On October 24, 2012, the Federal Minister of Finance released a detailed Notice of Ways and Means Motion to implement outstanding technical tax amendments, including significant amendments to Canada's income tax rules applicable to non-resident trusts (NRTs) and offshore investment funds (the Proposals). The Proposals notably expand the exemption to the NRT rules for commercial trusts, and create a detailed new regime that effectively divides certain non-resident trusts into two separate trusts for Canadian tax purposes in circumstances where there are both Canadian and non-Canadian contributors to the trust.
The majority of these Proposals implement amendments that were previously released for public consultation as far back as 1999, and replace proposed amendments that were released on August 27, 2010 (the Previous Proposals). The Proposals will generally have retroactive effect. The Proposals may be enacted as early as sometime in 2012.
This update summarizes the key Proposals. Other Osler Updates address the other tax aspects of the Notice of Ways and Means Motion. To access our update on Canada's Foreign Affiliate Rules, click here and for the update on the remaining tax aspects of the Notice of Ways and Means Motion click here.
Parliament enacted existing section 94 of the federal Income Tax Act (the Act) to counter the use of non-resident trusts to avoid or defer Canadian tax. Section 94 addresses this issue in two specific ways. First, in certain circumstances, it deems a discretionary non-resident trust to be resident in Canada if a Canadian resident has transferred property to the trust for the direct or indirect benefit of a Canadian resident. Deeming the trust to be resident in Canada generally results in the trust being taxable in Canada on its worldwide income and in certain circumstances allows the Canada Revenue Agency to collect a portion of the resulting tax liability of the trust from the Canadian resident transferor. Second, section 94 requires that certain beneficiaries of non-discretionary non-resident trusts report income on a modified "foreign accrual property income" (FAPI) basis where the fair market value of the beneficiary's interest in the trust exceeds 10% of the value of all interests in the trust.
Over the years, the Minister of Finance has proposed a number of draft amendments to improve the effectiveness of these NRT rules, the most recent of which are the Previous Proposals. The Previous Proposals would expand the NRT rules by deeming a NRT to be resident in Canada and taxed on a portion of its world-wide income if it has a Canadian resident contributor (which includes persons who have made certain indirect transfers or loans to the NRT) or a Canadian resident beneficiary. The Previous Proposals divide the trust's property into a "resident portion" and a "non-resident portion," with the result that Canadian tax generally applies only to the income arising or gains realized within the resident portion (the non-resident portion is also subject to Canadian tax in some circumstances). Each Canadian contributor or beneficiary of the NRT then becomes jointly and severally liable with the trust for its resulting Canadian tax liability, subject to certain limits. The two principal exemptions from the application of the NRT rules under the Previous Proposals are the concepts of an "exempt person" and an "exempt foreign trust."
The Proposals retain the principal framework of the Previous Proposals, with several important changes intended to better target the rules. These changes to the Previous Proposals are discussed below.
Exemptions – New Exemption for Mutual Funds
Under the Previous Proposals, a Canadian resident person that qualifies as an "exempt person" is deemed not to be a Canadian contributor or a Canadian beneficiary under a trust for the purposes of the NRT rules. This exemption has two beneficial consequences: (a) an "exempt person" who becomes a beneficiary of or contributor to a NRT does not cause the trust to be deemed resident in Canada, and (b) even if the NRT under which the exempt person is a contributor or beneficiary happens to be deemed resident in Canada (say, as a result of there being another resident contributor/beneficiary under the trust that is not an exempt person), the exempt person will not become jointly and severally liable for any of the trust's Canadian tax liability. The Previous Proposals define "exempt persons" to include Canadian tax-exempt entities, such as pension funds, Crown corporations and registered charities, as well as certain entities wholly-owned by such tax-exempt persons.
The Proposals expand the list of exempt persons by adding mutual fund trusts and mutual fund corporations (as defined in the Act). However, in order to be considered an exempt person, the relevant mutual fund trust or mutual fund corporation cannot be represented or marketed to investors as resulting in lower overall taxes on the fund's income or gains in respect of fund property that is (or that derives its value from) an interest in a trust than if the investors directly invested in such property. Provided it meets this requirement, a Canadian retail mutual fund, exchange-traded fund or real estate investment trust (each of which typically qualifies as a mutual fund trust or mutual fund corporation, depending on the type of entity in question) would no longer need to determine whether a particular foreign trust is an "exempt foreign trust" in order to conclude that investing in the trust will not result in adverse consequences under the NRT rules.
Exemptions – Broadened Exemption for Commercial Trusts
Under the Previous Proposals, an "exempt foreign trust" will not be deemed resident in Canada, even if it has Canadian resident beneficiaries or contributors. This exemption is intended to ensure that the NRT rules do not capture trusts with a low risk of being used for tax avoidance. Therefore, the Previous Proposals define "exempt foreign trust" to include trusts such as foreign, tax-exempt charitable trusts and pension plans. Consistent with this objective, the Previous Proposals also include as "exempt foreign trusts" certain widely-held commercial trusts. According to statements by the Minister of Finance, this exemption is intended to shield bona fide commercial trusts from the NRT rules.
However, the Previous Proposals were drafted in a way that did not clearly achieve this objective. The Previous Proposals contain a "no discretion" condition, which specifies that no amount of the income or capital of the trust to be distributed at any time can depend on the exercise by any person of, or the failure by any person to exercise, any discretion. If a distribution from a commercial trust relies on any discretion, then the trust may not qualify as an "exempt foreign trust."
This "no discretion" rule is at odds with commercial reality. As a practical matter, bona fide Commercial trusts typically allow for some measure of discretion – for example, with respect to the timing or amounts of distributions. If the Previous Proposals were enacted, few bona fide commercial trusts would clearly satisfy the "exempt foreign trust" exemption.
The Proposals aim to rectify this problem by relaxing the "no discretion" condition. The Proposals allow commercial trusts to exercise discretion with respect to distributions as long as three conditions are met:
- the discretionary power is consistent with normal commercial practice;
- the discretionary power is consistent with terms that would be acceptable to trust beneficiaries dealing at arm's length; and
- the exercise of, or failure to exercise, the power will not materially affect the value of a beneficiary's interest in the trust relative to the value of other such interests.
An interest in a trust that satisfies these more lenient terms with respect to the exercise of discretion is referred to as a "fixed interest."
By relaxing the "no discretion" condition to take into account standard market terms, the Proposals will result in it being clearer that most commercial trusts will qualify as "exempt foreign trusts" (such a trust, an Exempt Commercial Trust). This is particularly valuable for commercial investment trusts that require that all distributions to holders of the same class of trust interests be made on a pro rata basis, notwithstanding the existence of some discretion with regard to distributions under the trust.
The "no discretion" condition is not the only condition for Exempt Commercial Trust status. The Proposals also require that the "fixed interests" in the trust must generally be: (a) held by at least 150 investors (each holding such interests worth at least $500); (b) listed and traded on a designated stock exchange; or (c) issued by the trust in exchange for not less than 90% of a proportionate share of the net asset value of the trust or acquired from other holders at fair market value. These additional conditions remain unchanged from the Previous Proposals.
Over 10% Investments in Exempt Commercial Trusts
As discussed above, the existing NRT rules require certain beneficiaries of a non-discretionary NRT to include a portion of the trust's FAPI in income (which means that undistributed, generally passive income of the trust must be recognized on a current basis by such beneficiaries) when the fair market value of their interest in the trust exceeds 10% of the value of all interests in the trust. The Previous Proposals and the Proposals expand the ambit of this rule considerably.
The Previous Proposals require the following persons to include a non-resident trust's FAPI in income, even in cases where the trust is an Exempt Commercial Trust:
(i) any Canadian resident beneficiary who – together with non-arm's length persons or persons that acquired their interests in the trust in exchange for consideration given to the trust by the beneficiary – holds at least 10% of any class of "specified fixed interests" in the Exempt Commercial Trust determined by fair market value; or
(ii) a Canadian resident who contributes "restricted property" to the Exempt Commercial Trust ("restricted property" generally refers to common shares or similar property issued as part of an estate freeze arrangement).
For such beneficiaries or contributors, this rule essentially eliminates much of the benefit that would otherwise be realized by virtue of a trust qualifying as an Exempt Commercial Trust under the Previous Proposals. Beneficiaries or contributors (described in clause (i) or (ii) above) will have to recognize certain income of the trust regardless of whether it is distributed to them.
The Proposals make two significant changes to this rule. First, the Proposals modify the ownership test in clause (i) above. Under the revised test, the question is whether the relevant person(s) hold 10% or more of all fixed interests in the trust of a particular class, rather than 10% or more of all fixed interests in the entire trust. The revised test will make it make it more likely that an investment by a Canadian resident in a commercial trust that issues multiple classes of fixed interests will exceed the 10% threshold, and therefore result in liability for tax on FAPI.
Second, the Proposals modify the range of persons/entities that can be required to include FAPI of a commercial trust in income. The rule will now apply to beneficiaries that are either a resident beneficiary, a mutual fund trust or mutual fund corporation, a controlled foreign affiliate of a person resident in Canada, or a partnership of which such a resident beneficiary, mutual fund or controlled foreign affiliate is a member.
The inclusion of controlled foreign affiliates in the foregoing list is intended to integrate the NRT rules with the regular FAPI rules applicable to Canadian resident persons that have controlling positions in foreign corporations. Where a controlled foreign affiliate of such a Canadian resident is a contributor or beneficiary under an Exempt Commercial Trust and is described in clauses (i) or (ii) above, FAPI of the trust will be reflected in computing the FAPI of such controlled foreign affiliate and thereby will be required to be included in income by that Canadian resident.
New Deemed Trust: Non-Resident Portion Trust
As noted above, the Previous Proposals introduced the notion of a resident portion and a non-resident portion of a NRT. Very generally, the resident portion would consist of property of the NRT derived from Canadian resident contributors, and the non-resident portion would consist of all other assets of the NRT. The NRT would be taxed in the manner of a Canadian-resident trust only with respect to the resident portion. The NRT would also be taxed as a non-resident with respect to the non-resident portion, as for example, on a disposition of taxable Canadian property included in that portion. There has been some concern that the Previous Proposals lacked sufficient guidance and detail to permit a NRT to determine those assets properly belonging to the resident portion. The Proposals introduce new rules that clarify, although arguably not always successfully, what assets form part of the resident portion. In addition, the bifurcation of the NRT into two separate taxpayers owning the NRT's resident and non-resident portions respectively makes the differing tax treatment of each such portion more explicit.
The Non-Resident Portion
The Proposals further define the resident portion (and by exclusion, the non-resident portion) with a series of rules that correspond to the provisions in new section 94 of the Act that cause certain transactions to constitute a deemed transfer of property to a NRT, and which, if made by a Canadian resident contributor, cause the deemed Canadian residency regime to apply to the NRT. These rules generally apply to indirect transfers to a NRT. The new rules are as follows.
Transfer or loan to a person or partnership: If the deemed transfer to a NRT is a transfer of property or loan made to a person or partnership that causes an increase in the fair market value of any property of the NRT, then each property of the NRT whose value is so increased will in its entirety be added to the resident portion of the NRT. The inclusion bears no relationship to the amount by which the loan or transfer increases the value of the NRT's assets. Thus, seemingly a $100 contribution to a NRT's wholly-owned subsidiary would cause all of the shares of the subsidiary to be added to the resident portion of the NRT, even if the value of the shares far exceeds the $100 contribution. Similarly, a contribution to the bottom or middle of a corporate chain "beneath" a trust that increases the value of NRT property would result in the addition of the entire chain to the resident portion. If, on the other hand, the transfer or loan results in a decrease in a liability or potential liability of the NRT, then there must be added to the resident portion an asset of the NRT as selected by the NRT (or failing which, the Minister) having a fair market value at least equal to the absolute value of such decrease in liability or potential liability.
Indirect transfers: The Proposals include a new anti-avoidance rule that deems a transfer of property to a NRT to occur where a person or partnership (i) transfers "restricted property" or loans property other than by way of an arm's length transaction, to an intermediary, (ii) at or after such time the NRT holds property (other than certain shares of a corporation, trust interests, or partnership interests) that derives its value in whole or in part and directly or indirectly from property held by the intermediary, and (iii) it is reasonable to conclude that one of the reasons for the transfer or loan is to avoid or minimize liability under the Act. In that case, there is included in the resident portion the NRT property that derives its value from the intermediary property. Again, the inclusion bears no relationship to the amount of any value so contributed to the NRT.
Financial assistance: If the deemed transfer of property to a NRT arises from the making of a guarantee, covenant or agreement by a person or partnership other than the NRT to ensure the repayment in whole or in part of a loan or other indebtedness of the NRT, there is included in the resident portion any property acquired by the NRT as a result of such guarantee, covenant or undertaking. The rule is ambiguous in at least two respects. First, the relevant rule presumably applies only when the property would have been acquired as a direct result of the NRT having obtained the loan proceeds or assuming the other indebtedness. The link between the provision of the financial assistance and the acquisition of the property is more tenuous: must the provision of the financial assistance by the person or partnership be a necessary pre-condition to the loan or indebtedness (i.e., a "but for" cause), or is the mere fact that the financial assistance is provided sufficient? Second, the rule is drafted much more narrowly than the corresponding deemed contribution rule which can apply when an undertaking or financial assistance is provided in respect of indebtedness of persons or partnerships other than the NRT. As drafted, it seems that the provision of financial assistance in favour of a subsidiary of a NRT, for example, would not create an inclusion in the resident portion, although it could nevertheless be treated as a deemed contribution to the NRT.
Provision of services: In the case of a deemed transfer of property to a NRT arising as a result of the provision of services to or on behalf of a person or partnership, the NRT must include in the resident portion an asset selected by it (or failing which, by the Minister) having a fair market value at least equal to the fair market value of such services.
Debt-financed property: The Proposals further include in the resident portion a property (a "subject property") acquired by way of indebtedness incurred by the NRT if (i) the indebtedness is secured by any property in the resident portion (other than the subject property), (ii) it is reasonable to conclude, at the time it was incurred, that the indebtedness would be repaid with recourse to any property (other than the subject property) in the NRT's resident portion at any time, or (iii) a person resident in Canada or a partnership of which a person resident in Canada is a member provides any undertaking including a guarantee, covenant or agreement to ensure whole or partial repayment of, or has otherwise provided financial assistance in respect of, the indebtedness of the NRT.
Non-Resident Portion Trust
Under the Previous Proposal, the resident and non-resident portions existed within the same NRT, and each was subject to different treatment. The Proposals significantly revise the approach to the resident and non-resident portion. In particular, if an election is made, the Act will now deem the creation of a non-resident inter-vivos trust that wouldhold the non-resident portion and would be separate from the NRT, which consequently would hold only the resident portion. This deemed trust, referred to as the "non-resident portion trust" (a NRPT), will be treated as a separate non-resident taxpayer under the Act. This new measure is likely intended to better ensure the correct tax treatment of the non-resident portion (i.e., it avoids the need to formulate a rule that would ensure the non-resident portion of a NRT is taxed as though it were owned by a non-resident, by simply deeming the non-resident portion to be owned by a non-resident).
Under these new rules, a NRT would be taxable as a resident of Canada on all income and gains from all of its assets (including all assets in the non-resident portion) unless it becomes an "electing trust," by making an election to deem the creation of a NRPT with respect to the NRT's non-resident portion. The election must be made by the electing trust for its first taxation year throughout which it is deemed to be a resident of Canada for purposes of computing its income, and in which it holds property that is part of its non-resident portion.
It is noted that the consequences of failing to make the election can be fairly draconian. If the NRT fails to make the election for its first taxation year, it is seemingly not available to it for subsequent years. As noted above, the determination of whether assets are in the resident (or otherwise non-resident) portion can be complicated. If a NRT mistakenly thinks if does not have a non-resident portion in a year, it may be the case that there would be no NRPT remedy available in subsequent years.
The NRPT is deemed to be created as of the first moment of the taxation year in which the electing trust makes the election. The NRPT will continue to exist until the earlier of such time as the electing trust ceases to be deemed to be a resident of Canada, the electing trust ceases to exist, or the electing trust becomes resident of Canada otherwise than as a result of the new NRT rules. All of the electing trust's property that is part of its non-resident portion is deemed to be property of the NRPT, and not of the electing trust.
The Proposals contain a set of rules intended to ensure general continuity between the circumstances of the NRPT and the electing trust. Accordingly, the NRPT is deemed to have the same trustees and beneficiaries as the electing trust, and the terms and conditions of the NRPT, and the rights and obligations of the beneficiaries of the NRPT, are deemed to be the same as for the electing trust. However, there is not necessarily complete continuity of status under the Act as between the electing trust and the NRPT. For example, although an electing trust may be a testamentary trust or estate, the corresponding NRPT could not have that same status under the Act.
The electing trust and the NRPT are deemed at all times to be affiliated with each other, and to not deal with each other at arm's length. If all or part of a property that is included in the non-resident portion of an electing trust becomes part of its resident portion (as for example where a Canadian contributor makes a contribution to a subsidiary of the electing trust), then the NRPT is deemed to have transferred the property to the electing trust at that time. A similar rule would cause deemed transfers by the electing trust to the NRPT of property that was included in its resident portion and becomes part of the non-resident portion. The explanatory notes released with the Proposals by the Department of Finance indicate that because the electing trust and NRPT do not deal with each other at arm's length, these rules will ensure that section 69 of the Act will then apply to cause the deemed transferor to realize fair market value proceeds of disposition on the deemed transfer.
The electing trust is made jointly and severally liable with the NRPT for amounts owing under the Act by the NRPT. If a NRPT ceases to exist (see above), the NRPT will be deemed to have disposed immediately before that time of all its properties on a rollover basis to the extent that the disposition of such property is taxable under the Act (e.g., in the case of taxable Canadian property), and for fair market value proceeds in any other case. The electing trust is deemed to have acquired the properties for these same amounts. Each person or partnership that was a beneficiary under the NRPT immediately before the time the NRPT ceased to exist will be deemed to have disposed at that time of its interest in the NRPT for proceeds of disposition equal to the beneficiary's cost amount in the interest.
The new rules that govern the determination of the resident portion and the creation of a NRPT apply for taxation years that end after 2006. The coming into force rules will permit a NRT to make an election to deem the creation of a NRPT as at that time by filing such election within 365 days of the Proposals receiving royal assent. There is no transitional rule that would permit the application of the Previous Proposals regime for periods prior to the release of the Proposals.
Other Changes to the NRT Rules
The Proposals contain other technical tax changes that will impact a variety of investments in NRTs. These other changes include:
- detailed rules concerning when a trust begins or ceases to be deemed resident in Canada under the NRT rules and the tax consequences of such changes in residence status, including deemed dispositions of trust property.
- a rule that clarifies that payments by one taxpayer in satisfaction of joint and several tax liability of that taxpayer and another taxpayer arising under the NRT rules will discharge both taxpayers' liabilities.
Offshore Investment Fund Property
The Proposals are generally consistent with the proposed amendments to the offshore investment fund property (OIFP) rules found in the Previous Proposals. The OIFP rules generally apply when a taxpayer holds an interest in a non-resident entity that derives its value, directly or indirectly, primarily from portfolio investments in certain types of investment property, where one of the main reasons for the taxpayer acquiring, holding or having the interest in the entity is to avoid Canadian tax. When applicable, these rules include a notional amount in computing the taxpayer's income equal to the designated cost of the taxpayer's interest in the entity multiplied by a prescribed interest rate, less any actual income (other than capital gains) received from the entity.
Consistent with the Previous Proposals, the Proposals modify the existing OIFP rules by increasing the prescribed interest rate to the three-month-average Treasury Bill rate plus 2%.
Unlike the Previous Proposals, the Proposals specifically include Exempt Commercial Trusts as a type of "non-resident entity" investment which can be subject to the OIFP rules. This makes it clear that if a foreign trust becomes exempt from the NRT rules as a result of being an Exempt Commercial Trust, its investors may still be taxed with respect to the investment under the OIFP rules. What is less clear is what happens if an investor in an Exempt Commercial Trust is subject to the modified FAPI regime described above with respect to its investment. Although the explanatory notes released with the Proposals by the Department of Finance suggest that it is not intended that there be double taxation under the OIFP rules and the modified FAPI regime, the actual text of the Proposals makes this less clear than it was under the Previous Proposals.
As in the Previous Proposals, the Proposals extend the normal reassessment period in respect of NRTs and OIFP by an additional three years.
Effective Dates and Transitional Rules
The amendments to the NRT rules in the Proposals apply to trust taxation years that end after 2006. There is also an option for taxpayers to elect to be taxed on the basis of the new rules for taxation years that end after 2000 and before 2007.
The amendments to the OIFP rules in the Proposals generally apply to taxation years that end after March 4, 2010. The Proposals contain transitional rules that address taxpayers that, in a period beginning after 2001, reported on the basis of the draft foreign investment entity rules that, until the 2010 Budget, were intended by the Government to replace the OIFP rules. The reassessment period is extended by the Proposals with respect to such taxpayers.
Navigating Canada's tax rules relating to investments in non-resident trusts and other offshore investment entities is often difficult. Many of the Proposals apply to the current taxation year of such trusts or entities, or retroactively; it is therefore key to review current and past transactions in order to determine the impact of the Proposals. Osler's international tax practitioners have a wealth of experience in dealing with these rules.
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.