Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, October 2010
In order to address the use of non-resident trusts (NRTs) to avoid Canadian tax, the existing section 94 of the Income Tax Act (the Act) provides that, if a non-resident discretionary trust has a direct or indirect Canadian beneficiary, the trust can be deemed to be resident in Canada for Canadian tax purposes under certain circumstances and for certain limited purposes.
In 1999, the Minister of Finance announced that changes would be made to the NRT provisions in order to address concerns about the effectiveness of the current rules.
Earlier Draft NRT Proposals
Draft legislation to amend the NRT provisions was first released in 2001. The proposals have undergone a number of revisions since then. They have also been widely criticized.
Under the NRT proposals, a non-resident trust is deemed to be a resident of Canada if the trust has a Canadian resident contributor or a Canadian resident beneficiary and an exemption does not apply. One of the concerns with respect to the earlier versions of these proposals was that, although Department of Finance officials consistently said that the provisions were not intended to apply to bona fide commercial trusts, the exemption for commercial trusts was difficult to apply in practice. This is a major concern because, if a non-resident trust is deemed to be resident in Canada under the NRT proposals, the trust is subject to Canadian tax and there could be Canadian withholding tax on distributions of trust income to non-residents of Canada. A Canadian resident beneficiary or Canadian resident contributor in respect of a non-resident trust could be personally liable for all or part of the trust's Canadian taxes.
August 27, 2010 Draft Legislation
In the March 4, 2010 federal budget, the Minister of Finance announced that there would be further changes to the NRT proposals. These changes are now reflected in revised draft legislation that was released to the public on August 27, 2010. The revised proposals contain a much simpler exemption for commercial trusts.
Exempt Commercial Trusts
The proposed exemption for commercial trusts is set out in paragraph (h) of the definition of "exempt foreign trust" in proposed subsection 94(1) of the Act ("Exempt Commercial Trust"). The key to the exemption is the definition of a "specified fixed interest" (SFI). In general terms, an SFI is a non-discretionary interest of a person as a beneficiary under a trust.
Under the revised proposals, the exemption for Exempt Commercial Trust will apply if two conditions are met:
- only holders of SFIs have any right to receive the income or capital of the trust, and
- any of the following applies:
- there are at least 150 beneficiaries, each holding SFIs with a total fair market value of at least C$500,
- all the SFIs in the trust are listed on a designated stock exchange and trade on that exchange on at least 10 of every 30 days,
- each SFI in the trust was either
issued by the trust for not less than 90% of the proportionate share of the net asset value of the trust's property at the time the interest was issued, or
acquired for consideration equal to the fair market value of the SFI at the time it was acquired.
The drafting of the revised exemption is significantly more straightforward than in earlier versions of the draft legislation.
Some of the new requirements proposed in the March 4, 2010 federal budget have also been dropped. In the budget, it was proposed that, in order for the exemption for commercial trusts to apply, an interest in the trust could not cease to exist otherwise than by way of a cancellation or redemption at fair market value. Also, the terms of the trust could not be varied without consent. These requirements are not included in the new draft legislation. Instead, it is proposed that a special rule will apply if a non-resident trust initially qualifies as an Exempt Commercial Trust and, at a later time, any interest in the trust ceases to be an SFI. If this occurs, the trust will become taxable on the increase in the fair market value of the trust property (net of trust liabilities and less contributions to the trust) during the "gross-up period" from the first time that the trust would have been taxable under section 94, if the exemption had not applied, to the time when an interest in the trust ceased to be an SFI. This amount is intended to be a proxy for the accumulated income of the trust during the gross‑up period. It is also proposed that the trust will be subject to special instalment interest for the gross‑up period.
While the changes in the draft legislation are welcomed, potential issues remain. One of these issues relates to the types of discretion which could disqualify an interest in a trust from being an SFI. An interest in a non-resident trust qualifies as an SFI "provided that no amount of the income or capital of the trust to be distributed at any time in respect of any interest in the trust depends on the exercise by any person or partnership of, or the failure by any person or partnership to exercise, any discretionary power."
The Department of Finance explanatory notes contain useful guidance on the intended scope of this proviso. The explanatory notes say that the proviso catches discretion which gives a trustee an ability to choose which beneficiary is entitled to a distribution or which provides a power to appoint new beneficiaries or vary the beneficial interests in the trust. The notes also say that discretion as to the timing of distributions by a trust does not disqualify an interest in the trust as an SFI, if there is no change to the rights to income and capital associated with the interest, even if the interest (and associated rights to distributions) could be transferred to a third party. Submissions have been made to the Department of Finance for confirmation that other kinds of administrative discretion given to a trustee or manager of a foreign trust is not intended to disqualify interests in the trust from being SFIs.
Indirect Contributions through an Exempt Commercial Trust
Another potential issue relates to tiers of trusts. In order to address anti-avoidance issues in the personal trust area, there are several provisions in the draft legislation which "deem" a person to be a contributor to a trust even if it is not a direct contributor. One of these rules is that, if a person makes a contribution to a trust and that trust makes a contribution to a second trust, the contributor to the first trust is deemed to be a contributor to the second trust. Thus, for example, if a Canadian acquires an interest in an Exempt Commercial Trust and that trust makes a contribution to an underlying trust, the underlying trust could be caught under the NRT proposals and deemed to be resident in Canada, unless that second foreign trust itself qualifies as an Exempt Commercial Trust. This would seem to be an inappropriate result.
The exemption for Exempt Commercial Trusts applies to both taxable and tax-exempt Canadian investors in foreign trusts. Canadian tax-exempt persons are also specifically excluded from the definition of a Canadian resident beneficiary or a Canadian resident contributor in respect of a non-resident trust. Accordingly, tax-exempts are specifically excluded from personal liability under the NRT proposals.
The exemption for commercial trusts is not restricted to unitized investment funds. For example, the exemption could apply to an internal trust in a corporate structure, if each beneficiary's interest in the trust was acquired at fair market value and there is no "discretionary power" as discussed above. Such a trust could have a Canadian entity as the direct beneficiary. The trust could also be embedded in an underlying chain of controlled foreign affiliates, if a Canadian corporation in the group is deemed to be a contributor to the trust under a deeming provision in the draft proposals.
If a Canadian resident beneficiary has contributed certain types of "restricted property" to an Exempt Commercial Trust or if the resident beneficiary (together with non-arm's-length persons and persons who acquired their interest in the trust as a result of a contribution by the Canadian resident) holds 10% or more of the fair market value of the interests in an Exempt Commercial Trust, the resident beneficiary is taxable on a proportionate share of the foreign accrual property income (FAPI) of the trust computed as if the trust were a controlled foreign affiliate of the Canadian resident beneficiary.
The revised exemption for commercial trusts in the NRT proposals is a significant improvement over previous versions. Nevertheless, potential issues still remain in some circumstances as discussed above. Submissions have been made to the Department of Finance on these matters and we will continue to monitor developments.
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.