Canadian non-resident trust rules: Enacted after 14 years

September 30, 2013

Surprise! Fourteen years after being proposed, and nearly seven years after their effective date, the new non-resident trust rules were finally adopted on June 26, 2013 (the "New Rules"). They were first mooted in the 1999 Canadian federal budget.

The New Rules substantially revise Canadian taxation of non-resident trusts. They generally apply from January 1, 2007, unless a trust elects to have the New Rules apply from 2001.

The New Rules make the tax regime for foreign trusts more attractive for immigrants who have been resident in Canada for less than five years, but more onerous for long-term Canadian residents. The New Rules provide an exception for so-called five-year immigration trusts. Generally, a non-resident trust is not deemed resident and not taxable in Canada (except on Canadian source income) if all contributors have been resident in Canada for less than five years. On the other hand, a trust may be deemed to be resident in Canada under the New Rules when a person resident in Canada for more than five years makes a contribution to the trust.

Gifts or bequests made by a non-resident to a Canadian resident through a trust also remain attractive under the New Rules, as the trust will not be deemed resident in Canada where it has no Canadian contributors. Canadian resident beneficiaries are not taxed on receipt of capital distributions (as determined for Canadian tax purposes).

Key characteristics of the New Rules are:

Deemed Resident Trusts - A non-resident trust that receives a "contribution" from a Canadian resident is deemed resident in Canada and generally taxable on its worldwide undistributed income. A non-resident trust is also resident and taxable in Canada where (i) the trust receives a contribution from a former Canadian resident, either within five years of leaving Canada or within five years before returning to Canada, and (ii) the trust has a Canadian resident beneficiary. There is no grandfathering for trusts established prior to the New Rules, so all transfers to a trust (including those made before 2007) should be reviewed in the context of the New Rules to determine whether a transfer could now be treated as a contribution to a trust.

Trustee Liable for Tax and Reporting / Settlor and Beneficiaries Jointly Liable - The non-resident trustee of a deemed resident trust remains liable for the trust's Canadian tax obligations. Should the trustee fail to pay the trust's taxes, each Canadian resident contributor is jointly liable with the trust without limit for the unpaid tax, unless the contributor elects to be taxed on their proportionate share of the income and gains of the trust (an "electing contributor"). Canadian resident beneficiaries are also jointly liable for the trust's Canadian tax obligations up to the amount of distributions received, benefits enjoyed from the trust and, after August 27, 2010, any amount received as a loan from the trust.

Relief for Contributions by Non-Residents Requires Filing an Election - A deemed resident trust must file an election with the Canada Revenue Agency to benefit from relief for contributions by non-residents to the trust. If the election is made, a notional trust (called a "non-resident portion trust") is deemed to be created for income tax purposes to hold assets attributed to the non-resident portion. This notional trust will not be taxable in Canada, except on certain types of Canadian source income. If no election is made, any contribution (even nominal) from a Canadian resident (or certain former residents) will result in the entire trust being subject to tax in Canada.

Contributions - The meaning of "contribution" is broadly defined in the New Rules and includes direct or indirect transfers or loans, the provision of services, guarantees or other financial assistance, certain transfers made at the direction or acquiescence of another person, and the issuance of shares or debt. There are exceptions for "arm's length transfers" (as defined), "exempt services" (as defined), and loans made by Canadian financial institutions to non-resident trusts.

Distributions Subject to Withholding Tax - Distributions of trust income from a deemed resident trust to a non-resident beneficiary are subject to Canadian withholding tax at a rate of 25%, unless reduced by a tax treaty. This includes distributions of non-Canadian source income. There is limited grandfathering from this withholding tax for trusts established before October 30, 2003.

Settlor and Beneficiary Reporting - A Canadian resident contributor must report a non-resident trust (including a deemed resident trust) annually. Canadian resident beneficiaries are required to report the receipt of distributions (both capital and income) or loans from such trusts.

Reversionary Trusts (the Sommerer Decision) - The March 21, 2013 Canadian federal budget proposes to amend the New Rules in response to the decision of the Federal Court of Appeal in The Queen v. Sommerer (2012 FCA 207). The court held that the trust attribution rule in subsection 75(2), which applies to reversionary trusts, did not apply where property is received by a trust in exchange for fair market value consideration. (The case actually dealt with an Austrian foundation assumed to be a trust for purposes of the decision.) The government did not agree with the decision. Budget 2013 proposes to make a reversionary trust that receives a contribution from a Canadian resident for fair market value consideration deemed resident and so taxable in Canada including on the income (and gains) that would have otherwise been attributed to a Canadian contributor had subsection 75(2) applied.

Exceptions for Commercial Trusts - The New Rules do not apply, under certain conditions, to non-resident commercial trusts (e.g., mutual funds, and superannuation or pension funds). However, the OFIP rules (see below) could apply to a Canadian resident holding an interest in certain non-resident commercial trusts.

Treaty Residence - The New Rules amend the Income Tax Conventions Interpretation Act (Canada) to treat a trust deemed resident in Canada under the New Rules as being resident in Canada for tax treaty purposes (and not a resident of the other contracting state). It is unclear how this will affect treaty tiebreaker rules in cases of dual residence.

Offshore Investment Fund Property (OFIP) Rules - The OIFP rules apply where a taxpayer has invested in "offshore investment fund property" and one of the main reasons for the investment is to reduce or defer the tax that would have arisen if income from the assets of the fund had been earned directly. Following adoption of the New Rules, the OFIP rules should only apply to Canadian resident beneficiaries of non-resident commercial trusts.

We are happy to assist with any questions arising from these matters. Feel free to contact any member of the International Private Client & Tax Policy Group.

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