Originally published in Blakes Bulletin on Pension & Employee Benefits, May 2007
On November 9, 2006, the Canadian Department of Finance published the fifth revised version of draft income tax legislation relating to non-resident trusts. The draft legislation is now before the House of Commons – as part of Bill C-33 – and has received First Reading. Barring a federal election in the immediate future, it is expected to become law. If enacted in its current form, this income tax legislation could significantly affect the participation of Canadian resident employees in various U.S.-based and other foreign retirement income, employee benefit and compensation plans which are structured as, or funded with, trusts. The new legislation will generally be effective starting in 2007, subject to a number of transition rules discussed below. Previous versions of the draft legislation were subject to extensive comment from numerous income tax professionals and organizations. Unfortunately, the Department of Finance has been unwilling to consider significant changes to the proposed legislation.
The legislation is intended to apply to various types of non-resident trusts to which a Canadian resident contributes – for example, a corporation that is resident in Canada and that contributes to the trust in respect of its employees – or under which a Canadian resident is a beneficiary. If the legislation applies, the U.S.-based trust, or other foreign trust is deemed to be a resident of Canada for income tax purposes and subject to Canadian income tax on its worldwide income. As discussed more fully below, the Canadian income tax authorities have stated that the tie-breaker rules in many income tax treaties that apply to individuals who are dual residents would not apply to a non-resident trust to save it from taxation in Canada.
In addition to the foreign trust itself, each Canadian resident contributor to the trust, and each Canadian resident beneficiary of the trust, would be jointly and severally liable in respect of the trust’s Canadian income tax liabilities. In certain circumstances, the income tax liability on Canadian resident beneficiaries and Canadian resident contributors will be capped.
For a foreign trust to avoid being caught by the proposed non-resident trust legislation, it will be necessary to establish either: 1) that there is no "resident beneficiary" and no "resident contributor" or 2) that the trust qualifies as an "exempt foreign trust".
EXEMPT FOREIGN TRUST
If a U.S. parent or affiliate (or other foreign entity) wishes to include employees of its Canadian affiliate in a plan that is not based in Canada, it should first determine if the plan could be caught by the non-resident trust rules.
If the plan is structured as a trust, or if it is funded through a trust, and Canadian resident employees become participants or beneficiaries of the U.S. plan, the non-resident trust rules will likely apply unless it can be established that the U.S. plan – particularly its related trust – is an "exempt foreign trust" or it can be established that there is no "connected contributor". Exempt foreign trusts will not be caught by the new legislation.
There are two potentially relevant types of "exempt foreign trusts" which could apply to foreign plans although each exemption imposes a number of qualifications that will, in many circumstances, be difficult for the U.S. trust, or other foreign trust, to meet.
The first exemption applies to tax-exempt foreign plans, particularly pension plans. This exemption applies where:
- the trust is operated exclusively for the purpose of administering or providing superannuation or pension benefits;
- the pension or superannuation benefits provided under the trust are primarily in respect of services of non-residents of Canada performed in the country in which the trust is resident, i.e., the home country;
- the home country is a jurisdiction which imposes an income or profits tax; and
- the trust is exempt from income or profits tax in the home country in recognition of the purposes for which the trust is operated.
For some types of plans, for example, stock compensation or welfare benefit plans, it will likely not be the case that the nonresident trust has been operated "exclusively for the purpose of providing superannuation or pension benefits".
Where the residence of the trust is a tax haven, it will be necessary to determine whether the reason why the trust is exempt from income tax in that jurisdiction could be said to be connected to the purposes for which the trust is operated – because income tax laws in that jurisdiction provide preferred income tax treatment for plans that provide employee benefits – and not for some other reason, such as the absence of local residents as beneficiaries. In addition, where the trust is resident in a tax haven, it may not be possible to establish that the benefits provided under the plan relate primarily to services performed in that jurisdiction as in many cases the employee beneficiaries will not be employed in the tax haven.
The second exemption applies to a potentially broader range of plans where:
- the related trust has been exclusively operated for the purpose of administering or providing employee benefits;
- the trust is a trust governed by an "employee benefit plan" as defined under Canadian income tax laws. (An employee benefit plan is very broadly defined under Canadian income tax laws and includes most types of non-Canadian plans which are established and operated primarily for the benefit of employees who are not residents of Canada including, for example, welfare benefit and capital accumulation or employee savings plans and many trusteed stock compensation plans.);
- the trust is maintained for the benefit of natural persons the majority of whom are non-resident;
- after 2006, the trust does not hold any "restricted property". (In brief, restricted property is a share, a right to acquire a share, and debt issued by a closely-held corporation. The term "closely-held corporation" is also defined in the draft legislation and essentially means any corporation other than a corporation of which there are at least 150 shareholders and where no shareholder (or another entity that does not deal at arm’s length with that shareholder) holds more than 10% of the voting shares or shares which are worth more than 10% of the fair market value of all issued and outstanding shares.); and
- the only benefits provided by the trust are benefits relating to "qualifying services".
- rendered to the employer by the employee during a period throughout which the employee was not a resident of Canada, or
- rendered to the employer by the employee which are not services performed primarily in Canada or are not performed primarily in connection with a business carried on in Canada, or
- rendered to the employer by the employee during the first 60 months of the employee’s residence in Canada where the employee was previously not a resident of Canada and became a member of the plan before the end of the month following the month in which the employee became a resident
This exemption will not be applicable where long-term or habitual Canadian residents become participants in the plan.
OTHER TYPES OF EXEMPT FOREIGN TRUSTS
Certain types of trusts which have a recognized income tax status under Canadian income tax laws will also be exempt foreign trusts and therefore not caught by the proposed nonresident trust legislation. In addition, certain types of U.S. arrangements will also be treated as exempt foreign trusts under the proposed legislation.
A plan which is structured as an employees profit sharing plan (EPSP) under Canadian income tax laws will be an exempt foreign trust. An EPSP is an after tax profit sharing plan under which an employer contributes a percentage of profits or makes a contribution out of its profits to a trust – which may be a non-resident trust. Under Canadian income tax rules, contributions made on behalf of an employee to the EPSP and income attributable to those contributions earned by the trust during the year must be allocated to the employee and included in the employee’s income for that year. Certain stock compensation plans, for example, are structured as EPSPs, but in many cases, an election will need to have been filed with the Canadian tax authorities when the plan was established for it to be an EPSP.
A retirement compensation arrangement (RCA) will also be an exempt foreign trust under the proposed legislation. The application of the RCA rules to foreign pension plans in which Canadian residents accrue benefits will be discussed in a subsequent bulletin.
U.S. Individual Retirement Accounts (IRAs), U.S. individual retirement annuities and certain U.S. custodial accounts will also be exempt foreign trusts under the proposed legislation. For purposes of the proposed legislation, such plans will be defined as: a plan or arrangement to which subsection 408(a), (b) or (h) of the United States Internal Revenue Code of 1986, as amended from time to time, applies.
NO CONNECTED CONTRIBUTOR
As noted above, the legislation applies to non-resident trusts where there is a resident contributor or a resident beneficiary. For there to be a resident beneficiary, there must be a "connected contributor" to the trust. In general, a connected contributor to a trust means an entity that is a contributor to the trust, other than an entity all of whose contributions were made when the entity was a non-resident. Accordingly, where contributions are only made to a non-resident trust by nonresidents, the non-resident trust may not be caught by the new legislation. There are rules to capture third party transfers and other deemed contribution rules, which should carefully be considered before concluding that there is no connected contributor.
TAX TREATY CONSIDERATIONS
One of the more controversial aspects of the proposed legislation is the effect it might have on certain types of non- Canadian tax exempt plans to which a Canadian resident contributes and which do not qualify as "exempt foreign trusts".
The Canada-U.S. Tax Convention (the Treaty) contains provisions which are applicable to dividend and interest income earned by tax exempt employee benefit trusts which are resident in one country and generally exempt from income taxation in that country. Article XXI 2 of the Treaty provides, for example, that a trust which is resident and generally exempt from income tax in the United States and operated exclusively to provide pension, retirement or other employee benefits is exempt from tax in Canada on dividend and interest income. According to the Canada Revenue Agency (the CRA), however, this provision in the Treaty may not prevent taxation of the trust’s dividend and interest income in Canada where a Canadian resident has contributed to the trust in respect of a Canadian resident beneficiary. In this situation, the CRA may take the view that, as a consequence of the application of the non-resident trust legislation, the U.S. trust is treated as a resident of Canada for the purposes of the Treaty and Canadian income tax laws. The trust would be dual-resident and recourse to the tie-breaker provisions in Article IV 4 of the Treaty would be necessary. The tie-breaker provisions in Article IV 2 of the Treaty, which apply to individuals, would not prevent the trust from being deemed resident in Canada and subject to Canadian income tax on its worldwide income. Article IV 4 of the Treaty provides that where a trust is dual resident, the competent authorities of the states shall by mutual agreement endeavor to settle the question and to determine the mode of application of the Treaty to such a trust.
As noted above, a non-resident trust governed by an employee benefit plan under which the only benefits provided by the trust relate to "qualifying services" may be an exempt foreign trust. The proposed legislation will provide some transitional relief for non-resident trusts governed by an employee benefit plan that provide benefits in respect of services performed prior to November 9, 2006 that were not "qualifying services". The transitional relief is available for the trust’s taxation years that end before 2009, which means that all benefits in respect of services performed prior to November 9, 2006 that were not "qualifying services" must be settled no later than the trust’s last taxation year that ends before 2009. In order to qualify for the transitional relief, the proposed legislation provides that written evidence of the arrangement must be filed with the Minister of National Revenue prior to April 30, 2007.
Given that the legislation has not yet become law, we understand from discussions with the Department of Finance that some type of accommodation will be made to extend the opportunity to file the election. There is no transitional relief provided in respect of a non-resident trust that provides benefits in respect of services performed on or after November 9, 2006 that are not qualifying services. If benefits are provided under the non-resident trust in respect of services performed on or after November 9, 2006 that are not "qualifying services", the election will be of no assistance and should not be filed.
The application of the proposed non-resident trust legislation needs to be carefully considered before a foreign entity or its Canadian affiliate enrolls Canadian residents in a foreign trusteed plan. It may be possible in some cases for the plan to qualify as an "exempt foreign trust" or determine that there is no connected contributor; however, this will require a review of the terms of the foreign plan and its related trust. If long-term Canadian residents have been contributing to, or accruing benefits under, the trusteed plan and the trust is captured by the new legislation, consideration should be given as to whether the proposed transitional relief may be of assistance. If the trusteed plan is captured by the new legislation and benefits are continuing to accrue under the arrangement in respect of services that are not "qualifying services", consideration should be given to ceasing such accruals and distributing benefits accrued to Canadian residents.
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.