Trusts are important tools in Canadian tax and estate planning. Discretionary family trusts, in particular, have become common and are continually evolving. Some of the most powerful benefits of these tools include:
- Flexibility – the ability to maintain control of assets while directing income and value as the trustees see fit.
- Income splitting – directing income of the trust to lower-income beneficiaries (usually family members) to minimize the overall family tax burden.
- Capital splitting – allocating capital gains to beneficiaries, enabling the use of multiple capital gains exemptions.
Trust use is even more common in U.S. tax and estate planning, but for different reasons. In fact, many of the typical planning strategies deployed in Canada are not effective – and may in fact be punitive – under U.S. tax law.
When a U.S. person (a U.S. citizen or resident alien) is connected with a Canadian trust, we must consider the U.S. tax implications of the trust arrangement. Two important distinctions under U.S. tax law are whether a trust is domestic or foreign, and whether the trust is a grantor or non-grantor trust.
Domestic or foreign?
Prior to 1996, whether a trust was foreign or domestic was a fact-based determination. In 1996, a two-part objective test was introduced. The test requires that a trust be considered foreign unless it satisfies two tests: the U.S. Court Test and the Control Test.
The U.S. Court Test is satisfied where a U.S. court is able to exercise primary jurisdiction over the trust. This, of course, is a question of fact and a matter of law in the relevant jurisdictions, but in general a U.S. court must have the ability and jurisdiction to determine all issues regarding the administration of the trust. The regulations do contain guidance in terms of certain facts that would, in the U.S. Treasury's eyes, meet the Court Test. In the case of an inter vivos trust, the trust will meet the Court Test if the trustees or beneficiaries take steps with a U.S. court that cause the trust to be subject to that court (e.g. registering the trust document with the court).
The Control Test is met if one or more U.S. persons have the authority to control all substantial decisions of the trust. Again, an examination of the trust indenture is required and factors such as the presence of a "primary trustee" must be considered.
If a trust meets both of these tests, it is considered a domestic trust and is taxable in the U.S. on its worldwide income. If the trust fails either test, it is a foreign trust. Most Canadian discretionary family trust arrangements would not meet the Court Test and, therefore, would be considered foreign trusts under U.S. tax law.
Grantor or non-grantor?
U.S. taxation of a foreign trust varies greatly depending on whether the trust is a grantor or non-grantor trust.
Foreign grantor trusts
Generally, where a U.S. person gratuitously transfers property to a foreign trust directly or indirectly, and that trust has a U.S. beneficiary, the grantor is treated as the owner of that trust property. As the owner of the property, the grantor is taxable on any income or gain relating to the property. In this regard, the grantor trust rules are similar to the Canadian reversionary trust rules. There are exceptions for testamentary transfers and for transfers at fair market value. However, the fair market value exception is limited in what consideration is considered fair market value in transfers from related persons.
The income of a Canadian discretionary family trust considered a grantor trust would attribute to the U.S. owner for U.S. tax purposes. This situation has the potential to create significant exposure to double taxation since, for Canadian tax purposes, the income of the trust often is taxed in the hands of other beneficiaries, or not taxed at all in the case of dividends allocated to a connected corporation.
While the settlement of a typical Canadian discretionary family trust would not generally involve a direct transfer from an interested party, the use of the term "directly or indirectly transfers" suggests a broad interpretation of the word "transfer." In fact, legislative history suggests the term "indirectly transfers" includes such situations as share reorganizations initiated by a controlling shareholder and transfers through foreign intermediaries. For example, if a controlling shareholder of a company caused that company to be reorganized to "freeze" the shareholder's value in fixed-value preferred shares and subsequently to issue low-value common shares to a trust, such an arrangement generally would be considered an indirect transfer by the controlling shareholder to the trust. There are also anti-avoidance provisions in the regulations for transfers through intermediaries where the principal purpose was to avoid U.S. tax.
The requirement that the trust have a U.S. beneficiary is far from straightforward. In addition to contemplating the expected scenarios, these rules were bolstered in 2010 to contemplate many "back door" provisions that would allow the addition of a U.S. beneficiary at a later time (i.e. power of appointment), and even to include contingent beneficiaries. Furthermore, the determination is made annually so it is possible for existing trusts to acquire U.S. beneficiaries and thereby become grantor trusts. This can be particularly punitive to the U.S. owner since the throwback rules would apply to any undistributed net income of the trust until the time it acquires a U.S. beneficiary. Thankfully, if a beneficiary becomes a U.S. person at a time that is more than five years after the transfer, they will not be considered a U.S. beneficiary for the purposes of the grantor trust determination.
Given today's global economy and the general mobility of talent between Canada and the U.S., the possibility of a beneficiary becoming a U.S. person is very real. Contemplating this possibility in the drafting of the trust indenture is feasible, but doing so might impact the planning flexibility and could be contrary to the settlor's intent. Mobility of the grantor can also be an issue. If a non-resident alien becomes a U.S. person within five years of the original property transfer, the trust can become a grantor trust upon the individual's residency start date.
Foreign non-grantor trusts
A foreign trust may be a non-grantor trust. Given the risks and pitfalls of the grantor trust rules, one might think this is a good thing. But it is not necessarily so if the trust has U.S. beneficiaries. Foreign non-grantor trusts generally are taxed as non-resident alien individuals. That is to say they are taxed only on their U.S. source income. Such trusts receive a deduction for the proportion of their distributable net income distributed to beneficiaries, and U.S. beneficiaries must include the distributed amounts in their income. To the extent that foreign (i.e. Canadian) tax has been paid on non-U.S. income, a foreign tax credit should be available for U.S. tax purposes.
Because foreign non-grantor trusts are taxed similarly to non-resident aliens, they have the ability to accumulate income without current U.S. tax to the extent that they do not distribute the income to U.S. beneficiaries. To discourage this type of tax deferral, the throwback rules apply to distributions of undistributed net income. The throwback rules are punitive, complex and for the most part, beyond the scope of this article. In general terms, however, they apply a tax rate and interest charge to "throw back" the income into the respective accumulation years. In addition, the accumulated income loses its character and is taxed as ordinary income to the U.S. beneficiary, possibly losing preferential tax treatment. Fortunately most, but not all, Canadian discretionary family trusts distribute their income currently and would not typically accumulate income.
U.S. reporting requirements for foreign trusts can be complex and the penalties for non-filing can be severe.
In addition to the U.S. tax implications of the trusts themselves, there are numerous U.S. income and transfer tax traps affecting much of the Canadian planning strategies for trusts. The most obvious example is a basic Canadian estate freeze transaction, which can result in a realization transaction for U.S. income tax purposes and can potentially trigger U.S. gift tax.
The bottom line is cross-border tax and estate planning is extremely specialized and requires the delicate touch of a tax specialist familiar with these issues. Achieving many of the above-noted benefits Canadians have come to enjoy is still possible but must be done in full contemplation of the tax laws in both countries. Your Collins Barrow advisor can help to ensure your U.S./Canadian trust matters are managed properly.
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.