Many Canadian residents invest in mutual funds established outside of Canada. Often, the motivation for such investments has nothing to do with tax issues. Rather, in many cases, such funds offer better yields or more attractive asset mixes than domestic funds.
In certain cases, such funds may not be directly distributed to Canadian residents, and a Canadian seeking to invest in them may have to form an offshore entity to acquire an interest.
Such funds can be structured either as trusts or corporations, and there is often considerable confusion regarding how such investments should be treated for Canadian tax purposes.
Canadian mutual fund corporations and trusts would normally distribute all their income annually (including realized taxable capital gains) to investors in order to avoid taxation at the entity level. A T3 or T5 would be issued to investors. That distribution would not normally happen with an offshore fund. If there were any distributions, a Canadian resident investor would have to determine the nature and taxability, and, if applicable, report income for Canadian tax purposes.
But, what if there are no distributions? In those cases, on the face of it, there is nothing for the Canadian resident to report until there is an actual sale or other “disposition” of the interest in the fund.
In this regard, it should be noted that section 94 of the Income Tax Act (“the Act”) has complex, often punitive rules that apply to situations where a Canadian resident makes a contribution to a non-resident trust. However, a widely-held offshore mutual fund trust would normally be an “exempt foreign trust” based on paragraph “h” of the definition thereof in subsection 94(1) of the Act.
In addition, if the mutual fund is a corporation, it is not likely that the “FAPI” rules would apply-that generally would require significant ownership by the Canadian investor.
Given that, holding an interest in an offshore mutual fund can provide significant tax deferral, since, normally, interest, dividends, and capital gains would be reinvested, rather than distributed. In addition, this can also result in the conversion of what would otherwise be income into capital gains.
It is precisely because of this potential for tax deferral and savings that the Ministry of Finance introduced and continually revised draft legislation regarding “foreign investment entities” (“FIEs”) during the first decade of this century. These rules were mind-boggling and would have required the adoption of various methods of reporting unrealized income. These “FIE” rules (in revised section 94.1 of the Act) were intended to replace the generally toothless “offshore investment fund property” rules that previously were housed in that section since 1984.
Eventually, Finance relented, and only made relatively minor changes to section 94.1, which in its current form, applies to taxation years ending after March 4, 2010.
If these rules apply, the investor is generally required to recognize income for tax purposes each year equal to the CRA prescribed rate plus 2% (currently amounting to a total of 3%) of the adjusted cost of the investment.
However, section 94.1 will only apply if a purpose test, found in paragraph 94.1(1)(e), is met.
In particular, section 94.1 will only apply if:
“it may reasonably be concluded, having regard to all the circumstances…… that one of the main reasons for the taxpayer acquiring, holding or having the interest in [the fund]was to derive a benefit from …. investments…… in such a manner that the taxes, if any, on the income, profits and gains from such assets for any particular year are significantly less than the tax that would have been applicable under this Part if the income, profits and gains had been earned directly by the taxpayer.” (italics added)
From my experience, Canadian investors often invest in offshore mutual funds for reasons that have nothing to do with tax deferral.
In addition, if tax deferral is a factor, at least within the context of equity-based mutual funds, it is not because the investor would have ever considered making direct investments in the underlying assets of the fund that generate its income. Rather, the investor would have invested in a mutual fund in any event because of the fact that it provides the diversity and management that he or she could never have achieved with direct investment of underlying assets. However, instead of investing in a Canadian-based mutual fund, an offshore fund was chosen to avoid the annual T3/T5. I submit that the wording of the purpose test is not broad enough to capture such tax-motivated investments.
Given that, it is doubtful that section 94.1 would apply to many situations in which Canadians invest in offshore mutual funds, and an investor who has an accountant who wants to report deemed income pursuant to that provision should seriously question whether that accountant has given appropriate consideration to the purpose test discussed above.
However, notwithstanding my views on this matter, taxpayers should be forewarned that the CRA may not be inclined to see matters in the same light. For example, in CRA Document 2013-0485311C6 they stated:
“One of the conditions for the application of section 94.1 is that one of the main reasons for the taxpayer acquiring, holding or having the interest in the offshore investment fund property was to derive a benefit from portfolio investments in certain assets in such a manner that the taxes on the income, profits and gains from the assets for any particular year are significantly less than the tax that would have been applicable under Part I of the Act if the income, profits and gains had been earned directly by the taxpayer.
Based on case law on the “one of the main reasons” test in other provisions of the Act, it is our view that tax reduction or deferral does not have to be the only reason, or even the main reason for the investment; it merely has to be one of the main reasons. A particular fund manager’s expertise may be another of the main reasons for the investment. The onus is on the taxpayer to prove that none of the main reasons for the investment is tax reduction or deferral”
It is questionable whether a taxpayer has the onus that the CRA suggests.
The one reported case that dealt with the prior version of section 94.1, which had a similarly worded purpose test, Walton v. The Queen, 98 DTC 1780 (TCC), found in favour of the CRA, but the facts in that case seemed to clearly support the conclusion that the purpose test was met.