If you are a beneficiary of a non-resident trust (NRT) or contribute property to one, you could find yourself in hot water with the Canada Revenue Agency (CRA).
To avoid unwanted CRA attention, you should ask:
- Do income and realized gains accumulating in the NRT become subject to Canadian tax, and if so, who pays?
- Will distributions I get from the NRT be subject to Canadian tax?
- Can foreign tax paid by the NRT reduce any Canadian tax I pay on the NRT's income?
- Will my interest in the NRT trigger Canadian tax even if I don't receive any distributions in the year?
- Must Canada's various foreign reporting requirements be complied with?
- Could I be liable for Canadian taxes owing by the NRT and if so, to what extent?
This article reviews these important Canadian tax considerations and outlines a couple of ways that high net worth families are using NRTs.
Canadian taxation of trusts
Before getting into the specifics on the taxation of NRTs and its beneficiaries, it helps to understand how Canada taxes trust income. In broad terms, whether a trust is resident in Canada or in a foreign jurisdiction, the income of the trust for Canadian tax purposes may be taxed either in the hands of the trust or in the hands of one or more of its beneficiaries.
Trust income generally will be taxable to a beneficiary to the extent that the income of the trust is paid or made payable to the beneficiary before the end of the year in which it is earned.
Distributions of capital are not subject to tax unless the distribution includes an amount that constitutes income for tax purposes, such as taxable capital gains.
As a result, if the current-year income of a trust is not payable in the year, so that the income (less any tax payable by the trust) is accumulated and added to the trust's capital, the accumulated income can be distributed in a subsequent taxation year as a tax-free capital distribution.
Canada's deemed trust residency rules
Canada's deemed trust residency rules ("old rules") were first enacted in the early 1970s to curb the use of offshore trusts in avoiding Canadian tax.
For the old rules to apply, generally:
- a Canadian resident had to be beneficially interested in the nonresident trust; and
- the trust must have acquired property from a Canadian-resident person (or a person who was, within a certain time before the transfer, resident in Canada) who was related to the beneficiary.
In general, if the old rules applied, a discretionary NRT was deemed to be resident in Canada and thereby subject to tax on its worldwide income, other than income paid or made payable to a beneficiary.
The rules affecting NRTs have had a turbulent history since substantial amendments to the Income Tax Act were first announced in the 1999 federal budget. Under the most recent version released by the Department of Finance on August 27, 2010, an NRT can:
- be deemed to be resident in Canada if a Canadian resident contributes property to the NRT, even if no beneficiaries reside in Canada.
- be subject to the proposed rules if the trust has Canadian resident beneficiaries even though the Canadian-resident contributor to the NRT has died or departed Canada shortly before making contributions to the NRT.
Canadian tax implications of being a beneficiary of an NRT
The Canadian tax implications of being a beneficiary of an NRT depend greatly on whether the NRT has received (or is deemed to receive) any property from a Canadian resident (other than an individual who has been resident in Canada for less than 60 months). If it has, the NRT will be deemed resident in Canada under Canada's proposed NRT rules. Canadian tax will be payable on income earned and net capital gains realized on the "resident portion" of the NRT's assets âĆ' in general:
- all of the NRT's property that can be historically traced to a contribution made by a Canadian resident;
- property substituted for those contributions; and
- income and gains derived from those contributions or substituted property.
Some high net worth families continue to use NRTs in their estate planning, sometimes for asset protection, even though the income earned in the NRT will be taxable in Canada.
Using NRTs for asset Protection
A trust that is created to provide protection against the claims of future creditors is known as an "asset protection trust." This type of trust can be established in Canada and hold its assets here. However, we understand that the trust's being in Canada could increase the risk that a court will review the trust, and potentially apply a statutory remedy to set it aside and give the assets to creditors. For this reason, asset protection trusts are often established in tax haven jurisdictions such as the Bahamas, the Cayman Islands and Barbados. Many tax haven jurisdictions have secrecy laws and some have specific legislation intended to restrict creditors' rights to the trust assets. If a Canadian resident transfers assets to an asset protection trust that is not resident in Canada, the proposed NRT rules will deem the NRT to be resident in Canada, unless the individual is a newcomer to Canada. Planning for newcomers to Canada is discussed below.
If a long-time Canadian resident transfers property to the NRT and is included as a capital beneficiary of the NRT, the investment income and realized capital gains will be taxable in the hands of the contributor even if those amounts are not distributed to him or her. An individual who elects to be an "electing contributor" should be able to claim a foreign tax credit for foreign tax the NRT paid on its income. Failing that, the income and realized net capital gains, reduced by any deductible foreign tax paid by the NRT on its income, will be attributed to the individual and the individual will not be able to claim a foreign tax credit for foreign taxes paid by the NRT. The contributor will also have to comply with Canada's foreign reporting requirements, which require filing a Form T1141 each year to report contributions to the NRT, and Form T1135 to report his or her interest in the NRT.
If the Canadian contributor is not included as a beneficiary of the NRT, the income and realized capital gains will be taxed in the NRT unless the income and gains are paid or declared as payable in the year to the beneficiaries, in which case the beneficiaries will pay the tax. Canadian resident beneficiaries who did not contribute property to the NRT will be required to file Form T1142 to report distributions received from the NRT.
The Canadian-resident contributor (other than an electing contributor) and beneficiaries can be jointly and severally, or solidarily, liable to pay the Canadian tax of the NRT under the proposed legislation.
The NRT will be required to file a Canadian tax return each year, which will be due 90 days after its December 31 year end. If the NRT holds its assets through a foreign corporation, the NRT will be required to file Form T1134 annually in respect of the foreign corporation. Significant penalties apply for failure to comply with Canada's foreign reporting requirements - for both the NRT and individuals who contribute to, or receive distributions from, the NRT.
Immigration trusts for newcomers to Canada
It may be possible to create an NRT without the NRT being subject to Canada's proposed deemed residency rules for trusts, if an individual is a new immigrant to Canada.
"Immigration trust" describes a trust created by an individual who has been resident in Canada for less than 60 months (during his or her entire lifetime) either before or shortly after immigration to Canada. Under the proposed rules, newcomers to Canada can create an NRT without the trust's being deemed resident in Canada until the calendar year in which the individual has been resident in Canada for 60 months. In addition, even if the immigrant is a capital beneficiary of the immigration trust, during the 60-month period the income and taxable capital gains (or allowable capital losses) will not be deemed to be those of the immigrant.
In addition, it may be possible to create a "granny trust" without the NRT being deemed resident in Canada. A granny trust is an NRT established by a nonresident of Canada for the benefit of persons who are resident in Canada (typically by an older generation for the benefit of a younger generation). The NRT may be established during the lifetime, or after the death, of the non-resident. So long as no Canadian resident is a contributor to the NRT and the contributions by non-residents are all made at non-resident times, such an NRT should not be deemed a resident of Canada under the proposed rules. The definition of "non-resident time" is complex, but this requirement will be met if the contributor has never been and never intends to be a Canadian resident.
For Canadians with wealthy relatives who have been non-residents of Canada for more than 60 months and who intend to never become resident in Canada in the future, instead of the Canadian's receiving the inheritance directly from these relatives, the use of a granny trust can provide for tax-free accumulation of income and capital gains in the NRT.
In summary, the Canadian tax rules surrounding NRTs and their beneficiaries are complex. Compliance with Canada's proposed NRT rules and foreign reporting requirements is essential to avoid the significant penalties that can be assessed by the CRA for failure to comply.
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.