Offshore Trusts: Opportunities for Families with Canadian Connections

March 19, 2013

Canada's rules for taxation of offshore trusts have been undergoing a fundamental review since 1999. The federal government on October 24, 2012 released the eighth iteration of draft legislation ("Draft Legislation") amending the Non-Resident Trust ("NRT") rules. The NRT rules are scheduled to become effective (retroactively) on January 1, 2007.

If adopted, the Draft Legislation will substantially revise the Canadian taxation of offshore trusts. The Draft Legislation limits opportunities for tax avoidance by deeming certain trusts not resident in Canada under general law to be resident where a person resident in Canada transfers or loans property or provides financial assistance or services to an offshore trust. The additional requirement under the existing rules that there must be a Canadian-resident beneficiary of the trust is dropped for most purposes in the Draft Legislation. Canada, unusually, imposes reporting and tax paying requirements directly on offshore trustees.

Notwithstanding these fundamental changes opportunities with using offshore trusts remain including for individuals wishing to move to Canada and for foreigners wanting to make substantial gifts or bequests to Canadian resident family or friends. These and other opportunities are discussed below.

A. Gifts or Bequests by Non-Residents

Gifts or bequests made by a non-resident to a Canadian resident through a trust remain attractive for Canadian beneficiaries under the Draft Legislation. The trust should not be deemed resident in Canada where the trust's sole Canadian connection is a beneficiary resident in Canada. Canadian resident beneficiaries should not be taxed on the receipt of capital distributions (as determined for Canadian tax purposes) including income and gains from prior years capitalised by the trustee. All distributions (whether of capital or income) must be reported. By contrast, where a gift or bequest is made to the Canadian directly, the Canadian will be subject to tax in Canada on worldwide income (and gains) earned from the gift or bequest. Thus, non-residents gifting assets to Canadians or making provision for Canadians in their will should consider transferring the property to a trust for the benefit of the Canadian, rather than directly.

Issues raised in the past for Canadian resident beneficiaries of non-resident trusts under the draft Foreign Investment Entity (FIE) and the Offshore Investment Fund Property (OIFP) regimes are generally no longer a concern. First, the 2010 Canadian federal budget abandoned the controversial draft FIE legislation (also originally proposed in 1999), which would have tightened the rules for Canadian residents holding non-controlling interests in non-resident entities owning primarily passive investments. Instead, the Draft Legislation proposes limited amendments to the existing OIFP rules. Secondly, the Draft Legislation clarifies that the OIFP rules should only apply to Canadian resident beneficiaries of non-resident commercial trusts.

B. The Five Year Immigration Trust

The Draft Legislation maintains the current attractive exception for a trust with non-resident trustees funded exclusively by a new immigrant to Canada. Such a trust is not generally taxable in Canada for a period of up to five years after the settlor becomes a Canadian resident. The offshore trust will be deemed resident and taxable in Canada from the beginning of the tax (i.e., calendar) year in which the settlor's fifth anniversary as a Canadian resident occurs. If the (sole) settlor decides to leave Canada within five years or if the settlor dies within this period, the trust would never be deemed resident in Canada.

Distributions during the five year period follow the same attractive rules as discussed above. A Canadian resident beneficiary can receive distributions of trust capital (as determined for Canadian tax purposes) without tax in Canada though the distribution would be reportable.

A 'five year immigration trust' is usually unwound at the end of the five year period, unless there are non-tax reasons for maintaining the structure. The structure can generally be unwound with little (or no) Canadian tax, and assets can be distributed to the settlor (or possibly another Canadian beneficiary) with a tax cost equal to the value of the assets at the time. As a result, careful planning may avoid Canadian tax on the asset portfolio held by the trust for the first five years of a settlor's residency in Canada.

The Draft Legislation bolsters the 'five year immigration trust' regime by exempting immigrant settlors from a domestic attribution rule that would otherwise attribute the income and gains of the trust to the settlor where the trust is revocable, the settlor is a beneficiary or the settlor retains control over distributions from the trust. Therefore such immigrant settlors may be able to participate as beneficiaries of non-resident trusts without inclusion of income accruing in the trust.

C. Trusts Established by Former Canadian Residents

Under the Draft Legislation a trust would be deemed resident in Canada where it (i) received a contribution from a Canadian resident within 60 months of the person leaving Canada and (ii) had a Canadian resident beneficiary. This 'look back' period is reduced to 18 months where a trust is created on the death of an individual. A former Canadian resident wishing to establish a trust for the benefit of a Canadian resident could (as an interim measure) provide for the creation of a trust in their will and, when the 60 months have elapsed, actually create the trust. This would permit the settlor to achieve his estate planning objectives while mitigating tax in Canada.

Alternatively, where a former resident does establish a trust within 60 months of leaving Canada and the rights of Canadian residents to benefit from the trust arise solely on the death of the settlor, the trust should not be deemed resident in Canada until the settlor's death.

D. Grandfathered Deemed Resident Trust with Non-Resident Beneficiaries

The worldwide income (and gains) of a trust deemed resident under the Draft Legislation will be subject to tax in Canada. However a trust can generally deduct from its income (as determined for Canadian tax purposes) distributions to beneficiaries of trust income. Income distributions may be subject to Canadian non-resident withholding tax at a rate of 25% (unless reduced by a tax treaty), except where the trust is grandfathered from the withholding tax and income distributions meet certain other requirements. A trust will generally be grandfathered if it was created before 30 October 2003 and no "contribution" (broadly defined) was made to the trust by any person (whether or not Canadian resident) after 17 July 2005. Accordingly, a grandfathered trust should not be subject to tax in Canada if it annually distributed all of its income and realized gains to non-resident beneficiaries. This would be attractive if the beneficiary lives in a low (or no) tax jurisdiction.

E. Trusts for the Mentally or Physically Infirm and Marriage Breakdown

Exceptions are also made where a Canadian resident establishes an offshore trust for non-resident dependents who are mentally or physically infirm and for a trust created as a consequence of the breakdown of a marriage for the benefit of the non-resident (former) spouse and children. The latter exception was secured by Stikeman Elliott.

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