NRT Tax Traps And The Non-Specialist Advisor1
—Michael Goldberg, Tax Partner, Minden Gross LLP, MERITAS law firms worldwide and June 2016 founder of "Tax Talk with Michael Goldberg", a quarterly conference call about current, Number 641 relevant and real-life tax situations for professional advisors who serve high net worth clients.
This article is the third instalment in a four-part series. The fourth and final instalment will appear in next month's issue of Tax Notes.
In the second instalment of the Series we began the arduous task of providing a high-level review of the Section 94 NRT Rules with a focus on just how easy it is for a contributor to make a contribution to a trust under these rules. Since not all contributions to trusts will engage the Section 94 NRT Rules, in this, the third instalment of the Series, we will consider the types of contributions that will cause otherwise Pure NRTs to become Section 94 NRTs subject to tax in Canada.
As you may recall from the second instalment of the Series, only contributions that involve a trust with a:
- "resident contributor", or
- "resident beneficiary",
will engage the Section 94 Trust Rules.2 Unfortunately, engaging these rules at any particular time is quite easy.
All that is required for there to be a resident contributor at a particular time is that an otherwise Pure NRT needs to have a contributor that is alive or otherwise in existence and that is resident in Canada. If the otherwise Pure NRT meets these criteria, then it will automatically be a Section 94 NRT.3
It is worth keeping in mind that ceasing to exist is a concept that is broader than dying. For example, it can include the winding-up of a trust or partnership and the voluntary dissolution of a corporation.4
Example 1 – New immigrant to Canada
Effective following 2014, the "immigrant trust" rules in the Act were eliminated. Since that time, the only grandfathering provisions that will allow an otherwise Pure NRT that has a contributor resident in Canada to avoid the new Section 94 NRT Rules will be in the rare situation in which a Pure NRT that was formed before 1960 has received no contributions by an individual (other than a trust) after 1959.
Consequently, if a client has immigrated to Canada and at any time after 1959 but prior to immigration that client made a contribution to a Pure NRT, that trust will be caught by the Section 94 NRT Rules, and it will become a Section 94 NRT.5
Example 2 – Granny Trust – Provision of services by Canadian resident
This example involved a Canadian resident client whose granny had created an otherwise Pure NRT for the granny's beneficiaries, including the Canadian resident client. It turns out that the Canadian client just happens to be an investment wizard. Well, being a good granddaughter she starts providing all sorts of cutting-edge advice to the otherwise Pure NRT and refuses to allow the trust to pay her any fee let alone an arm's length fee sufficient to satisfy the arm's length transfer requirement. What a shame since the provision of the advice for less than arm's length compensation will constitute a contribution by a Canadian and the Section 94 NRT Rules will cause the otherwise Pure NRT to become a Section 94 NRT.6
Example 3 – Canadian subsidiary of EU family Business – non-interest bearing loan
Let's assume that the Canadian resident client in this example who, as you may recall, started the Canadian subsidiary of the EU family business owned by the Pure NRT of which he is a beneficiary receives an arm's length salary for his services from the Canadian subsidiary. Assuming that it can be established that the provision of services by the client (and any other Canadian residents) constitutes "exempt service", there shouldn't be an indirect contribution to the Pure NRT; however, assume that one day in the future the Canadian subsidiary has an urgent need for liquidity and the client does what most Canadian business persons typically do—he makes a non-interest bearing loan to the Canadian subsidiary. Unfortunately, this loan won't qualify as an arm's length transfer. If the loan results in an increase in the FMV of the trust's shares of the EU corporation,7 then the making of the loan would constitute a contribution and the Section 94 NRT Rules will likely be engaged.
Unfortunately, due to how broad the contribution concept is, it is entirely possible that clients who make contributions to otherwise Pure NRTs will often not even know that a contribution has been made in any of these types of situations. In fact, until you or some other advisor discovers the contribution, the client might not even know that the trust has become a Section 94 NRT.
Even if a trust doesn't have a resident contributor at a particular time, it could still be a Section 94 NRT where it has a resident beneficiary. As the definition suggests, a resident beneficiary will exist if, at a particular time, a trust has a beneficiary that is resident in Canada. Fortunately, simply having a beneficiary resident in Canada is not enough to cause a trust to have a resident beneficiary.
The trust must also have a "connected contributor" at that time. With a limited exception for contributions made during certain periods when a contributor was not a Canadian resident, a connected contributor will include any contributor who was ever a resident of Canada even if the contributor ceases to exist.
If a trust has Canadian resident beneficiaries and the contributor ceases to be a Canadian resident or ceases to exist, then the resident beneficiary concept will expand the application of the Section 94 NRT Rules to situations not caught by the resident contributor definition.
It is worth noting that the term resident beneficiary specifically excludes "successor beneficiaries", which is a term that includes certain closely related persons whose right to be a beneficiary is dependent on the death of a contributor.8 As a result, if a trust has a connected contributor and at some point after the connected contributor's death a resident Canadian becomes a beneficiary of the trust, then the trust could fall into the Section 94 NRT Rules and become a Section 94 NRT.
An otherwise Pure NRT that has received even a nominal contribution from persons who are resident contributors or connected contributors will become a Section 94 NRT, and all of its income will be caught by the Section 94 NRT rules unless the trust is able to file an election to become an electing trust. If this election is filed, then only income from the so-called "resident portion" of the trust property will be taxable in Canada.
Essentially the resident portion of the trust property will be all of the trust's property derived from a resident contributor or a connected contributor. The resident portion of the income from the trust property will be tracked separately from the non-resident portion of the trust's property. For older trusts where record keeping may not be available, tracking could be a challenge.
Aside from tracking problems, one of the other big issues with the electing trust rules is that the election must be made in writing at the time of filing the Section 94 NRT's first taxation year after 2006 in which it is both deemed to be a Section 94 NRT and has a non-resident portion.9 Due to certain transitional rules, older trusts generally had until June 26, 2014 to file the election. However, other than the transitional exception there does not appear to be any ability to late-file (or revoke) an election to be an electing trust. This seems particularly cruel when one considers both the breadth of the contribution rules that have been reviewed in the Series and the possibility that the application of the Section 94 NRT Rules may not be discovered until well after the deadline for filing the election.
Liability for Section 94 NRT Taxes
Collecting taxes from a Section 94 NRT will often not be easy since the Section 94 NRT Rules can apply to NRTs that have very little nexus to Canada. So, it should come as no surprise that the Section 94 NRT Rules come with some pretty powerful collection provisions to collect the taxes from persons resident in Canada. In particular, paragraph 94(3)(d) makes resident beneficiaries and resident contributors jointly and severally liable for a Section 94 NRT's unpaid taxes.10 Although subsection 94(7) together with subsection 94(8) may in some situations create a "recovery limit", which can limit the amount that the CRA can recover from a resident beneficiary or contributor, the relief will often not be available.
At this point hopefully it has become clear that the Section 94 NRT Rules have been drafted way too broadly. These rules may apply in many situations that could impact on non-specialist advisors and their clients and when they do their application can be harsh. In addition, even when the Section 94 NRT Rules offer relief, such as for an electing trust, one may often find it to be impossible for a Section 94 NRT to take advantage of the relief provided in the Act.
The fourth and final instalment of the Series will begin by reviewing the impact of the Section 94 NRT Rules first applying and later ceasing to apply to a trust. It will then review how the Section 94 NRT Rules can negatively impact on traditional cross-border Canada–US testamentary planning for Canadian clients with US beneficiaries. The Series will close with a review of some tax traps involving Pure NRTs.
1 Unless otherwise noted, defined terms in this article have the meaning designated in the first instalment of the Series.
2 Unless otherwise noted, defined terms in the Act that are used in the Series can be found in subsection 94(1).
3 The CRA has commented on the requirements to be a resident contributor in document 2012-0448681E5, dated January 4, 2013.
4 In the case of an involuntary dissolution, query whether a corporation can be said to have ceased to exist prior to the expiry of the period permitted to revive such a corporation (see corporate legislation such as subsection 241(4) – (6) of the Business Corporations Act (Ontario), R.S.O. 1990, Chapter B.16). This is because until such period has run, if the corporation is revived, it will be treated as having never ceased to exist (see Leger v. The Queen, 2010 FCA 278).
5 As a planning point, consider asking clients who have immigrated to Canada about whether they are aware of any trusts that they or members of their family have worked for, are beneficiaries of, or have established.
6 The provision of services related to the administration of the trust should be an "exempt service" and should not result in a loss of Pure NRT status, regardless of the consideration paid by the trust.
7 It may be possible for one to craft arguments that the making of a particular loan that does not constitute an arm's length transfer would not result in an increase to the FMV of the trust's shares of the EU corporation. For example, arguably a demand loan made by the Canadian resident to the Canadian subsidiary should not increase the fair market value of the shares held by the trust as it would not increase the fair market value of the equity of the Canadian subsidiary or otherwise affect the fair market value of the property held by the trust. However, such a loan may nonetheless result in a transfer of property to the trust pursuant to paragraph 94(2)(c) if one of the reasons for making the loan was to avoid or minimize a liability under Part I of the Act. Such a discussion is beyond the scope of this Series.
8 Exempt persons, such as government and tax exempt entities, and persons who are "successor beneficiaries" (see the defined term in subsection 94(1)) at a particular time are also excluded from being resident beneficiaries.
9 For a more detailed discussion on this subject see the article by Harris et al. (cited in the first instalment of the Series).
10 Pursuant to the rules in subsections 94(16) and (17) it is possible for one or more "electing contributors" to elect to pay each of their proportionate shares of a Section 94 NRT's tax liability. The rules relating to electing contributors are complex but there are excellent discussions of these rules in the Harris et al. article, which was cited in the first instalment of the Series.
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.