November 21, 2012, Bill C-48, the Technical Tax Amendments Act, 2012, received first reading in the House of Commons. Bill C-48 includes, among numerous outstanding technical amendments to the Income Tax Act (Canada) (the "Act"), a revised version of the proposed amendments to the tax rules relating to non-resident trusts ("NRTs") in section 94 of the Act (the "Current NRT Proposals"). Several successive versions of the proposed amendments to section 94 have been released over a period of more than a decade. The Current NRT Proposals make several significant changes to the prior version of the proposed rules, which was released on August 27, 2010 (the "2010 Proposals") and discussed in detail in our November 2010 tax law bulletin.
The Current NRT Proposals contain two important relieving changes, absent from the 2010 Proposals, relevant to commercial NRTs and Canadian mutual funds investing in NRTs. First, the exemption from the proposed NRT rules for commercial NRTs has been expanded to apply to NRTs containing terms providing for discretion with respect to the distribution of income or capital of the trust, but only if the discretionary power meets specified conditions. Second, mutual fund corporations and mutual fund trusts that meet specified conditions will be included in the category of "exempt persons" for whom an investment in a NRT will not result in the NRT becoming subject to the NRT rules (or the mutual fund becoming jointly and severally liable for the NRT's Canadian tax liability). These and other notable changes are discussed in more detail below.
OVERVIEW OF THE PROPOSED NRT RULES
The basic scheme of amended section 94 as set out in the Current NRT Proposals remains unchanged from the 2010 Proposals, and the rules generally apply from January 1, 2007. A NRT will be caught by the proposed NRT rules for a taxation year if, at the end of that year (or if the NRT is terminated in that year, on such termination date) both of the following conditions are met:
- The NRT is not an "exempt foreign trust"; and
- The NRT has a "resident contributor" or a "resident beneficiary" (each of which excludes an "exempt person").
If the proposed NRT rules apply to a NRT for a taxation year, the NRT will be deemed to be a resident of Canada for the purposes of various provisions of the Act and subject to Canadian tax on its worldwide income. In contrast to the 2010 Proposals which introduced an automatic exclusion from Canadian taxation for certain passive income and taxable capital gains generated from the "non-resident portion" of a NRT's assets, the Current NRT Proposals provide that the NRT will automatically be taxed on its worldwide income, except if the NRT makes an election for its first taxation year throughout which it is deemed to be resident in Canada under the proposed NRT rules and in which it holds property that is part of its non-resident portion. If the election is made, a separate non-resident portion trust ("NRPT") is deemed to be created, which has the same terms, conditions, trustee(s) and beneficiaries as the NRT. However, the NRPT is deemed to own the property included in the NRT's non-resident portion and is deemed not to have a resident contributor or a resident beneficiary so that the proposed NRT rules do not apply to the NRPT. The result of the election is that the NRT will be subject to Canadian tax only in respect of the resident portion of its assets. Additional rules provide for deemed transfers between the NRT and the NRPT where resident portion assets become non-resident portion assets (and vice versa), ensure that the NRT is jointly and severally liable with the NRPT for any tax owing by the NRPT, and deem the NRPT to have disposed of its assets to the NRT at the time it ceases to exist. The Current NRT Proposals also expand on the 2010 Proposals by introducing additional rules to clarify what assets of an NRT are included in the NRT's resident and non-resident portions for purposes of determining an electing NRT's Canadian tax liability under the proposed NRT rules.
EXEMPTION FOR COMMERCIAL TRUSTS BROADENED
The proposed NRT rules will not apply to a NRT for a tax year as long as it qualifies as an "exempt foreign trust" at the end that year, regardless of whether it has a resident contributor or a resident beneficiary at that time. The 2010 Proposals expanded the concept of "exempt foreign trust" to include a commercial NRT where the only investors in the NRT who may receive any income or capital of the NRT hold "specified fixed interests" in the NRT, which were defined as interests in respect of which there was no discretion regarding the distribution of income or capital of the trust.1 In the context of commercial trusts there is frequently, if not typically, an element of discretion involved in making distributions among different classes or series of unitholders, and with regard to the timing of distributions.
The Current NRT Proposals have broadened this exemption for commercial NRTs: the "specified fixed interest" concept has been replaced with the more generous concept of "fixed interest", which allows for the exercise of discretionary power in respect of interests in the commercial NRT as long as all three of the following requirements are met:
- the discretionary power is consistent with normal commercial practice;
- the discretionary power is consistent with terms that would be acceptable to the investors in the NRT if they were dealing with each other at arm's length; and
- the exercise of (or failure to exercise) the discretionary power will not materially affect the value of an investor's interest in the NRT relative to the value of other such interests in the NRT.
This broadening of the commercial NRT exemption is an important and welcome change that should give significantly greater comfort to commercial NRTs seeking to rely on exempt foreign trust status to avoid the application of the proposed NRT rules.
On the downside, the Current NRT Proposals have also expanded the scope of the rule in new section 94.2, which was introduced by the 2010 Proposals. Under the 2010 Proposals, if a "resident beneficiary" of the NRT held, together with persons not dealing at arm's length, 10% or more of the fixed interests in a commercial NRT that qualified as an exempt foreign trust as described above, and contributed "restricted property" to the NRT as defined in proposed subsection 94(1), the resident beneficiary would be required under new section 94.2 to include in income a participating percentage of the NRT's foreign accrual property income under the foreign affiliate rules (determined as if the NRT were a foreign corporation) for taxation years ending after March 4, 2010.2 In essence, the trust would be treated as a controlled foreign affiliate of the resident beneficiary for Canadian tax purposes.
The Current NRT Proposals widen the scope of section 94.2 by applying the 10% ownership threshold on a class-by-class basis, rather than in relation to all fixed interests in the NRT as a whole. This will make it easier for an investor in a NRT to exceed the 10% threshold and potentially trigger the application of the rule. In addition, under the Current NRT Proposals, it is not only "resident beneficiaries" who can be caught by the rule in section 94.2, but also beneficiaries that are mutual fund trusts and mutual fund corporations as described below, controlled foreign affiliates of a Canadian resident person, and partnerships of which such a resident beneficiary, mutual fund or controlled foreign affiliate is a member, as well as persons (other than certain individuals) of which any such beneficiary is a controlled foreign affiliate.
MUTUAL FUNDS INCLUDED AS EXEMPT PERSONS
As outlined above, a person who qualifies as an "exempt person" will not be considered to be a resident contributor to, or a resident beneficiary of, a NRT under the proposed NRT rules. The Current NRT Proposals expand the list of "exempt persons", introduced by the 2010 Proposals, to include mutual fund trusts and mutual fund corporations that qualify as such under the Act, as long as the fund (or a promoter3 or other representative of the fund) has not made any statements or representations in respect of the acquisition or offering of an interest in the fund, that Canadian taxes on the income, profits or gains for any particular tax year in respect of fund property that is (or derives its value from) a trust interest are (or are expected to be) less than the taxes that an investor in the fund would have paid if the investor had earned such income, profits or gains directly.
The result is that as long as a Canadian mutual fund that invests in a NRT qualifies as an exempt person, the NRT will not be subject to the Proposed NRT Rules merely because of the mutual fund's investment in it. In addition, if the NRT otherwise is or becomes subject to the Proposed NRT Rules – for example, because the NRT does not qualify as an exempt foreign trust and a Canadian resident that is not an exempt person invests in it – the mutual fund will not be jointly and severally liable with the NRT for the NRT's Canadian tax liability. Thus, qualifying mutual funds will not need to determine whether the NRT qualifies as an exempt foreign trust to ensure that they will not be exposed to liability for any Canadian taxes owing by the NRT under the Proposed NRT rules.
However, as a result of the indirect contribution rule in paragraph 94(2)(n) of the Current NRT Proposals4 (which remains unchanged from the 2010 Proposals), it appears that Canadian resident investors in a mutual fund trust that are not exempt persons would be deemed to be resident contributors to the NRT and would be jointly and severally liable with the NRT (subject to a maximum recovery limit) for Canadian taxes owing by the NRT under the Proposed NRT rules where the NRT does not qualify as an exempt foreign trust. Canadian resident investors in a mutual fund corporation may suffer the same consequences as a result of the indirect contribution rule in paragraph (b) of the definition of "contribution" in subsection 94(1)5 or the rule in paragraph 94(2)(a)6 of the Current Proposals (both of which remain unchanged from the 2010 Proposals). Presumably this result is unintended and will need to be addressed.
OTHER NOTABLE CHANGES
The Current NRT Proposals have introduced a new rule that deems a loan made by a specified financial institution to a trust not to be a contribution to the trust for the purposes of the proposed NRT rules if the loan is made by the financial institution in the ordinary course of its business and on arm's length terms. In addition, the Current NRT Proposals have supplemented the rules that determine when, and what happens after, a NRT ceases to be deemed to be resident in Canada under the proposed NRT rules.
1 In addition, under paragraph (h) of the definition of "exempt foreign trust" in proposed subsection 94(1) of the Act, the NRT must satisfy one of the four following conditions:
- there are at least 150 beneficiaries of the NRT each of whom holds fixed interests having a total fair market value of at least $500; or
- all fixed interests in the NRT are listed on a designated stock exchange and were traded on a designated stock exchange on at least 10 days in the immediately preceding 30 day period; or
- each outstanding fixed interest in the NRT was either
- ◊ issued by the NRT for at least 90% of the interest's proportionate share of the net asset value of the NRT's property at the time it was issued; or
- ◊ acquired for fair market value at the time the interest was issued; or
- the NRT is governed by
- ◊ a Roth IRA (as defined in the U.S. Internal Revenue Code); or
- ◊ a plan or arrangement created after September 21, 2007 that is subject to the U.S. Internal Revenue Code and that the Minister of National Revenue agrees is substantially similar to a Roth IRA.
2 If section 94.2 does not apply, the offshore investment fund property rule in existing section 94.1 could instead apply in certain circumstances to require the beneficiary to include an imputed amount in income for each taxation year during which the interest is held.
3 For these purposes, the Current NRT Proposals expand the definition of "promoter" to include not only any person or partnership that establishes, organizes or substantially reorganizes the undertakings of the mutual fund corporation or mutual fund trust, but also any person or partnership who in the course of a business (i) sells or issues, or promotes the sale, issuance or acquisition of, an interest in a mutual fund corporation or mutual fund trust; (ii) acts as an agent or advisor in respect of the sale or issuance, or the promotion of the sale, issuance or acquisition of, an interest in a mutual fund corporation or mutual fund trust; or (iii) accepts, whether as a principal or agent, consideration in respect of an interest in a mutual fund corporation or mutual fund trust.
4 Paragraph 94(2)(n) provides that a contribution made at any time by a particular trust to another trust is deemed to have been made jointly by the particular trust and by each person or partnership that is at that time a contributor to the particular trust.
5 Paragraph (b) of the definition of "contribution" provides that if a particular transfer of property that is not an arm's length transfer (the first transfer) is made by a particular person as part of a series of transactions that includes another transfer of property that is not an arm's length transfer to a trust by another person (the second transfer), the second transfer is considered to be a contribution by the particular person to the trust to the extent that it can reasonably be considered to have been made in respect of the first transfer. An "arm's length transfer" is defined to exclude a transfer of property if one of the reasons for the transfer is the acquisition by any person of an interest in a NRT.
6 Paragraph 94(2)(a) provides that a person is deemed to have transferred a property to a trust at any time if (i) at that time the person transfers property (other than by way of an arm's length transfer) to another person and (ii) because of that transfer the fair market value of one or more properties held by the trust increases at that time, or a liability or potential liability of the trust decreases at that time.About BLG
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