiently increase the ACB of properties prior to their distribution to Canadian resident beneficiaries. For example, subject to advice from competent foreign counsel, where a Pure NRT is located in a low tax or no tax jurisdiction and the Pure NRT has low ACB properties that it desires to distribute to Canadian residents, it may be possible to take steps to cause the unrealized gains to be realized in the foreign jurisdiction and thereby increase the ACB of the assets prior to a distribution to Canadian residents.

As this is the end of the Series, I hope that I've been successful in achieving the modest goals of keeping you, the non-specialist advisor's attention and giving you a high-level overview of some of the many tax traps waiting for unsuspecting practitioners in the NRT world. Actually dealing with these issues – well that is likely best left to the specialists . . .

Special thanks to Ryan Chua of Minden Gross LLP for his comments on earlier drafts of this article.

Footnotes

1 Unless otherwise noted, defined terms in this article have the meaning designated in the first instalment of the Series.

2 For a more detailed discussion on this subject see the article by Harris et al. (cited in the first instalment of the Series).

3 It would appear that the rules that permit the posting of security pursuant to the provisions in subsection 220(4.5) et seq., should apply to Section 94 NRTs that become liable to pay emigration taxes pursuant to subsection 128.1(4).

4 Because my practice is limited to Canadian law, the discussion below is only based on my general understanding of US laws and should not be construed as US tax or legal advice.

5 Such trusts are often referred to as "dynasty trusts".

6 Unless otherwise noted, defined terms in the Act that are used in the Series can be found in subsection 94(1).

7 See for example, CRA document number 2013-0514771E5 dated June 26, 2014, and CRA document number 2014-0523071C6 dated June 16, 2014 (from the CRA Round Table at the 2014 STEP Conference, Question 12). The CRA's 2014 response contains a statement that, pursuant to paragraph 94(2)(g), the time the interest in the deceased's estate is acquired by the otherwise Pure NRT (usually the date of death of the deceased) will give rise to the deemed transfer by the deceased's estate to the otherwise Pure NRT and will result in a contribution to the otherwise Pure NRT by the estate. Whether this position is correct or whether the correct time of the estate's contribution is the actual time when the otherwise Pure NRT receives property from the estate is a matter that remains open to debate.

8 As mentioned in the preceding section, the rules in subsection 94(4) will apply to deem the US Trust to have effectively immigrated to Canada. Assuming at the time of immigration the US Trust has only nominal assets then the consequences of such immigration should, in general, be mainly administrative but otherwise inconsequential from a Canadian tax perspective.

9 See section 4.3 Income Tax Conventions Interpretations Act, and see cases such as Perry v. MNR et al., 2008 DTC 6623 (FCA); aff'g. 2007 DTC 5625 (FC).

10 For example, see the Estates Act, R.S.O. 1990, c. E.21

11 There is no requirement in the Trustee Act, R.S.O. 1990, c. T.23, for a trustee of an inter-vivos trust in Ontario to post an administrative bond.

12 Subject to the possibility of posting security for such tax with the CRA (which is often problematic), the results could be extremely problematic if there is insufficient liquidity to fund the subsection 94(4) taxes arising upon the status change of the trust.

13 As that term is defined in subsection 248(1). Gains that are subject to treaty protection or that involve "exempt property" would not be caught under the 21-year rule.

14 Dated May 25, 2015

Previously published by Wolters Kluwer

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.