Originally published by Tax Notes. This article is the first instalment in a four-part series that will appear in Tax Notes over the next few months.
The purpose of this series of articles ("Series") is to provide non-specialist advisors with a high-level overview of some the tax traps1 that can impact non-resident trusts ("NRTs") with a focus on the recently expanded rules relating to NRTs in section 94 of the Income Tax Act (Canada) ("Act")2 ("Section 94 NRT Rules"). Unfortunately, given the high level of complexity of the rules that apply to NRTs and, in particular, the new Section 94 NRT Rules, achieving even this limited objective will not be easy.
This first instalment of the Series will tackle issues associated with the concept of "residency" in Canadian tax law and how residency concepts have recently been expanded under the Section 94 NRT Rules. Following the residency discussion, a few real life examples of how the Section 94 NRT Rules could impact a non-specialist advisor's practice and his or her clients' affairs will be provided. These examples will be fleshed out during the discussions in later instalments of the Series.
The second and third instalments of the Series will delve into certain technical aspects of the Section 94 NRT Rules, which will focus on how easily Pure NRTs (as defined below) can become caught by these rules. In addition, the third instalment will review some of the relieving provisions in the Section 94 NRT Rules and will discuss why these provisions will often be of limited relief. To add insult to injury, the third instalment of the Series will close with a discussion of the broad and unfair joint and several liability provisions found in the Section 94 NRT Rules.
The fourth and final instalment of the Series will explore what happens when trusts become ensnared and later escape from the Section 94 NRT Rules and it will also review how these rules can negatively impact common cross-border Canada–US testamentary planning for Canadian clients with US beneficiaries. As a bonus, the last instalment will also review some issues involving Pure NRTs and, in particular, will review a potential trap highlighted by a recent Canada Revenue Agency ("CRA") technical interpretation dealing with distributions from Pure NRTs.
Canadian Tax Residency
Canada taxes Canadian residents on their worldwide income.3 As a result, the determination of a taxpayer's residency status is of primary importance when considering Canada's right to levy tax. Unfortunately, the determination of a trust's residency status is complex.
Common Law or factual residency
Under Canadian taxation principles a trust will be a factual resident in Canada if, pursuant to common law principles, the location of its "central management and control"4 is found to be in Canada. This concept is short-hand lawyer speak that is intended to allow one to determine the residency of a trust by identifying if the people who are really making decisions for the trust are doing so in Canada or not.
While the location of central management and control of a trust will usually be determined by examining where the trustees make their decisions, the test is fact based so that if the real decision makers are not the trustees, then the trust's common law or factual residency will be the location of those persons who are actually the real decision makers. The first time that the "central management and control" concept was applied to a trust in Canada was in Garron, where the Supreme Court of Canada ("SCC") determined that although the trustee of the offshore trust under review was not a Canadian resident, Mr. Garron, a Canadian resident who was not a trustee of the trust, had central management and control of the trust because he had too many powers and directed the decision making of the trustees. As a result, the SCC determined that the trust was a common-law resident of Canada.5
Putting situations like Garron aside, with proper attention to how a trust is established and provided that central management and control is truly not taking place in Canada then it is possible for a trust to be a non-resident of Canada. This type of legally and factually non-resident trust will be referred to as a "Pure NRT" throughout the Series.
The Section 94 NRT Rules
Under the Section 94 NRT Rules, which were enacted in 2013 and are generally effective after 2006, an otherwise Pure NRT can be deemed to be a resident of Canada for most purposes of the Act in a broad spectrum of situations. How this can occur will be the primary focus of the Series.6 Throughout the remainder of the Series trusts caught under these rules will be referred to as "Section 94 NRTs".
The Section 94 NRT Rules — They can happen to you — real life examples7
I imagine that many readers might think that NRTs of any type are exotic creatures that have nothing to do with their practices. However, in today's world of cross-border families I believe that at some point in time nearly all advisors, including non-specialists, will need to consider whether trusts they are dealing with could be NRTs and, as a result, they will end up having to deal with the Section 94 NRT Rules. To try and prove this point to you, some real life examples of situations that can involve NRTs are described below.
Example 1—New immigrant to Canada
The most straightforward NRT situation that I can imagine involves a typical wealthy immigrant. Unfortunately, due to the elimination of the immigrant trust rules in Budget 2014,8 any immigrant to Canada who has settled or made just about any type of loan or transfer to an otherwise Pure NRT will, except in extremely limited circumstances, cause that trust to be caught by the new Section 94 NRT rules once they immigrate to Canada.
Example 2—Granny Trust—provision of services by Canadian resident
If a Canadian resident client has an offshore granny who creates a trust for, among others, the Canadian resident client that trust could be a Pure NRT – completely free from Canadian tax. However, there are many ways that this status can be lost. For example, if a Canadian resident provides services to the Pure NRT without receiving arm's length consideration then Pure NRT's status could be jeopardized and the trust could become a Section 94 NRT.
Example 3—Canadian subsidiary of EU family Business—non-interest bearing loan
A variant of the preceding granny trust example could involve a purely Canadian resident client who wants to help his family expand its European business into Canada by setting up and managing a Canadian subsidiary of the European corporate group. In this situation, the Canadian resident client will earn arm's length compensation from the subsidiary. However, if the client or any other Canadian resident makes a low or non-interest bearing loan (e.g., to help fund the subsidiary) that directly or indirectly benefits a Pure NRT that is a shareholder of the European corporate group then that otherwise Pure NRT could become subject to the Section 94 NRT Rules.9
Example 4—Canadian estate planning for US beneficiaries
Another typical situation that I see in my practice involves Canadian clients whose children have emigrated from Canada to the United States. In these situations it is common for the Canadian client's US advisors to request that the Canadian clients' Wills are structured so that their estates fund or "pour-over" into one or more US trusts set up for the clients' US beneficiaries. Unfortunately, due to the expanded scope of the new Section 94 NRT Rules, such planning is likely to be impacted by these new rules.
Hopefully, these innocent and rather straightforward examples have gotten your attention. However, keeping it during future instalments of the Series is going to be much more difficult. This is because the Section 94 NRT Rules are incredibly complex and there doesn't appear to be any way to even begin to appreciate just how these rules might impact clients or advisors without reviewing the Section 94 NRT Rules in an at least "somewhat" technical manner.
This review will begin in the next instalment of the Series.
Thanks to members of the Minden Gross LLP Tax Group for reviewing earlier versions of this series of articles. All errors and omissions are my own.
1. There are many other traps that will not be canvassed in the Series. For some recent far more detailed discussions of the Section 94 NRT Rules see, for example, Bruce M. Harris, Kathy M. Munro, and Angela M. Ross, "The Long and Winding Road: Sections 94, 94.1, and 94.2," 2013 Conference Report, (Toronto: Canadian Tax Foundation, 2014), 23: 1-60 and Tony Schweitzer and Jesse Brodlieb, "Canadian Taxation of Income Earned and Distributed by a Subsection 94(3) Trust" in "International Tax Planning," (2013), vol. 61, no. 2 Canadian Tax Journal, 461-478.
2. Unless otherwise noted all statutory references are to the Act.
3. As set out in section 3.
4. See Fundy Settlement v. Canada, 2012 SCC 14. The decision is alternatively known as Garron and St. Michael Trust. In the Series the case will be referred to as Garron.
5. The "central management and control" test espoused in Garron has been followed in two recent domestic trust decisions, Discovery Trust v. Minister of National Revenue, 2015 NTLD(G) 86, and in Boettger c. Qu´ebec (Agence du revenue), 2015 QCCS 7517 (French only).
6. The Series will not review the workings of section 94 prior to the enactment of the Section 94 NRT Rules.
7. A more detailed discussion of the examples discussed below will follow in later instalments of the Series.
8. See Bill C-43, the Economic Action Plan 2014 Act, No. 2; SC 2014, c. 39; Royal Assent December 16, 2014.
9. As is discussed later in the Series there may be arguments that pure demand loans would not cause the Pure NRT to become a Section 94 NRT.
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.